Franchising information for [potential] franchisees

Franchising is a long term relationship. It requires significant commitment of capital and personal time, and does not guaranty success. You should:

• Investigate thoroughly, and
• Seek professional advice, such as from attorneys and accountants

Franchising is often viewed as a way to start a business with decreased risk of failure, and reduced time to become operational and then profitable. This is particularly likely to be the case if you lack sufficient business experience to strike out on your own. While studies support that franchisee businesses have lower failure rates than non-franchise start-up businesses, that does not guaranty success for all franchise systems or the individual new franchisee.

Franchising likely will NOT achieve you being the owner of your own business

• Franchisor generally “licenses” your use of their business model and they own the business concept. They may specifically “own” the “goodwill” and have a “right of first refusal” to purchase your franchise operations if you want to sell.
• Franchisor retains substantial control over your operation.
• Your right to operate the franchised business is tied to your continuing to be a franchisee.
• Even a lengthy license period normally ends, likely leaving you with no renewal rights beyond expiration of the license and unable to continue the franchised business outside of the franchise system.
  You are generally prohibited from competing with the franchised business after the termination of your franchise license.
• Your ability to sell or transfer the business is likely limited, including, e.g., leaving the business to your children or spouse on your death.

Is the opportunity a good match for your “style” and personality?

• Will you be happy performing the tasks a particular franchise requires?
• Do you have necessary personnel, management, sales and other skills?
• Does being the franchise business owner match your view of your place in the community?

Due diligence investigation

Your investigation before purchasing a franchise should include contacting current and former franchisees (listed in the required disclosure document) regarding their experiences and satisfaction with the franchise. But, be cautious in accepting what they tell you. People are often are reluctant to admit they made a mistake in purchasing the franchise or to tell you they are not a success. Current franchisees may not be forthcoming with you for fear of repercussions from a franchisor with whom they must continue to deal. Former franchisees may have agreed not to “disparage” franchisor or want to put the experience behind them. Pay particular attention to lawsuits between current or former franchisees and franchisor (listed in the required disclosure document). Are there numerous suits ? What do they involve ?
You should determine that the franchise offers sufficient income opportunity at a level satisfactory to you. This may be difficult. Regulatory restrictions on franchisors’ ability to make “earning claims” often results in franchisors not providing any financial information on franchisee operations. Inconsistent franchisee accounting practices make review of financial information obtained directly from franchisees difficult. Again, franchisees may be motivated to distort financial information, e.g., by pride and wanting to appear more successful, or understating income, and or overstating expenses, to avoid tax, royalties, etc.

Franchising is a long term relationship

It needs to be beneficial to both parties. Franchisors earn income through royalties from ongoing franchisee operations, and so depend on franchisees being profitable and continuing in operation. Initial franchise fees may be largely consumed by costs of the sale and training and assisting the new franchisee to become operational. A franchisor’s dependence on franchise sales rather than royalties for income is reason for caution. A significant number of franchisees failures or lawsuits between franchisees and franchisors (disclosed in the franchise offering circular) are also counter-indicators that a quality long term relationship exists.

Does the franchisor provide continuing value for ongoing royalties

You may be happy early in the relationship, feeling the initial fee was worth the head start franchising provided. But, royalties continue through the franchise relationship and are paid to franchisor “off the top” whether or not franchisee makes a profit. Franchisees often become discontent after several years as they continue to pay royalties and feel franchisor does not continue to provide value in exchange. What will franchisor do years after you are up and running to “earn” the royalties you will be paying?

• advertising or promotions (Note: you may pay an advertising fee, which may NOT guaranteed to be proportionately spending in your area)
• research into new or improved products or services or updated trade dress (which may require you to spend money refurbishing your premises)
• research consumer trends
• substantial system leverage in purchases required to operate the franchised business not available to non-franchisees

Franchising for franchisors

Franchisors license their business concept and marketing plan, and provide assistance to franchisees in implementing the concept in exchange for an initial franchise fee and ongoing royalty payments. Franchisors often view franchising as a way to exploit their business concept and expand using other people’s (franchisees’) money and manpower while the franchisor collects the money.
Increased franchisor obligations
While franchising avoids franchisor’s directly providing financial and manpower resources to individual operations, it still requires substantial capital and management resources to:

• sell franchisees
• train and support franchisees
• comply with disclosure and other franchise regulatory requirements

Repeatable / teachable business concept

Franchising can be a good “match” for some but not all business concepts. The business concept must be capable of being duplicated and susceptible of persons being trained to operate it. Some business concepts depend on a particular location or other circumstances, or require certain expertise or experience, education, knowledge or entrepreneurial talent not easily duplicated or trained for.

The franchise relationship

Franchising is a long term relationship and needs to benefit both parties to be successful. Initial franchise fees may be largely consumed by costs of the sale and training and assisting the new franchisee to become operational, and franchisors earn their income through royalties from ongoing franchisee operations, and so franchisors depend on franchisees being profitable and continuing in operation.
Franchisees are often happy early in the relationship, feeling the initial fee was worth the head start that franchising provided. But royalties continue throughout the franchise relationship and are paid to franchisor “off the top”, whether or not franchisee makes a profit. Franchisees not infrequently become discontent after several years as they continue to pay royalties and question what the franchisor is doing on an ongoing basis to provide value in exchange for the continuing royalties, e.g.:

• advertising or promotions to “drive” customers to franchisee
• research into new or improved products or services
• research consumer trends
• substantial system leverage in purchases required to operate the franchised business not available to non-franchisees

Franchisees are looking to build and own their own business, and franchising may NOT achieve this and can be a source of friction in the relationship.

Starting up a new franchise operation

Start up franchises generally must demonstrate viability of their business concept to be able to attract potential franchisees. This generally requires several “company” franchise operations in various settings, e.g., large cities, small college towns, urban and suburban locations, etc. These company operations also serve to “fine tune” operating procedures.

Franchisors must deal with various legal considerations, e.g., preparing the franchise agreement and other agreements, and meet a number of regulatory requirements, most specifically preparation and furnishing of the “disclosure document” or “offering circular” to potential franchisees (required in all states). Registration is required in a number of states prior to even “offering” to sell a franchise in the state. Numerous other matters must be considered such as whether special industry laws apply.

Disclosure requirements mandate that franchisors have certified financial statements, starting at least from the time the franchisor starts offering franchises. This results in significant additional costs and must be planned for, or franchise sales will have to be suspended until the certified financials can be obtained.

Weak financial status may also trigger “impound” requirements for initial franchise fees, resulting in franchisor’s inability to use those funds for operations until all franchisor’s obligations in setting up the new franchisee are fulfilled, or providing a bond which is an additional expense and may be difficult to obtain.

Amended FTC Franchise Rule 16 C.F.R. Part 436 5/9/08

The Federal Trade Commission (FTC) has approved amendments to the Franchise Rule, which was originally promulgated in 1978.

Effective date

The amended Rule has a phased-in effective date:

• as of July 1, 2007, franchisors MAY follow the amended Rule, or
• they may continue their current practice of complying with the original FTC Rule or individual state franchise disclosure laws that require an Uniform Franchise Offering Circular (“UFOC”)
• by July 1, 2008, they MUST follow the amended FTC Rule only.

Between July 1, 2007 and July 1, 2008, franchisors may NOT “pick and choose” and select portions of the new rule and portions of the old rule, but must comply in its entirety with either the original rule or the amended rule.

State coordination with the new rule

Under the original rule the FTC found that the UFOC format substantially complied and satisfied the need for disclosure to potential franchisees and could be used as a substitute for an FTC format disclosure document. The UFOC will no longer be allowed as a substitute format after July 1, 2008.

The ability of franchise regulating states to incorporate these new changes is complicated because while some states only require regulatory amendments to accomplish the changes, a number of states’ franchise laws are set by statute which will require legislative action.

NASAA adopted Interim Guidelines for the filing of a Uniform Franchise Offering Circular (UFOC) on June 22, 2007. The interim guidelines recommend that, as of July 1, 2007, registration states permit franchisors to file disclosure documents prepared in accordance with the new FTC franchise rule, adopted January 23, 2007. NASAA issued the proposed 2008 Franchise Registration and Disclosure Guidelines February 26, 2008 (Amended And Restated UFOC Guidelines).

The amended FTC rule does not preempt state law

The revised FTC rule does not preempt state law, but merely sets a floor on the disclosure. States can continue to require additional disclosure and other matters extending beyond the FTC requirement, e.g., cover page risk factors. State laws generally do not have any provisions dealing with “pure electronic disclosure.” The ability of franchise regulating states to incorporate these new changes is complicated because although some states only require regulatory amendments to accomplish the changes, a number of states’ franchise laws are delineated by statute which will require legislative action.

UFOC “Guidelines”

The UFOC guidelines (explanatory commentary for preparing the UFOC) will cease to have effect except to the extent that the regulating states either now or in the future require franchisors to go beyond the revised rules disclosure mandates. For example, states may continue to mandate risk factors on the cover page and disclosure in the UFOC Item 2 of the identity of franchise broker.

Timing implementation

Some commentators suggest not implementing the new FTC rule version of the disclosure document at the annual renewal date due to concern that the flood of new documents and substantial revisions to be reviewed will delay registration and require “going dark” or ceasing franchise sales until registration is completed. Instead they are suggesting filing the renewal in the ordinary course, and then “amending” that renewal filing, for example in May of 2008, with the notation it is a “non-material” amendment, so franchisors can continue using their current UFOC disclosure documents until the revised FTC rule document registration is granted and avoid any franchise sales down time.

New disclosure timing rules

The timing requirements for delivery of disclosure documents will be changed.

Eliminated are:

• the “first personal meeting” disclosure requirement
• the “ten business day” trigger for delivery of disclosure documents, and
• the “five business day” trigger for franchise agreements in execution ready form.