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Wednesday
Sep202017

Before Franchising Your Business, First Consider These Factors

Chair, Franchise & Distribution Practice Group

by Barry Kurtz

818-907-3006

 

Franchising is so much more than casual burger chains with drive through windows and dollar menus. It’s an industry that incorporates a wealth of blue and white collar services; distributes both high- and low-end products (consumables and non-consumables) around the globe; and provides the means for many first time entrepreneurs with the formulas to launch businesses successfully.

Professional Services Franchise

According to the International Franchise Association, franchises will generate over $700 billion in 2017.

While most people have a general sense of the structure of the franchise model, few realize the breadth of businesses that successfully employ the model, despite their interaction with these businesses on a daily basis.

Almost any successful business can be franchised, including those providing services in automotive, pet, business, personal care, real estate, and many other industries. They also include businesses selling products, whether the goods are foods, flowers, vehicles, clothing or other items.

However, franchising is not right for all businesses or business-owners. A certain mind-set is required to be a successful franchisor. Because the industry is highly regulated and laws vary state-to-state and country-to-country, starting a franchise requires the investment of a lot of heart and soul, as well as a lot of time and money.

Selling Franchises Means Starting Another Career

Keep in mind: selling franchises is a totally new and separate line of business.

For example, after selling her first franchise, the owner of a bedbug remediation service is no longer solely in the business of pest control; she is now in the business of selling franchises, too. To be successful, she will not only need to be able to sell the concept, but she will need to comply with all applicable laws and regulations relating to the sale of this type of investment, which is likely to be something that is outside of her wheelhouse. For these reasons, a business owner should evaluate whether the business would be right for franchising.

Franchising Requires Dedication

Franchising is regulated at the federal level by the Federal Trade Commission (FTC). In addition, many states have enacted franchise specific laws, and 13 states require franchisors to register before offering franchises within their states to provide additional protections to potential franchisees. These “registration states” have taken the position that franchise arrangements provide a greater potential for fraud, noting that franchise agreements are typically drafted by the franchisor’s attorneys and usually favor the franchisor.

Before offering franchises, the franchisor will have to prepare a franchise disclosure document (FDD) that complies with the FTC’s Franchise Rule.  

An FDD is an offering prospectus that provides prospective franchisees with information pertaining to 23 specific items about the franchisor and the proposed franchise. The FDD must include, among other things, background information about the franchisor and its executives, fee and cost information, samples of the contracts franchisees will sign, and information about the franchisor’s trademarks and patents.

Franchisors will generally need audited financial statements to include in its FDD. The FDD will have to comply with the laws of any of the “registration states” in which the franchisor intends to sell. The franchisor must register in those states before selling.

Formula for Franchise Success Required

Sushi Restaurant FranchiseFranchises must be attractive to prospective franchisees. A franchisor’s business model is attractive if it is based on a concept that is sustainable in the marketplace. Franchises based on fad products or services rarely survive. To be sustainable, the concept must be unique enough to withstand competition and must be one potential franchisees are willing to pay to learn.

Other factors to consider include: 

  • Laws and regulations that are applicable to the particular type of business;

  • Whether it is clear the concept will be profitable for both the franchisor and its franchisees;

  • Initial cost of creating the franchise;

  • Length of time it will take to achieve success;

  • Rate at which the franchisor can reasonably expect to expand; and

  • Franchisor’s ongoing ability to ensure its franchisees will be supplied with the inventory, supplies and equipment they require to operate. 

Franchising is a proven means for successful businesses to expand, but choosing to franchise one’s business is a decision that must be well considered.

In some cases, a business owner looking to expand may be better off selling licenses or distributorships instead of franchises if it is legally possible to do so. An experienced franchise attorney can help answer those questions.

Barry Kurtz is a California Bar Certified Specialist in Franchise & Distribution Law.

Disclaimer:
This Blog/Web Site is made available by the lawyer or law firm publisher for educational purposes only, to provide general information and a general understanding of the law, not to provide specific legal advice. By using this blog site you understand there is no attorney client relationship between you and the Blog/Web Site publisher. The Blog/Web Site should not be used as a substitute for obtaining legal advice from a licensed professional attorney in your state.

Tuesday
Nov292011

Franchise Law – 23 Items of the Franchise Disclosure Document (Part 2 of 2)

Business Litigation Attorney EncinoFranchise & Business Litigation Attorney

 

by David Gurnick
818.907.3285

This is the second of a two part blog on the Franchise Disclosure Document, or FDD.  Anyone who offers or sells a franchise in the United States must prepare an FDD and present it to their prospective franchisees.

A prospective franchisee must receive the FDD at least fourteen (14) days before any agreement is signed, or before the franchisor receives any consideration relating to the sale of the franchise.

The FDD contains information about the franchisor, its history, management personnel, litigation, terms and obligations of the franchise and other key aspects about the franchise that an investor should know.

The first 12 points of the FDD are explained in: Franchise Law – 23 Items of the Franchise Disclosure Document (Part 1 of 2). Items 13-23 are discussed below.

13. Trademarks.

One of the defining elements of every franchise is the existence of a trademark that the franchisor permits the franchisee to use, and that the franchisee uses to identify the business.

In this disclosure the franchisor identifies its principal trademarks, provides details as to their registration status in the United States Patent and Trademark Office and the trademark office of any state, and discloses if there have been any infringements of the trademark.

14. Patents, Copyrights and Proprietary Information

In addition to trademarks, most franchise systems also claim to own trade secrets. In a few systems, the franchisor claims to own valuable copyrights or patents that are licensed to the franchisee. Information on trade secrets, copyrights and patents is disclosed in this disclosure item.

15. Obligation To Participate In The Operation of the Franchise Business.

Often, an individual or couple buys and actively operates their franchise. It is common to see the owner behind the counter of a Subway sandwich shop, or local gas station, or in the management office of a franchised hotel. Franchisors prefer this and sometimes require that the franchisee actively participate in operation of the business.

Some franchisees acquire multiple units. When that occurs, the franchisee cannot possibly be in all locations at once. Sometimes investors buy franchises, planning to hire others to run them.  This item discloses the extent that the franchisor requires the franchisee to actively participate in operating the business or will allow the franchisee to be absent or passive with the franchise operated by others.

16. Restrictions On What The Franchisee May Sell.

All McDonalds sell hamburgers, fries and shakes. Imagine if some locations also sold tacos, burritos and enchiladas, and other locations sold spaghetti, ravioli and macaroni, and still others sold chop suey and won ton soup. Soon the public would be confused about the system’s products.

To maintain uniformity between locations, franchisors set limits on the products and services that their franchisees may sell. This disclosure item summarizes those limits.

17. Renewal, Termination, Transfer and Dispute Resolution.

At its core, a franchise is a license that permits a franchisee to do business using the system and identity and know-how of the franchisor. Because franchises involve a sizeable investment, some important considerations in buying a franchise, are the duration of the license, circumstances in which the license could be terminated early, whether it can be renewed and any restrictions on the franchisee’s ability to transfer the franchise to someone else.

This disclosure item is a table that identifies and summarizes key provisions of the franchise agreement on these and related subjects.

18. Public Figures.

In the 1970s franchisors often enlisted famous people to endorse their business and lend their names and reputation to the process of offering and selling franchises. Typically, these famous people were getting paid, but that was not disclosed to naive franchisee investors. Therefore, the FDD is required to disclose whether any famous people are involved in offering and selling franchises, and summarize their compensation for doing so.

19. Earnings Claims.

A question that many potential franchisees ask is “how much money will I earn?” By presenting selective data, or even manipulating numbers, the answer to this question could potentially be overly positive, or even misleading.

The FDD permits a franchisor to present information on the past financial results and even future projections. But they must be accurate, have a reasonable basis, and be accompanied by certain disclaimers specified in the disclosure rules. Any such earnings claims are contained in this item of the FDD.

20. List of Outlets.

The franchisor is required to attach a list of locations, with names and contact information for the owner of each franchise.  A list of ex-franchisees who recently left the system must also be attached.  This information assists a prospective franchisee who may wish to contact and interview some existing and former franchisees to hear and evaluate their satisfaction with the franchise system.

22. Financial Statements

A franchisor is required to provide its audited financial statements for the past three years. This is useful for the prospective franchisee to evaluate the franchisor’s financial performance and financial condition.

22. Contracts.

A copy of each contract to be entered into, must be attached as an exhibit to the FDD. This provides the potential franchisee an opportunity to review the actual contracts before they are entered into.

23. Receipt.

The last item of the FDD is a receipt. Two copies of the receipt are attached to the FDD. One copy is to be signed by the recipient of the FDD and returned to the franchisor. The recipient may keep the other copy.

The franchisor is required to present the FDD to the prospective franchisee at least 14 days before any agreement is entered into and any consideration is paid. The receipt, when signed and dated to acknowledge receipt of the FDD, provides the franchisor a record confirming that this requirement was satisfied.

Franchise Law in the United States

The FDD is a useful tool for prospective franchisees in evaluating a franchise being offered. Even though the categories of information are uniform, each company’s FDD differs from each other company, and a particular company’s FDD will differ from year-to-year.

This article has summarized the contents of the FDD’s 23 disclosure items, but the discussion is only a summary. The detailed regulatory instructions for preparing the FDD include various additional subjects and requirements within the above categories.

David Gurnick is a franchise law attorney and author of two books, Distribution Law of the United States and Franchise Depositions, both available through Juris Publishing, Inc.  Mr. Gurnick is certified as a specialist in Franchising and Distribution Law by the State Bar of California, Board of Legal Specialization. You may reach him at Lewitt Hackman: 818.990.2120 or dgurnick@lewitthackman.com.

 

 

Disclaimer:
This Blog/Web Site is made available by the lawyer or law firm publisher for educational purposes only, to provide general information and a general understanding of the law, not to provide specific legal advice. By using this blog site you understand there is no attorney client relationship between you and the Blog/Web Site publisher. The Blog/Web Site should not be used as a substitute for obtaining legal advice from a licensed professional attorney in your state.

Wednesday
Nov232011

Franchise Law – 23 Items of the Franchise Disclosure Document (Part 1 of 2)

Business Litigation Attorney EncinoFranchise & Business Litigation Attorney

 

by David Gurnick
818.907.3285

 

Since 1979, any company wishing to offer and sell franchises in the United States has been required to prepare and present a written disclosure document to prospective franchisees.

The document provides extensive information about the company that offers and sells franchises, and the terms of the franchise being offered. Over time, the rules have changed concerning the name and precise contents of the document. But generally, the overall categories of information to be disclosed have remained the same. Today, it is called a “Franchise Disclosure Document,” or an “FDD.”

Here are the first 12 of the 23 categories of information that a franchisor's FDD is required to contain.

1. The Franchisor, It’s Predecessors and Affiliates.

This category provides a general introduction to the franchisor and the business. It describes the nature of the business, the market for the services or merchandise to be sold, particular laws the franchisee must comply with, the franchisor’s history, and information about companies affiliated with the franchisor.

2. Business Experience.

The FDD identifies the board of directors, officers and other key management personnel of the franchisor, and describes their current positions and employment histories, going back five years. With this information a potential franchisee can assess the business experience of the franchisor’s management in relation to the business of the franchise.

3. Litigation.

Litigation and arbitrations brought against the franchisor during the last 10 years, and their outcomes are described here. This category also provides summary information on suits and arbitrations that the franchisor brought against its franchisees. This information can be a useful tool in assessing the quality of relations between the franchisor and franchisees, and the types of problems that have occurred, that resulted in litigation.

But it is only a partial tool. The existence of litigation and claims does not automatically mean franchisor-franchisee relations are generally bad. The cases that were brought could be aberrations. The absence of litigation or arbitration does not mean relations are good. There could be disputes that did not result in litigation.

4. Bankruptcy

Bankruptcies of the franchisor or management during the past ten years are covered here. As with litigation, the existence of a bankruptcy or two among management does not, by itself, mean the franchise should be avoided.

Many individual managers, like other people, have been forced into bankruptcy for extraneous reasons having little to do with the franchise, such as a spouse or relative experiencing costly health issues. On the other hand, where key management has had one or more bankruptcies, it may be fair to ask why, and evaluate if they are individuals who have problems managing financial affairs.

5. Initial Franchise Fee

This information category discloses all amounts the franchisee must pay to the franchisor before the franchise starts operating.

6. Other Fees

Other Fees include all amounts the franchisee must pay to the franchisor after the franchise starts operating. This can be a particularly useful disclosure as it assists the potential franchisee in understanding the various fees and charges that will be imposed.

7. Initial Investment

Food FranchiseThe Initial Investment appears in a table that shows, for each category of expense that a franchisee will incur, a high-low range and an overall high-low range for the total investment to establish and start operating the franchise. This disclosure item can be particularly useful for a franchisee in determining affordability of and budgeting a potential franchise investment.

8. Restrictions On Sources Of Products And Services

Franchise systems often set restrictions on who the franchisee may obtain supplies, inventory and services from. Franchisors do this as a quality control measure, and to assure uniformity among the various outlets in their franchise system.

This category discloses the restrictions that the franchisee will be subject to in obtaining merchandise and services for the franchise.

9. Franchisee’s Obligations

The obligations table outlines 24 categories of obligations the franchisee will be required to comply with, and identifies particular sections in the Franchise Agreement, and/or in other agreements to be entered into, that concern that type of obligation. Rather than state the substantive obligation, this disclosure table points the franchisee to the statement of the obligation in the written agreement to be entered into.

10. Financing

Many franchisors offer to assist their franchisee with financing the franchise investment, either by accepting a promissory note for some of the investment obligation, or by making arrangements with third party lenders. This disclosure item provides a table summarizing key aspects of any financing arrangements that the franchisor is willing to make.

11. Franchisor’s Obligations

This disclosure category is one of the most extensive in the FDD. It summarizes assistance the franchisor has promised to provide before the franchise starts operation, and ongoing assistance to be provided after the start of operation.

Franchisors usually offer a training program in the operation of the franchised business. This category details the training, in a table that lists subjects, hours devoted to each, and whether that portion of the program is conducted in a classroom or on-the-job setting.

Other subjects addressed in this disclosure item include information on the franchisor’s advertising program, existence of advertising cooperatives, required participation in an advertising fund, details of any electronic point-of sale system the franchisee must purchase and the table of contents of the franchisor’s operating manual.

12. Territory.

Franchisees often want, and receive, a promise of exclusivity in a geographic area or market sector. Their franchisor promises not to establish another franchise within a stated area or market sector. This disclosure describes any territory exclusivity for the franchisee, how it is determined, and the circumstances in which exclusive territory may be modified.

In my next blog, we’ll discuss the final items franchisors must divulge in Franchise Law - The FDD Part 2 of 2. In the meantime, please contact me if you have any questions regarding franchise law, the Franchise Disclosure Document, or any of the points above.

David Gurnick is a Certified Specialist in Franchise and Distribution Law, as specified by the State Bar of California’s Board of Legal Specialization. E-mail him at dgurnick@lewitthackman.com

 

 

Disclaimer:
This Blog/Web Site is made available by the lawyer or law firm publisher for educational purposes only, to provide general information and a general understanding of the law, not to provide specific legal advice. By using this blog site you understand there is no attorney client relationship between you and the Blog/Web Site publisher. The Blog/Web Site should not be used as a substitute for obtaining legal advice from a licensed professional attorney in your state.

LEWITT HACKMAN | 16633 Ventura Boulevard, Eleventh Floor, Encino, California 91436-1865 | 818.990.2120