Julie Lusthaus Answers Common Franchise Questions

Video Transcript:

What Are Some Important Franchising Terms? [00:05]

I’m often asked to explain various franchise terms like who’s who, the franchise relationship. Let’s start at the beginning. Franchising is a strategy for business expansion whereby one party licenses its trademark or brand name and method of business operation to another party who uses that name and method in the operation of the business. The franchisor is the individual or company that sells or grants a franchise for the sale of goods or services, McDonald’s corporate. The franchisee is the independent person or business entity that purchases the rights from the franchisor to own and operate a franchise at a specific location or in a specific territory. The term franchise generally refers to the business that the franchisee will operate. Franchisors are required to provide prospective franchisees with a document known as a Franchise Disclosure Document or FDD. The FDD contains certain information about the franchisor and the franchise system.

The FTC and various states require franchisors to provide the FDD to potential franchisees to help them make an informed decision about whether to buy the franchise. The FDD outlines the essential business terms between the franchisor and franchisee, including fees, territories, initial investment requirements, training and support, and other provisions. The franchise agreement is the document that will control the relationship between the franchisor and the franchisee. It is included in the FDD as an exhibit, and once the franchisee is ready to join the system, the parties will sign the franchise agreement, which will set forth the terms governing the relationship between the franchisor and the franchisee. It will identify their rights and obligations during the franchisee’s ownership and operation of the franchise.

What Is Included In A Franchise Disclosure Document? [02:05]

A Franchise Disclosure Document, also known as an FDD, is the document that franchisors are required by law to provide to prospective franchisees before the prospect signs a binding agreement or pays the franchisor any consideration or fee. The FDD contains 23 items of information about the franchisor, franchise business and the investment that the franchisee will make. It’s a form document that franchisors must prepare in accordance with various rules and regulations. So let’s look a little more closely at some of the items in an FDD. Item one will describe information about the franchisor, its affiliates that are for franchises or provide products or services to the franchisees. It will also include information about the business that the franchisee will conduct as well as the general market for the product or service the franchisee will offer. It’s really the one item that franchisors have a little bit more leeway, shall we say, in giving information about their franchise system.

Items three and four require franchisors to disclose information about current and prior litigation and bankruptcy filings, and this includes whether the franchisor or any predecessors, affiliates, and certain other individuals who will be identified in item two have been convicted of certain crimes or found liable relating to the franchise relationship. Items five and six describe the fees that the franchisee may be required to pay during the term of the franchise agreement. Item seven is a chart that will describe the franchisee’s estimated initial investment, and typically the chart will include the franchisee’s investment costs through the first three months of an operation of the franchise. Item eight will disclose the franchisee’s obligations to purchase or lease goods or services from the franchisor or its designated or approved suppliers. Item 11 is typically a long item of disclosure and it will sit forth the franchisor’s contractual obligations of support to franchisees, and it will also provide information about the franchisor’s training program.

Item 12 will indicate whether or not the franchisee will receive an exclusive or otherwise protected territory. Items 13 and 14 describe the franchisor’s trademarks and other intellectual property. Item 19 is one of those items that everybody wants to look at because it is where franchisors can include financial performance information. We refer to this information as an FPR and it’s a representation about a franchisee’s future financial performance or the past financial performance of company-owned or franchised outlet. Item 19 is the only optional item, and not all franchisors include item 19 in their FDD, but if their goal to provide an FPR to prospective franchisees, it must be included in item 19. Item 20 is also worth looking at in detail as it will contain charts as to the status of franchise outlets in the system for the past three years. But importantly, it will also reference an exhibit to the FDD, which will provide contact information for current and former franchisees, and that’s a very good resource for prospective franchisees who want to learn more about the system from those who operate in it. In addition to the information disclosing the FDD, it will contain certain exhibits such as the form of franchise agreement a prospect may be required to sign, as well as the franchisor’s financial statements.

Is It Time To Franchise Your Business? [05:52]

There are many ways to develop and expand a business, and franchising is certainly one of them. One of the first things to think about if you’re considering whether franchising is right for you, is to recognize that operating a franchise system is a very different business than running your corporate locations. So the first question is, are you interested in operating a completely different type of business when you become a franchisor? But if you are looking to expand and are considering franchising, the next question will be, is your business franchisable? And so by that what we mean is it easily replicated? Can you teach someone to operate the business efficiently in a short period of time? Is there a market outside of your territory for the products and services that the franchisee will be offering? Is there a market for the business that you can expand in areas you might not otherwise be able to if you were doing it yourself?

And importantly, will the franchise be profitable for the franchisee? Because remember, in addition to the costs that you incur in connection with operating your business, the franchisee will also have to pay you the franchisor, an ongoing royalty, and the question will be, is the business going to be profitable enough for the franchisee to earn an adequate return on the investment of timing? Once you’ve decided that you think yes, your business is franchisable and you’re interested in franchising, the next question is to think about what type of franchise business model are you going to use for your expansion? There are several types to consider. So the first, the most basic is single unit franchising where a franchisee is going to purchase the right to operate one franchise business at one location or within one territory. You also might want to consider multi-unit development offerings, where the franchisee will purchase the right to develop more than one franchise over the course of a negotiated development schedule and in a much larger area.

Another option to consider is what we refer to as an area representative franchise. With this model, the business of the franchisee will be to solicit and service single unit and multi-unit franchisees, though you as the franchisor will ultimately sign the franchise agreement with the franchisees. So when you have an area represented model, you would also have single unit and possibly multi-unit development franchises. The other option that is not as commonly used in the US as it is internationally, is what we refer to as master franchising, and in this case, the master franchisee will purchase the right to sell franchises and essentially step in the shoes of the franchisor in a particular territory. And as I say, this is more commonly used when franchisors take their brands abroad, but it is used in some industries in the US. Once you decide that you’re going to move forward with franchising, the next step will be to start the process of preparing your Franchise Disclosure Document, also known as an FDD.

The FDD contains information about the franchisor, the franchise system and so forth, Federal Trade Commission rule on franchising, and the various state Franchise Sales Laws​​, require franchisors to provide the FDD to potential franchisees to help them make an informed decision about whether to buy the franchise, but it has to be provided before you engage in any substantive conversations with prospective franchisees. So it’s really the first debt towards becoming a franchisor. You will also have to prepare an operations manual, which is the document where the franchisor will describe the history or vision of the company, as well as brand standards such as equipment and inventory requirements for franchisees, build out timelines and specifications, financial reporting obligations, and so forth. It’s where franchisors will put the secret sauce of the brand, and the purpose of the manual is to give franchisees the detailed information they need to operate the business so that customers can have a uniform experience across locations. Franchising is not right for everyone, but when done well, it enables business owners to grow their brands quickly and economically.

Is Multi-Unit Franchise Development Right For You? [10:24]

Multi-unit development is attractive, particularly for sophisticated and franchise buyers. It allows them to take advantage of market conditions and have larger territorial control over the brand, increased revenues, and can improve efficiencies or reduce costs because they’ll be running multiple local businesses. Area developers will aim to secure a protected territory in which to open a predetermined number of franchises pursuant to a specific time period. This requires the developer to purchase the rights to open multiple locations from the franchisor through what we refer to as an area development agreement. The development fee and initial franchise fee for each location are usually non-refundable, but franchisors may often more favorable rates when the franchisee is agreeing in advance to develop more than one unit. However, the clock is always ticking for area developers and they only have a certain amount of time to open up each location where they will risk defaulting on their area development agreement.

For example, a developer may have the right to open five units of a particular brand in a development area and may be required to open one per year for each of five years. Of course, the length of time will vary by franchise system and the number of units planned for the area, as well as the developer’s ability to move quickly to develop locations. Since it takes time to launch and establish multiple locations, area developers are often provided with exclusivity within development area, which will operate to preclude other franchises from operating units within that same area, at least during the development period. This will allow the developer to have first shot at the best real estate for different locations, and this is part of what developers get in exchange for making the commitment at the outset to develop more than one franchise location. However, once the schedule has been completed and the locations are open, any exclusive protection that the developer received for the development area will end and will be replaced by territorial protections that are granted, if any, to each franchise location.

So once the developer has opened, let’s say their five locations in a particular county in a state, after that schedule ends, the franchisor will be permitted to open additional locations in that county or allow other franchises to do so. The FDD that the developer will receive will include a copy of the franchise agreement for its first location, but also the area development agreement, which will provide for the developer’s rights to open the additional units pursuant to the schedule and within the agreed territory. When reviewing the area development agreement, it’s important to consider how is the territory defined? Is it by zip code? Is it county? Is it by population? Any exclusivity rights and exceptions to those rights that the developer will have? Oftentimes, developers envision that they will be the sole developer for this brand in a particular city, and they don’t necessarily see that the franchisor still has the right to open up a location, let’s say, on a college campus, even if it’s within that city.

So it’s important to look at the territory rights and exceptions. Developers will also want to be really careful about the development schedule, including the number of proposed locations and timeframes. It’s great if a developer is going to open up or thinks they can open up one a year, but what happens if they run into difficulty finding real estate with permitting and so forth, better to have a longer schedule that gives them a little bit more flexibility. There’s nothing stopping them from opening sooner, but at least they’ll give themselves a little bit of time if they need it. Another thing to note for area developers is the termination provision that’s in the area development agreement, recognizing that if they don’t meet their development schedule, they’re likely to lose their development rights for any further locations. So when acquiring development rights to more than one franchise, area developers will have to invest more than single-unit franchisees. And in part, because of this, they often have more leverage than single-unit franchisees in negotiating the agreements with the franchisor. So it’s important that they review them carefully to ensure that they receive as much protection as possible over their investment.

What are Some Considerations For Buying and Selling an Existing Franchise Business? [15:06]

Buying an existing franchise is a popular choice for many entrepreneurs. In addition to getting the name recognition and support of the franchise system and franchisor, the seller has already developed the location such that the buyer will generally walk into a turkey business. However, in these transactions, the franchisor will often require the buyer to sign a new franchise agreement rather than assuming the seller’s obligations under the seller’s agreement. And this raises some concerns that are not present when buying an independent business or when buying the right to develop a new franchise business. The seller’s franchise agreement, particularly where a seller has been operating for many years, is likely to be very different than the franchise agreement the buyer will be asked to sign. And these differences may have a substantial impact on the purchase as well as the subsequent operation of the business. One of the most important terms of the seller’s franchise agreement to review will be the transfer provision because that’s going to control the party’s sale process.

This clause will give the franchisor the right to approve the buyer, explains how and when a sale to a new franchisee will be permitted and what the parties need to do to secure the franchisor’s consent to the sale. So if you were looking at selling your franchise business, this is really one of the first provisions to look at so that you know the process for moving forward. Both parties, particularly the buyer, will want to review the fee provisions in the seller’s franchise agreement and compare them to the agreement that the buyer will sign. Any changes to the fees can have a significant financial impact on the profitability of the business. For instance, the seller may be paying the franchisor a royalty of 6% of gross sales, but the buyer will end up paying a royalty of 8%. In that case, the buyer will certainly want to consider these increased costs when negotiating the purchase price for the business.

Another provision that’s important to consider during the sale process is the refurbishment requirement that franchisors often impose in connection with a sale. Franchisors use the sale process to ensure that the franchise business will be modernized or upgraded to meet its then-occurring standards. So the buyer will want to determine what the tie requirements are cost to complete these upgrades, and often these costs are going to be a point of negotiation between the buyer and the seller. In addition, the seller’s franchise agreement should be reviewed to determine whether or not the franchisor has a right of first refusal. Before spending a significant amount of time and running negotiating the transaction, the parties are going to want to ensure that the franchisor does not intend to exercise such a right if it has one. And these are just some of the considerations that are unique to the purchase and sale of an existing franchise.

What Laws Apply To Franchising? [17:52]

In addition to laws and regulations that apply to all businesses, there are two categories of laws that apply to franchise, Franchise Sales Laws​​, and those that we refer to as franchise relationship laws. Franchise Sales Laws​​ are essentially consumer protection laws that are intended to ensure that franchisees can make an informed investment decision and that franchisors will not engage in deceptive and unfair trade practices in the offer and sale of franchises. Pursuant to these laws, franchisors are required to provide prospective franchisees with a Franchise Disclosure Document, which will contain information about the franchisor, the franchise, and the investment costs the franchisee will incur. There is a federal rule that applies to the sale of franchises anywhere in the United States, and that’s the FTC, Federal Trade Commission rule on franchising. There are also state statutes that apply to the sale of franchises in those states, and those often require franchisors to register their FDD with the state prior to selling a franchise within that state.

The other category of laws that we refer to are relationship laws. And these laws are applicable once a franchisee has entered into the franchise relationship and executed a franchise agreement. There’s no federal rule governing franchise relationships per se, but more states have franchise relationship laws, than have Franchise Sales Laws​​, and some have both. Relationship laws operate to Trump contract provisions in the franchise agreement, and among other aspects of the franchise relationship, they tend to impact the franchisor’s right to terminate a franchise agreement, even if a franchisee is in breach of the agreement. They limit the franchisor’s ability to not renew a franchise, and they often address venue provisions and dispute by solution provisions in franchise agreements. As a franchisor or a franchisee, it’s important to know which of these laws apply to the relationship. Franchisors are going to want to ensure that they do not inadvertently violate a franchise law. And franchisees are goal to want to ensure that they do not waive any rights they have under these franchise laws.


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