Cara's Purchase of The Keg - Part II: Main Components of Value

In our last post, we looked at what Cara will be acquiring when it closes its acquisition of Keg Restaurants Ltd. (KRL). In this post, we dig into the Keg’s numbers a little more to try and figure out why Cara is reportedly paying over $200M for KRL’s shares. Bear in mind that these observations are based on a somewhat cursory review of the transaction and the limited data that is publicly available; I certainly would not recommend basing any investment decisions on them.

As we discussed previously, Cara is acquiring three main assets in this deal:

• KRL’s 3.5M units in the partnership that underlies Keg Royalty Income Fund (KRIF), an investment vehicle that receives a royalty equal to 4% of the gross sales from all Keg restaurants. These are assigned a market value of $73.9M on KRIF’s 2017 Q3 financials (the units are recorded as long term liabilities on KRIF’s balance sheet).
• A 2% royalty (i.e. the 6% charged to franchisees, minus the 4% paid to KRIF) on the gross sales of the 56 franchised Keg restaurants.
• The revenue and expenses from the 48 corporate-owned restaurants that do around $300M in annual sales.

Let’s take a closer look at each of the above.

Partnership units

KRIF reports that it has around 11.4M units outstanding, but that on a fully-diluted basis the number of units would be 14.9M (2017 Q3 report, p. 12). This is because KRL’s 3.5M partnership units are exchangeable for KRIF units on a 1:1 basis. Given that the 11.4M fund units have a market cap of around $220M (it was slightly higher at the time the 2017 Q3 balance sheet was prepared), the 3.5M partnership units would therefore now be worth around $68M ($220M/11.4M x 3.5M = $68M).

Looking a little closer, I am not sure if the math is as simple as that. It appears that the partnership units get a slightly better distribution from KRIF than the regular unit holders; they have received around 27% to 28% of KRL’s total operating income over the past year, as opposed to 23% (which they would receive based on 3.5M/14.9M = 23% of the fully diluted units), as shown below:

There also appears to be some reference to this in the notes to the latest quarterly report; for example, Note 7 to the financial statements says:

The Class D units were issued to KRL in return for adding net sales from new Keg restaurants to the Royalty Pool and are entitled to a preferential proportionate distribution and a residual distribution based on the incremental royalty paid to the Partnership.

This would imply a somewhat higher valuation for these partnership shares ($220M/73% x 27%) = $81M.

Now, this assumes that the cash flows for both the KRIF units and the partnership shares will continue to grow at the same rate. This is likely not reasonable; as we discussed in our previous post, when a new Keg store is added, most of the value of the incremental royalties from that store accrue to KRL in the form of new partnership shares. How do we adjust for that?

The yield on the KRIF units is around 6%; that is, the annual distribution is around $1.20 for every unit worth $20. The yield, or capitalization rate, is a function of:

a) the risk free rate,

b) the equity risk premium,

c) an industry risk factor (this will likely be negative, since the cash flows of KRIF are very stable, as we’ll discuss below)

d) a projected growth factor.

Without getting into the details of all this, if one assumes that the income allocated to KRL’s partnership shares will increase, say, 1% per year faster than the income to the regular KRIF fund units, then the required yield on the KRL shares would be 5%, and the value of the shares would be 20% higher than the KRIF units. If we make that adjustment, our $81M suddenly becomes $97M ($81M x 6%/5%).

The 2% royalty

The 2% royalty alone would appear to be worth around $6M per year in revenue (based on annualized franchised sales of around $320M. How much of this flows to the bottom line? Looking at Cara's segmented reporting for 2017, it seems like around 85% of royalties flow to the bottom line as pre-tax operating income:

So the $6M in revenue yields around $5.2M in pre-tax profit, or $3.9M after tax (using a tax rate of around 25%). Assuming a capitalization rate of 5% (based on the same growth assumptions as above) would give a value of around $77M for the royalty stream to goes directly to KRL.

The Corporate Stores

This is a bit more tricky to figure out.

We know the existing 48 corporate-owned restaurants do around $300M in annual sales (2017 Q3 report, p. 13).

Based on Cara's management presentation, normalized EBITDA for KRL prior to payment of royalties to, and receipt of interest income from, KRIF, was $41.9M; after considering those amounts, the EBITDA is $23.5M. I find these figures somewhat puzzling; the corporate stores only pay around 4% x $300M = $12M in annual royalties to KRIF, and the partnership shares receive around $10M in annual distributions, so I don’t see how you get an adjustment to EBITDA of $18.4M.

In any event, the value of the interest paid to the partnership shares is the basis for the value of those shares, so to value the corporate stores on a standalone basis, we need to take their pre-royalty EBITDA (which I’ll assume for purposes of this exercise is $41.9M) and deduct $12M in royalties paid to KRIF. We also need to strip out the $5.2M in royalty operating income, which we’ve treated separately. This suggests that on $300M in annual sales, the corporate stores are generating EBITDA of around $25M, or around 8%.


Interestingly, this is very similar to the EBITDA margin that Cara’s corporate-owned restaurants earned in Q3 of both 2016 and 2017. At first glance, this is somewhat surprising, given that the narrative around this deal is that the management team from the Keg will be coming in to improve operations at some of Cara’s higher end brands. However, don't forget that our 8% margin is after deducting a 4% royalty paid to KRIF; Cara's corporate stores (I assume) do not pay such a royalty, so actually KRL's operations do seem to be more efficient than Cara's.


So that’s EBITDA; how much free cash flow does KRL make on these restaurants? Unfortunately, we don’t have enough information to say. Cara’s financial filings indicate that capex for corporate stores for the past couple years have averaged around 10% of sales. I haven’t researched whether this is a long-term average or just a temporary surge; if the former is the case, then it would suggest that corporate restaurants are not generating much, if anything, in the way of free cash flows or standalone value.

Debt

So far, we've looked at the cash flows to KRL before consideration of debt. To get the share value, you need to deduct the value of the interest bearing debt.

Cara's management presentation shows that KRL has net debt of $25M ($35M in debt less $10M in cash).

KRIF's balance sheet shows that KRL owes it $57M on a note payable, which pays an interest rate of 7.5%. KRIF thus gets around $4M in interest payments from KRL per year.

Conclusion

After all that, things are still pretty murky. However, we can offer a few tentative conclusions:

• The main source of value in KRL lies in the royalties that are generated from The Keg restaurants. This value is split between a) KRL’s partnership units in the underlying partnership of KRIF and b) the additional 2% royalty stream that franchisees pay to KRL.
• The corporate owned stores, while they generate $300M in annual revenue, do not have as much value, at least on a standalone basis.

This does not mean that KRL should simply close up these locations, of course; the larger footprint created by having over 100 restaurants creates value to the brand, and absent those stores the other sources of value would shrink dramatically.

---

Cara's Purchase of The Keg - Part I: An Overview of Keg Restaurants Limited

Yesterday, Cara Operations Ltd. – owner of such iconic brands as Harvey’s, Swiss Chalet and East Side Mario’s – announced the purchase of Keg Restaurants Ltd. (KRL) in exchange for $105M in cash and around 3.8M new shares of Cara with a current value of $94M. In the next few days, I'll be doing a series of posts on the transaction. Today's post gives an introduction into just who KRL is.

Prior to the acquisition, KRL was 51% owned by Fairfax Financial. Fairfax is a large company, and does not disclose KRL’s results – either its balance sheet or income statement - separately. This raises the question: What is Cara buying?

While information on KRL is not so easy to come by, around 15 years ago KRL spun off its intellectual property (mainly its brands) into a separate, publicly traded entity called the Keg Royalties Income Fund in exchange for around $113M. (The publicly traded KRIF units are not part of the Cara transaction, although the ones owned by KRL are.) The public filings of KRIF contain some interesting information on KRL and give us some picture of what Cara is getting in the deal. To wit:

• As of October 1, 2017, KRL owned and operates 48 “Keg” restaurants in Canada and the USA. There are an additional 56 franchised restaurants, all of which are located in Canada (KRIF 2017 Q3 Report, p. 3). The total number of stores has actually declined somewhat in the past couple of years (ibid, p. 6), but has hovered between 100 and 105 in the past couple of years.
• Interestingly, in the quarter ended October 1, 2017, the 56 franchised stores did $80.6M in sales (or $1.4M per store), while the 48 corporate stores did $73.8M in sales (or $1.5M per store) (ibid., p. 13), so at least on a sales basis there is not much difference between the franchised and corporate stores.
• According to the Keg’s website, franchisees pay a royalty equal to 6% of gross sales. In addition, they pay a marketing fee equal to 1.5% of gross sales.
• KRIF receives a royalty equal to 4% of gross sales from (essentially) all of the Keg restaurants (both franchised and corporate-owned). Annual sales from these restaurants are around $600M (which means the average Keg restaurant does around $6M in annual revenue), so royalties paid to KRIF are around $24M per year.
• KRIF has around 11M units that are publicly traded, with a market price per unit of around $20 (although this dropped by almost 4% yesterday), and thus a total market cap of around $220M. KRL owns around 3.5M shares in The Keg Rights Limited Partnership (the legal entity that actually owns the Keg brands and which issues the payouts to the KRIF) that are exchangeable for KRIF units on a 1:1 basis; effectively, KRL’s shares in KRIF are the equivalent to around 1/3 of the market cap of KRIF, or $74M. At least, that is the value assigned to the KRIF partnership units in Cara’s management presentation yesterday and which appears on KRIF's balance sheet, although I wonder at this valuation, given that historically the distributions of “interest” payments to the KRL units have represented a higher proportional allocation (closer to 1/3 of KRIF’s operating income than the 1/4 they would be entitled to if they converted to KRIF units). I'll talk a bit more about this in my next post.
• Moreover, while existing unitholders of KRIF benefit from growth in same-store sales of existing Keg units, whenever a new Keg store is added almost all of the benefit accrues to KRL in the form of additional partnership units being issued.

So what is Cara buying? It is getting:

• A 2% royalty (i.e. 6% minus the 4% paid to KRIF) and 1.5% marketing fee on the gross sales of the 56 franchised restaurants.
• 3.5M Partnership units in the underlying partnership of KRIF.
• The revenue and expenses from the existing 48 corporate-owned restaurants.
• The potential for growth in either corporate stores (and their associated profits) or franchised stores (which generate initial franchise fees of $75,000 and incremental royalties).
• Based on yesterday’s management presentation, KRL has $25M in net debt ($35M of debt, less $10M in cash).

In the next post, I'll delve into KRL's numbers a bit more from a valuation perspective.

---

The Award in an Alberta Franchise Rescission Case - Essa v Mediterranean Franchise Inc.

Introduction

Reported decisions dealing with the quantification of the rescission remedy under the various provincial franchise disclosure acts are rare. Of the few reported cases, most have come out of Ontario. The trial decision in Essa v. Mediterranean Franchise Inc 2016 ABQB 178 provides a welcome opportunity to see the rescission remedy of the Alberta Franchises Act (“AFA”) in action. In this article, I analyze the financial concepts behind the different categories of expenditures that comprised the trial judge’s award.

Background

Mr. Essa and his business partner purchased a “Taste of Mediterranean” franchise in Edmonton in 2010. The business was not successful, and closed after nine months of operation.

The trial judge found that the disclosure document provided was deficient in several respects, including:

• Failing to disclose telephone numbers of existing franchisees
• Failing to disclose a list of all unit closures within the past three years
• Failing to comply with disclosure requirements regarding earnings claims
• Failing to comply with disclosure requirements regarding financing arrangements

For these reasons, statutory rescission was granted under section 13 of the AFA.

Unlike all of the other provincial franchise disclosure legislation, the AFA does not break down the rescission remedy into four separate components or "buckets". Section 14(2) of the AFA states simply that in the event of a rescission due to non-disclosure:

 “The franchisor or its associate, as the case may be, must, within 30 days after receiving a notice of cancellation under section 13, compensate the franchisee for any net losses that the franchisee has incurred in acquiring, setting up and operating the franchised business" (emphasis added)

In Essa, while the evidence was that the plaintiff lost money operating the business, the plaintiff did not present a calculation based on the overall results of the business; though not stated in the decision, this may be because detailed accounting records were not kept. Instead, Mr. Essa presented the following claims for losses:

  

 These amounts were all accepted by the trial judge.

Analysis

Do the above amounts overcompensate or undercompensate the franchisee? It is not possible to say, based on the information contained in the decision. However, we can offer the following conceptual commentary:

In general, businesses spend money to either a) buy assets or b) fund operating losses. In a franchise rescission, assuming the assets are no longer of any value, the franchisee is entitled to receive an amount equal to what it paid to fund its assets and operating losses. Broadly speaking, this is how Ontario's Arthur Wishart Act works, and there is no reason the AFA would not work the same way. The only difference is that under the AFA, these two categories can be offset against one another; thus, if a franchisee paid $100,000 for the assets of her business and made a $30,000 profit, the rescission remedy in Alberta would be $70,000, whereas in Ontario it would be $100,000.

With that introduction, we can now analyze the rescission award in Essa.

• The franchise fee and store purchase amounts are moneys paid for assets that are of no value following a rescission. Given that it was established that the plaintiff did not make any money running the business (i.e. there is no offsetting profit), the amounts awarded under these categories make ample sense.
• In Ontario, a separate claim for royalties and ad fund payments would be uncontroversial; there is a separate subsection (6(6)(a)) for amounts paid to the franchisor. In Alberta, however, the only reason to include these as separate heads of claim would be if it were established that the business broke even (or lost money) prior to considering these amounts. This may have been the evidence before the court; it is difficult to tell.
• The claims for capital infusions are amounts paid into the business, not out of the business. These infusions would be used to either buy assets or fund losses. Strictly speaking, if a franchisee is already claiming for amounts paid for a) assets and b) operating losses, it cannot also claim for the cost of funding those cash outflows; to do so would likely result in double-counting. That is, if the business incurred $100,000 in operating losses and borrowed $100,000 to fund those losses, it can only claim a rescission remedy of $100,000, not $200,000. This is an error I have seen in many rescission claims.
• That said, in cases where it is very difficult to quantify the amounts spent based on the accounting records, it may be possible to arrive at a reasonable estimate of the franchisee’s losses by looking at how much money the franchisee invested (both debt and equity) in the business; that is, if you can't measure the money going out of the business, you can measure the money going in. It appears that in this case the cash infusions were being used by the trial judge in precisely that manner, as a proxy for operating losses.
• Finally, the claim of $36,000 for unpaid owner/manager labour was based on an hourly wage of $10. Based on 9 months of operating the business, this works out to around 50 hours per week for each of Mr. Essa and his wife. The court noted that Mr. Essa’s hourly rate as an engineer was $300, and concluded that the claim for unpaid wages was “properly compensable as part of their net loss just as much as actual payments to employees would have been compensable had they any other employees” (para. 230).

All in all, the overall rescission remedy appears reasonable.

Dow Chemical v Nova - Differential Profits and "Indirect NIA"s

Last year’s award of over $644M in Dow Chemical Company v. Nova Chemicals Corporation, 2017 FC 350 [1] is one of the largest awards for intellectual property infringement in Canadian history. The decision of Justice Fothergill contains many novel points of interest, but perhaps none so significant as his treatment of the issue of non-infringing alternatives and the deduction of fixed and capital costs in determining Nova’s profits to be disgorged to Dow.

The case involved Dow’s patent (the “705 patent”) for the production of a certain type of metallocene linear low density polyethylene (mLLDPE), a type of plastic. The patent was used by Dow to produce its ELITE mLLDPE, and the same technology was used by Nova in its SURPASS product. A previous trial had found that Nova had infringed on the 705 patent from 2002 until it expired on April 19, 2014, and as its financial remedy Dow elected (and was granted) an accounting of Nova’s profits from the sale of SURPASS.

Differential Profits

Over the past decade, Canadian courts have generally adopted what has come to be known as the “differential profits” approach. This approach, as described by the Supreme Court in Monsanto Canada Inc. v. Schmeiser, [2004] 1 SCR 902, 2004 SCC 34, says that in accounting for the defendant’s profits from infringement, one makes “a comparison … between the defendant’s profit attributable to the invention and his profit had he used the best non-infringing option”.

The notion behind this treatment is that the defendant should only be required to disgorge the incremental benefit it received as a result of the infringement of the patent. If, instead of infringing, the defendant would have devoted its efforts to some other enterprise, then the true benefit of the infringement is only the difference between the profit actually earned and the profit that would have earned from the alternative.

In much of the case law since Schmeiser, the application of the concept of “differential profits” has generally been limited to cases where it has been possible to identify a non-infringing alternative product (or technology) that would have been sold to the same customers that purchased the infringing units.

The effect of this focus on non-infringing alternative products has been that, when the infringing product embodies proprietary technologies that are key drivers of sales, such that it is not plausible the same customers would have purchased an alternative, non-infringing product from the defendant, the differential profits approach has generally been ignored, until Nova.

“Indirect NIA”

In Nova, it was acknowledged that there was no real non-infringing product that could have been sold to the purchasers of SURPASS; while Nova produces many other types of LDPE, none of these contained the unique features of ELITE or SURPASS that made those products so appealing to their customers.

However, Nova argued that but for its infringing activities, it would have deployed the production capacity used to manufacture SURPASS to make other types of plastic, which would have been sold to different customers. Nova referred to this as an “indirect non-infringing alternative” (para. 146).

The court accepted this argument, and allowed Nova to deduct a proportionate share of its fixed costs and capital expenditures related to the plant that had been used to manufacture the infringing product. The court noted that:

The “best non-infringing option” has generally been interpreted to mean a “true substitute” or “real alternative”. But appellate courts have frequently sought to reduce over-generous awards, including those that neglected to take into account alternative profits. The Federal Court of Appeal recently emphasized that “at bottom is the need to ensure that a patentee only receives that portion of the infringer’s profit that is causally attributable to the invention” (para 164, citations omitted).

Did the Court Apply a True “But for” Analysis?

Nova had argued that but for the infringement, it would have manufactured other products; if so, then it might have been appropriate for the court to analyze what the profits from those other products would have been. The court could have looked to the average profit per pound of other product during the relevant period and deducted this amount against the actual profits.

Why did the court instead simply allow for a pro-rata deduction of fixed and capital costs? First, it is not clear from the written decision whether Nova in fact attempted to claim as an offset, the profits it would have made from these alternate products. In addition, there is precedent for the court’s approach from other Commonwealth jurisdictions.

As a “shorthand” approach, the court’s approach has much to recommend it; rather than undertake a full analysis of the profits earned on other products, one can likely assume that in most cases, at the very least, those profits would have covered the fixed operating costs of the plant. But by deducting only a pro-rata portion of fixed and capital costs, rather than projecting the profit Nova would have made from alternate use of its fixed capacity, the court may have overstated Nova’s true benefit from its infringing activity.

What this means

This ruling would seem to augur the adoption of a broader, more holistic approach to the accounting of profits. The profits to be disgorged should be equal to a) the actual profits achieved as a result of the infringement in the real world, less b) the level of profit that would have been achieved in the “but for” world in which the defendant does not infringe.

This article originally appeared in The Lawyer's Daily (a LexisNexis Publication) on September 14, 2017

---

[1] In that decision, Justice Fothergill set out the framework for the calculation of damages. In 2017 FC 637, he addressed certain outstanding issues and issued the award.

Ontario's New Minimum Wage - Impact on Profits of the Restaurant Industry

Introduction

On January 1, 2018, the minimum wage in Ontario government changed from $11.60 to $14.00. It is scheduled to rise to $15.00 in 2019.

The move has provoked negative reactions from business groups. For example, according to Restaurants Canada:

“These aggressive changes to labour legislation will have severe and immediate consequences for the foodservice industry and the customers they serve every day. Prices for consumers will go up. Jobs will be lost, it’s as simple as that." A recent story in the Globe and Mail contains different reactions from restaurant owners; some are unfazed, others somewhat less so.

This issue is also of interest to business valuators such as myself. Valuations of established businesses are often based on the future anticipated profits or cash flows of a business. These are typically projected based on an analysis of the business's historical results, adjusted for forecasted changes. Valuators need to understand how the change to the minimum wage will impact profitability going forward.

The Data

Somewhat surprisingly, when we look at average labour costs for limited service restaurants (as a percentage of revenue) for the period 2001 to 2012, we see surprisingly little change:

The chart (which is based on data from Statistics Canada, CANSIM Table 355-0005) includes several periods where the minimum wage stayed constant in nominal dollars.

For example, in BC the rate was stagnant at $8.00 per hour from November 2001 until May 2011.  During that period, the CPI for restaurant food grew by 35%. Assuming that the average restaurant has 75% of its employees making the minimum wage, one would have expected the average cost of labour at BC restaurants to fall to 23% of revenue. Yet that did not happen.

The chart also includes periods in which the minimum wage grew very quickly. Again looking at BC, the minimum wage in 2010 was $8.00; in 2012, the average was approximately $10, an increase of 25% (slightly higher than the proposed Ontario change). A restaurant with 75% of its employees making the minimum wage would expect to see its cost of labour rise from 29% to 33%. Yet that did not happen.

Some (Tentative) Theories

What should one make of the data?

One theory might be that restaurants are able to pass along wage increases to consumers in the form of higher prices; the Globe and Mail article gives some examples of restaurants that are planning to do precisely this. Unlike, say, a manufacturing plant, restaurants cannot really be moved to other jurisdictions with more favorable labour laws. A change affecting all restaurants will therefore result in higher prices for consumers.

Another possibility is that the aggregate data shown above masks significant changes.

Imagine for a moment that there are two types of restaurants: prosperous ones who have an average wage cost of 25%, and less efficient ones whose average cost is 35%. The former have profit margins of 15%, the latter have profit margins of 5%. A rapid hike in wage costs equal to 5% of revenue will mean that the less prosperous firms will no longer be viable; they will be forced to close.  The more prosperous firms, meanwhile, will see an increase in their labour cost, such that the industry average will remain 30%.

A third possibility is that the increase in third-party wage costs results in owners (many of whom pay themselves via a salary) being forced to reduce their own wages.

Reasonable Royalties in Patent Litigation

Introduction

Until recently, there had been few reported Canadian patent infringement decisions dealing with reasonable royalties. This has changed in the past several years. This article looks at some of the key developments in this area of patent infringement financial remedies.

In patent litigation, the concept of a “reasonable royalty” is employed in two ways. First, a plaintiff is entitled to a reasonable royalty for infringement during the period between when the patent is “laid open” to inspection and when it is issued. Second, during the period following the issuance of the patent, a plaintiff who elects an award of damages and who is not able to demonstrate a direct loss of sales as a result of the infringement may claim a reasonable royalty on each infringing act.

Previous Approaches

In AlliedSignal Inc. v. Du Pont Canada Inc., 1998 CanLII 7464 (FC), the court ruled that a reasonable royalty would generally pay the patentee 25% to 33% of the incremental profit earned by the defendant from the use of the technology. The court noted various factors that would tend to move the rate within that range of percentages. For example, if the patentee was a competitor of the infringer, selling its products to a similar group of customers, this would tend to increase the royalty rate.

In Jay-Lor International Inc. v. Penta Farm Systems Ltd., 2007 FC 358, the court considered both the Allied Signal approach as well as two other approaches: the “analytical approach” and the “anticipated profits approach”.

The infringer’s use of the invention will often lead to a) higher selling prices for its goods, and/or b) lower manufacturing costs, depending on the nature of the invention.  Under the analytical approach as described in Jaylor, one measures the royalty rate based on the increase in the infringer’s gross margin percentage as a result of the infringement. For example, if the gross margin on non-infringing product sales is 30%, and the gross margin on infringing product sales is 50%, then the royalty on infringing sales should be somewhere between 0% and 20% of infringing sales.

Under the anticipated profits approach, one estimates the increase in the overall profit of the infringer as a result of the infringement, some portion of which is then allocated as a royalty to the patentee. The advantage of this approach is that it considers not only changes in gross margin percentage, but other changes in the business that result from the infringement, including (potentially) higher sales volumes and higher administrative costs. This was the approach adopted by the court in Jaylor; it determined that for every sale of infringing products, 20% of the selling price made its way to the bottom line. It then decided to award 35% of these profits to the patentee based on its analysis of the Allied Signal factors.

More recent cases

Some recent cases have continued with the sort of approach used in Allied Signal and Jaylor. In Frac Shack Inc. and Frac Shack International Inc. v AFD Petroleum Ltd. 2017 FC 104, for example, the court accepted the evidence that a royalty rate, across all technologies, would typically fall between 25% and 33% of the defendant’s profits. It adopted a mid-point of 29%.

However, most recent Canadian cases have tended to move away from these sorts of “rules of thumb”, mirroring a similar development in the United States (e.g. Uniloc USA Inc et al v Microsoft Corporation, 632 F (3d) 1292 (2011)). Instead, they have adopted a bargaining framework that considers two main elements of a hypothetical negotiation:

• The patentee’s minimum willingness to accept (MWA); and,



• The infringer’s maximum willingness to pay (MWP).

The reasonable royalty will fall somewhere in between the MWA and the MWP. For example, if the patentee’s MWA is 5% and the infringer’s MWP is 10%, the reasonably royalty will be somewhere between 5% and 10%.

The idea behind these concepts is that an economic actor will gauge what it is willing to pay or accept for a piece of technology based on the economic benefit or harm that this will cause to that actor.

Thus, in deciding to license its technology to an infringer, a patentee will consider:

• Whether this will result in a loss of market share due to granting a competitor access to a key technology.
• Whether this will result in a loss of sales dollars to the patentee, as a result of its loss of its previous monopoly position in the marketplace.

For the infringer, the analysis is the same, but from the opposite perspective, namely: will use of the invention allow the infringer to sell more units, and/or sell its existing products for a higher price?

In some instances, the patentee’s MWA may be quite low; this will be the case where the patentee does not produce or sell any products embodying its invention, such that any volumes sold by the infringer will not displace amounts that would otherwise have been sold by the patentee.

In other instances, the MWA will higher than the MWP, and there will be no effective bargaining range. Consider a case where the patentee and the infringer are the only two competitors in a given market. If the patentee keeps a monopoly on its invention, it will be able to sell to 100% of the potential market at monopolistic prices. If it licenses its invention to its competitor, every sale its competitor makes will represent a lost sale to the patentee; moreover, the presence of competitor in the marketplace will lead to a decrease in prices and an increase in certain expenses such as advertising. In this type of a scenario, no rational patentee would choose to license its technology.

The first mention of the MWP/MWA approach in Canadian jurisprudence appears to be Merck & Co., Inc. v. Apotex Inc., 2013 FC 751. Notwithstanding that Justice Snider ruled that she was not required to rule on a reasonable royalty rate, she accepted the basic MWP/MWA framework as conceptually sound. She also accepted that in a case where there is no effective bargaining range, the royalty should be set at the plaintiff’s MWA. In such a case the reasonable royalty will be very similar to an award for lost profits.

The approach was used again in Airbus Helicopters S.A.S. v. Bell Helicopter Texteron Canada Limitée, 2017 FC 170.  In that case, much of the analysis centred on the MWP, rather than the MWA; the facts of the case were somewhat unique, in that the infringing products were never actually sold by the defendant, and the financial impact of the infringement on the patentee was very difficult to measure. Most recently, the MWP/MWA approach was adopted by both experts in Dow Chemical Company v. Nova Chemicals Corporation, 2017 FC 350; once again, in that case the court found that there was no effective bargaining range and awarded a royalty based on Dow’s MWA.

Conclusion

Over the past several years, Canadian courts have adopted a more rigorous approach to quantifying reasonable royalties that considers the economic impact of the use of the technology in question on both the patentee and infringer. Similar to claims for lost profits or an accounting of the defendant’s profits, litigants in reasonable royalty cases will now need to address this fundamental point: what is the technology really worth to their business?


(This article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.)

 

Franchise Rescission under the Wishart Act - Treatment of HST

I have been involved in quantifying financial remedies in roughly 50 franchise rescission cases under the Arthur Wishart Act and other franchise disclosure acts. One of the most common errors I have seen in calculations prepared by franchisee counsel relates to the treatment of GST/HST. This article discusses how these taxes should be treated in such cases.

(Throughout the article, for the sake of brevity I will refer to HST only, using the 13% rate in effect in Ontario; the principles set out here will apply equally to provinces that have GST).

 An Example

 Consider a simple example in which an Ontario franchised business paid a $50,000 franchise fee, purchased $200,000 in equipment and leaseholds from third parties, did $100,000 in sales, and had expenses of $200,000. Here is how the rescission remedy would be presented, on both a pre- and post-HST basis:

Which is the correct figure for the rescission remedy? Is it the $350,000 or the $389,000? To answer this question, it is necessary to understand how the HST system works.

Businesses that are registered to collect HST are required to remit the net HST they collect. If the HST they paid to other vendors exceeds the amount of HST they collected, then they are entitled to a refund for the difference.

Returning to our example, if the franchised business is registered to recover its net HST paid, then the $39,000 in net HST paid gets refunded back to the business when it files its HST return, and the true losses are only $350,000, not $389,000.

It is for this reason that I typically calculate rescission damages on a pre-HST basis.

Some Other Arguments

Is this issue black-and-white? Or are there some cases in which it might be appropriate to include the HST paid?

If the franchised business is HST-exempt, then it cannot recover the HST it has paid on its expenditures. Examples of HST-exempt businesses that are sometimes franchised would include child care services, medical services, and (in some cases) educational services. In those cases, it would certainly be appropriate to include the HST paid as part of the rescission remedy.

There may also be semantic arguments to be made. Here is the actual text of subsections 6(6)(a) to (c) of the AWA:

(a) refund to the franchisee any money received from or on behalf of the franchisee, other than money for inventory, supplies or equipment;


(b) purchase from the franchisee any inventory that the franchisee had purchased pursuant to the franchise agreement and remaining at the effective date of rescission, at a price equal to the purchase price paid by the franchisee;


(c) purchase from the franchisee any supplies and equipment that the franchisee had purchased pursuant to the franchise agreement, at a price equal to the purchase price paid by the franchisee;


Subsection (a) speaks of the “money received” by the franchisor. When the franchisor is paid a franchise fee or royalty, the amount includes HST. A literal reading of subsection (a) would seem to argue in favour of including the HST paid.

Similarly, one might argue that the “purchase price paid” for inventory, supplies and equipment referred to in subsections (b) and (c) might also include HST.

Will this literal approach result in a windfall to the franchisee? In most cases, the answer should be “no”. Where a claim is also being made under subsection (d), then to the extent that the HST paid by the franchisee is being considered under subsections (a) to (c), it would be appropriate to consider the tax credit received by the franchisee under the calculation of operating losses.

Thus, using our example from above, if one includes the $6,500 in HST paid on the franchise fee as part of the calculation under subsection (a), one would need to deduct the very same $6,500 from the calculation of operating losses. Effectively, the final amount calculated would still be a pre- HST amount.

But what if no claim is being advanced under (d), for whatever reason?[1] In those cases, a strict reading of the language of the AWA might indeed result in a windfall to the franchisee if they are granted the post- HST amount under subsections (a) through (c).

---

[1] Such cases are possible; see 2189205 Ontario Inc v Springdale Pizza Depot Ltd, 2013 ONSC 1232