New York Franchise Law Blog : Franchise Lawyer & Attorney : Charles N. Internicola Law Firm: National representation of Franchisees and Franchisors

This afternoon in consulting with a client who had recently signed a franchise agreement involving a substantial commitment of capital, I was reminded about the importance of maintaining "realistic" expectations when buying a franchise. When discussing his expectations about his franchise purchase and the business that he will be developing, he was extremely "realistic" as to his expectations and the work ahead of him.  That is: 

(a) He diligently evaluated the "franchise opportunity" that he was investing in and thoroughly understood that, as with many businesses, it would be a number of months and possibly years (hopefully not) before he achieved a level of profitability and acceptable return on his franchise investment; and

(b) He understood that the success of his franchise rested on the hard work, marketing and business development that he (and his family) would bring to this new business. Significantly, his approach is not one of "lets wait and see" what business comes through the door.

The most important lesson that I was reminded of by my client - a lesson that future franchisees and franchisors may also put to use - is that getting your expectations "right" is critical.  When considering a business opportunity and setting your "expectations", franchisors and franchisees should consider:

• Profitability will Take Some Time -   Profitability is not guaranteed and, depending on your particular franchise opportunity, may take 8 days (unlikely), 8 months or 8 years (hopefully not).  That is, you must plan ahead and account for the extremely realistic fact that you in selling a franchise or purchasing a franchise you must properly communicate and/or understand that reserve capital will be critical.  Evaluate the opportunity thoroughly and ensure that you have developed the correct expectation about the future profitability of your business.

• Franchisors Can't (and Shouldn't) do Everything - Buying a franchise does not mean you just pay money and then sit back and wait for business to "walk through the doors".  You must be actively engaged in the marketing and "development" of your business.  Look to your franchisor as your "partner" and not your "caretaker".  Franchisors, be selective about the franchisees that you approve - look for franchisees that will contribute to the development of your franchise system. 

Get your expectations right.

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NYC Business Solutions (a division of NYC Small Business Services), the Manhattan Chamber of Commerce and the US Department of Commerce will be conducting and coordinating a seminar - "How to Buy Your First Franchise or Grow the One you Have" -  for both prospective and current franchisees.  

Seminar Date:  February 17, 2010

Seminar Time:  8:00 AM - 10:00 AM

Seminar Location:  110 William Street, 4th Floor, New York, NY 10038

Seminar Registration Information

 If you are considering the purchase of a franchise your best resource and asset will be "information". Information about the franchisor, information about your legal rights, information about your estimated start-up expenses and information about your rights and obligations as a franchisee.  My point being attending a seminar such as the one offered by NYC Business Solutions can only be helpful in this important decision making process.

Hopefully, you will also find our articles about  buying a franchise to be helpful. Good luck.

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Part of the “Franchisor Basics” Series

Under the Federal Franchise Rule franchisors are required to disclose their “Financial Statements” in Item 21 of the Franchise Disclosure Document. All financial statements must be prepared in accordance with Generally Accepted Accounting Principals ("GAAP") and in all but an extremely limited number of situations involving a start-up franchisor, a franchisor’s financial statements must be “audited”.   In the franchise regulations (16 CFR Parts 436 and 437) FTC provides detailed information respecting a franchisor's "Item 21" disclosure requirements, including:

•  Financial statements must be audited by an independent certified public accountant and prepared in accordance with GAAP;

• Financial statements must be prepared in a "tabular" format providing for a comparison between current and prior fiscal years; and 

• Financial statements must include (a) Balance Sheet for the prior two (2) fiscal years and (b) Statement of Operations, Stockholders Equity and Cash Flows for each of the franchisor's prior three (3) fiscal years. 

Other provisions apply for "start-up" franchisors (a topic that will be discussed in future posts) and the disclosure of the financial statements of a franchisor's "affiliates". 

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In an effort to expand the information provided at the New York Franchise Law Blog and, hopefully, the timeliness and value of this information for our readers and subscribers, we will now be featuring a continuing series of succinct fact based articles (in addition to our commentary and reports) focused on the "basics of franchising", comprised of "Franchisor Basics" and "Franchisee Basics".

These articles will serve as a valuable reference tool to our readers and, as always,  it is important that you discuss the specifics of your franchise system, disclosure obligations and franchise decisions with your franchise attorney.

As always, we appreciate and welcome the comments and suggestions that we have been fortunate to receive from our readers. Please let us know if there are any specific franchise topics that you like us to address.  Thanks.

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When  purchasing an "existing business" (whether a franchised or independent operation) prospective purchasers are faced with the critically important task of conducting a "due diligence" evaluation/investigation of the business under consideration.  While there are many steps to the "due diligence" process and while many of these steps are the same whether the business is a "franchised operation" or an "independent location", one critically important distinction and factor that should not be overlooked and must be evaluated by the prospective purchaser of an existing franchise is:

"whether or not there is value in the franchise system?".

That is, as a purchaser, you must evaluate and determine what added value (i.e., profits and cash flow), if any, that you will be afforded by purchasing and operating a "franchised business" (and becoming a franchisee) as compared to a competing but "non-franchised" independent operation. When making this "assessment" you must recognize that there is tremendous variation and value between franchises - that is, some franchise systems add real value and advantages while some poorly run "franchise systems" simply drain the profitability of its franchisees.  When making this assessment, some of the factors that you should consider, include:

• Higher Sales Do Not Necessarily Equate to Higher Profits.  As a franchisee one substantial obligation that you will be undertaking will include the payment of "royalties" to the franchisor.  Since royalties are typically based on a percentage of your "gross sales" the franchised business that you are evaluating will most likely have higher operating costs than the non-franchised business.

• Not all Franchise Systems are Equal.  Some "franchise systems" are simply poorly run and ill conceived business operations that afford little, if any, value to its franchisees.   So, don't just "assume" that the franchise business that you are considering will be properly supported by the franchisor - ask questions, speak to other franchisees and evaluate the benefits of the franchise system that you are buying into.

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For the "start-up franchisor" (and even established franchisors) determining the appropriate franchise fee and royalty structure for your franchise system is a critical task that will have long standing implications.  The fee structure that you establish will serve as the primary source of revenue for your franchise system and will represent one of the most significant "expenses and obligations" on the part of your franchisees.  Set the fees to high and you risk franchisee and, ultimately, franchise system failure.  Set the fees too low and you risk "franchise system" failure resulting from your inability (as the franchisor) to properly support, develop and expand your system. 

The process of establishing your franchise fee and royalty structure should not be based on a rigid formula or a formula that simply duplicates the fees charged by your "perceived" competitors. Rather, your franchise fee and royalty structure should reflect the unique characteristics of your business, the sophistication of your existing business systems, the strength of your trademarks and your future obligations to maintain, develop and refine your franchise system and the rights of your franchisees.

When establishing these fees, some of the critical factors/principals that you should be considering, include: 

• The Initial Franchise Fee Should Reflect the Value of Your Existing System(s). In many respects the initial upfront franchise fee that you will charge to your franchisees should reflect the value of the existing "system(s)" that you have already established.  Higher franchise fees are usually predicated on valuable, well established and tested "systems" and intellectual property assets.  In making this assessment, consider:

(a)  The legal strength of your trademarks and their USPTO registration status;

(b)  The strength and recognition of your trademarks and trade dress by consumers in the marketplace;

(c)  The competitive advantage(s) that will be afforded to your franchisees by your "established" business systems, products and services, including unique products and sources of supply.

•  The Initial Franchise Fee Should Reflect Your Initial Training Obligations. The initial training of your franchisees will play a significant factor in the development of your franchise system and the success of your franchisees.   Your initial franchise fee should reflect and give consideration to the initial training obligations that you will be undertaking as you add each franchisee.  Your franchise fee must be sufficient to ensure that you possess the necessary financial resources and systems to properly train your franchisees.

• Your Royalty Structure Should Reflect Your Business and be Geared toward Franchisee Success. The relationship between franchisor and franchisee is one of interdependence.  That is, to be a truly successful franchisor, you need successful franchisees.  When structuring the ongoing royalty obligations of your franchisees, consider:

(a)  Successful franchise systems require successful franchisees, so ensure that the ongoing royalty rate reflects the economics of your individual franchise units and does not inhibit franchisee "profitability";

(b)  Royalties must be sufficient to support and pay the expenses associated with your current and ongoing efforts and obligations to continuously refine, develop, recreate and protect the core components of your franchise system.  As a franchisor you will possess some serious and necessary obligations respecting the continued development and refinement of your franchise system.  this is a serious obligation and your royalty structure must be sufficient to properly fund these activities;

(c) Your royalty structure should reflect your business.  Although the typical or predominant royalty structure is based on a fixed percentage of gross sales, start-up (and even current) franchisors should consider possible alternatives that may  better reflect the "unit economics" of their franchisees.

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For the successful business owner considering the franchised expansion of his or her business one critical question that must be answered is "how do you approach the preparation and development of your franchise agreement."  That is, do you "approach" the preparation and development of your franchise agreement (and franchise disclosure documents) as:

(a) A "legal obstacle" that requires the preparation of "generic" agreements and disclosure documents;

OR

(b) A collaborative process focused on the development of a critical "asset" that uniquely reflects, identifies and protects the components of your business (that is what has made your business successful),  franchise, and  franchise system.  

Why do I ask?  Because your approach will determine the ultimate outcome of this important process.  

Approach "(a)" - the "legal obstacle approach" will typically lead to generic  agreements and disclosure documents that, by all accounts, result in little (if any) value to a developing franchise system.  While this approach may satisfy (or appear to satisfy) your regulatory disclosure requirements they do nothing to advance the development of your "franchise system".  That is, approach "(a)" typically leads to "form over substance" and not much else.  When speaking with start-up franchisors that have followed this approach - an approach that they followed with the best of intentions but based on what may be poor advice - I am typically advised that their franchise agreements simply do not work for their business and franchise system.   

For the start-up franchisor, approach "(b)" is the only true option.  By following this approach your franchise agreement and disclosure documents will serve as core business "assets: that will reflect and protect  the unique and critical components of your business and your newly established franchise system.  

When starting a franchise keep in mind that all agreements are not the same and and that your input will be critical to insuring that your agreements and disclosure documensts reflect the unique nature of your business.  This is no easy task and is not one that is not simply delegated - an indepth working relationship with your franchise lawyer is required.

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Recently on satellite radio I listened to a radio advertisement, allegedly, by a national franchisor promoting the resale of what I believe to be previously closed franchise locations. The franchisor is allegedly Quiznos and this morning I checked out their website relating to their promotion and sale of opportunities relating to the "re-opening" of closed Quiznos locations. Basically, the website is promoting and offering prospective franchisees the opportunity to acquire rights to own or operate closed Quiznos locations.  Presented as a "low start-up cost" opportunity, the website operator makes the following "promotional" statments about this Quiznos "re-open" opportunity:

Own a Big Brand without a Big Investment.

Jump into a proven business system for as little as $12,500 down.

Own your own business in as little as 90 days.

Quinos has a limited inventory of stores available through this program.

 While I readily admit that I have not reviewed  Quiznos disclosure documents respecting this alleged  "reopen opportunity", here is my take on this advertisement and potential opportunity:

• Understand Why the "Closed Location" Originally Failed.   Franchise failure resulting in closed stores  may be attributed to many factors and may not necessarily be attributed to the the Franchisor, i.e., failure could be attributed to a deficient and non-performing franchisee. However, when a franchisor possesses an "inventory of closed stores" and is looking to resell these opportunities you must question whether or not the closed stores (and especially the particular store that you are considering) may be attributed to failings or deficiencies on the part of the franchisor, the franchise system or the business location, i.e., Is the continuing royalty too high? Is the food cost too high? Is the rent reasonable? Is the advertising program insufficient? Does the location generate enough traffic?  You must understand what contributed the original "store closing" and insure that the facts and legal obligations that you are undertaking are different.  That is, learn from the mistakes of others.

• Your Investment Goes Far Beyond your Initial Out of Pocket Expense.  When buying a franchise your investment goes far beyond  "out of pocket" expenses.  Although this opportunity is presented as one with limited start up costs, you must also consider the loan obligations that you will be agreeing to and assuming.  While your "out of pocket" may be nominal you could be acquiring substantial debt obligations.  Also, always remember that your time has value and in and of itself represents a substantial investment - especially if your store is not generating a profit.

• Don't Just "Jump In". I think that you probably know this already, but we all need to be reminded of this critical point.  So, "don't, do not just jump in".  Due diligence is key.

Disclaimer: Michael Webster of BizOp makes a great comment about this  alleged Quiznos website and the possibility that it may not be directly affiliated with Quiznos. Michael's comment is instructive for prospective franchisees and a reminder as to why prospective franchisees must engage in a detailed due diligence process.  Thanks Michael.

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Can you expand your business in the State of New Jersey through a "license agreement" without triggering New Jersey's franchise relationship laws?  (This is not a simple question and, unfortunately, the answer involves an evaluation of both "objective" and "subjective" factors.)

Short Answer:  

Yes, however you must discuss and evaluate the substance of  your license agreement, including your degree of control over your "licensees" operations and your economic influence over your "licensees" business.  

Long Answer :

The New Jersey Franchise Practices Act contains extensive prohibitions and restrictions governing (and in many cases modifying) the contractual relationship between franchisors and franchisees within the state.  Under New Jersey law the following criteria give rise to a franchise relationship and the potential imposition of franchise regulation:

1. The existence of a written agreement for a definite or indefinite period;
2. Providing for a license to use a trade name, trademark, service mark or related characteristic is granted; and
3. The existence of a community of interest in the marketing of goods or services at wholesale, retail, by lease, agreement, or otherwise.

With New Jersey's definition of a "franchise" heavily dependent on the existence of a "trademark license", your contemplated "license agreement" may have the unintended consequence of creating a regulated "franchise relationship".  To determine if your (1) written (2) trademark license agreement "crosses the line into franchise territory" you must evaluate the (3) community of interest criteria and determine whether or not your written license agreement "creates a community of interest [between you and your licensee] in the marketing of goods or services..."

This "community of interest" criteria is not defined by the New Jersey statute, involves a subjective determination and has been expansively evaluated by New Jersey courts in favor of finding a franchise relationship. To make this determination the courts look to the relationship between the parties and, among other things, the extent to which the licensee (franchisee) is economically dependent on the licensor (franchisor).  That is, where a licensee invests in a business that is largely dependent on a licensor's trademarks, products and/or services and where the licensor possesses significant influence over the licensees business, a "community of interest" (and thereby a franchise relationship) may exist.  Some of the factors that the courts have found to be relevant, include:

• The extent and nature of the licensees /franchisees business investment;
• The bargaining power between the parties;
• The licensees/franchisees economic dependence on the licensor's/franchisor's goods or services;
• The licensor's/franchisor's control over the goods and services offered by the licensee/franchisee; and 
• The licensees/franchisees ability to procure and/or offer goods supplied by a third-party.

Ultimately, any determination as to whether or not your New Jersey license agreement "crosses the line" into franchise territory will require a detailed evaluation of your written agreement and the economic relationship and legal rights that you create.  If your "license agreement" gives rise to a "franchise relationship", your licensee (and now franchisee) will be granted substantial protections and rights granted by the New Jersey Franchise Practices Act.    The key is to be aware of this "unintended consequence" when structuring and planning your "license" agreements and business relationships

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