New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

So, it is 2013 – Yes, Happy New Year – but now getting to some serious issues, one that will impact and you, your family and your business interests for many years to come, you may be considering the purchase of a franchise.  You may be in the initial preliminary stages of your franchise search or you may be at some advanced stage having met with the franchisor and are ready to "pull the trigger" on signing a franchise agreement.  In either case, both as a franchise lawyer and a tremendous proponent of the "franchise business model", you need to proceed with caution and thoroughly evaluate your options and what will be right for you.  

Below I have linked to some important articles that you "MUST READ BEFORE SIGNING A FRANCHISE AGREEMENT" but, before I do that I want to give you two key critical low cost recommendations (one is actually no cost) that you should not overlook:

1. Order a complimentary copy of my book "An Entrepreneurs Guide to Purchasing a Business or Franchise" - Complimentary order form;

2. Schedule a Consultation with Franchise Specialist Joel Libava, before selecting a franchise opportunity. Speak with Joel and obtain  what I believe to be invaluable and personalized insights into franchise ownership and understanding what franchise opportunities may or may not be right for you  -  Order Form to Arrange for a Consultation with Franchise Specialist Joel Libava  (I believe Joel charges $250 for the consultation and, in my opinion, it is invaluable).

Below are the links to the articles you should be reading:

• Buying a Franchise: How Much Reserve Capital Should You Have? 
• Buying a Franchise: What Does the Franchise Fee Cover?
• 5 Things to Know Before Buying a Franchise
• Franchisee Profitability: 8 Days, 8 Months or 8 Years
• "Low Cost Start-Up Costs High Returns"?
• Avoid the Hype When Buying a Franchise: Focus on Specifics and Not Overall Industry Trends

So, from my perspective, in business "action is good", "taking chances is good", "doing is good", "inaction is bad" but, even worse, acting without equipping yourself with specialized information, resources and advice (all readily available to you) would be the worst mistake to make in 2013.

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With 2013 and the beginning of the new year upon us, as an entrepreneur and business owner, it is quite common to, again, start some fresh thinking about your business, business goals, expansion and expansion options offered by franchising.  Maybe you have thought about franchising in the past or now, for the first time, you believe that you are ready to take this leap forward.  I happen to believe – for the right business and entrepreneur – franchising in 2013 will serve as a tremendous tool for building your brand and lifestyle.  However, like everything in life, not all who enter this ring will survive.  Some will fail to execute and, worse of all, some will fail to "get started".

So if franchising is a business option that you are considering, here are some important articles and facts that have helped many franchisors who, like you, evaluated the formula for franchising, and who, in 2013 will be benefiting as a franchisor.

• Starting Your Franchise and Raising Capital: Beware of Violating Securities Laws
• Creating Your Franchise System: Why the FDD Preparation "Process" Matters
• Franchising Your Business: What is the Right Franchise Term?
• Preparing Your FDD: Why You Must Avoid the Generic
• Blatant Franchise Violations: Franchise Agreements Disguised as License Agreements
• FDD Trademark Disclosures: What Disclosure is Required When Your USPTO Trademark Application is Rejected
• How to Franchise Your Business Seminar Podcast
• Legal and Developmental Services to Start a Franchise
• Trademark and Trade Dress Basics for Franchisors
• Advantages Versus Disadvantages of Being a Franchisor
• The State Franchise Resources Map

Yes – franchising is not right for every business but, if you fall within the right criteria, franchising could be the business model that accelerates the growth and expansion of your business in 2013.  Now may be the time to "get started" - you know before 2014.

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Although this blog post will be short, the topic is of critical importance to both franchisors and franchisees.  The topic is "reserve capital", that is, how much in savings should a new franchisee possess establishing a new franchise location.  Without reserve capital (funds in a bank account after the grand opening of the franchised business) franchisees may face unnecessary business failure which, in turn, causes a degree of failure for the franchisor – a closed franchise location.

Time and again, I have seen that one of the largest reasons for franchisee failure is insufficient reserve funds.  Without these funds, the pressure is on starting on day one and with the added financial pressure comes, many times, a franchisees failure to reinvest revenue into the continued marketing and development of the new franchised business.

Here are some general thoughts:

• Reserve capital requirements will absolutely vary based on the nature of the franchised business, i.e.,  does the  business involves the sale of "services" which may require a longer development period or the retail sale of "goods" which may have more immediate sales but, typically, higher operating expenses?
   
• Reserve capital requirements will vary based on the individual circumstances of the franchisee, i.e., does the franchisee have a spouse who will earn a salary from a separate job or business?
• No business is profitable on day 1, week 1, month 1 or, quite frankly month 6 and if you think that you are, you are probably not as you, most likely, will be diverting capital / revenues / perceived profits to pay for your personal expenses when there should be reinvested in your business.

If you are buying a franchise, consider that FDD "Item 7"("Your Estimated Initial Investment")  will include an estimate of "Additional Funds" / reserve capital that you should include in your estimated overall investment.  Give serious consideration to this estimate and, if it were me, I would assume that my start-up reserve capital should be equal to no less than 6 months of my living expenses.

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It is certainly common for business owners who are considering expansion and the establishment of a franchise system to consider and evaluate a less "regulated" pathway toward franchise development.  One option that many consider (an option that I strongly advise against and one that 99% of the time is not the right course of action) is licensing.  Another option or "path" that many consider – a path down the franchising road – is one relying on the "fractional franchise exemption".  As will be discussed below, the fractional franchise exemption is a limited exemption that is not designed for start-up franchisors and, as such, not something that I would recommend.

• A LIMITED EXEMPTION – The fractional franchise exemption, under Federal Law is a limited exemption to the FDD disclosure mandates.  That is, if the fractional franchise exemption applies, the franchisor is not required to  prepare, disclosure or register its FDD.  The fractional franchise exemption is designed to reduce disclosure obligations and burdens when dealing with sophisticated franchisees with industry experience and an existing business within the same industry as the franchise offering.

• REQUIREMENTS FOR A FRACTIONAL FRANCHISE – To qualify under the federal fractional franchise exemption: (a) The prospective franchisee must have more than two (2) years experience in the same type of business as the franchised business; and (b) the franchisor and franchisee must have a reasonable basis to anticipate that the franchisees sales (from the activity of the franchised business0 will not exceed twenty (20%) percent of the franchisees total dollar volume in sales for the first year.

• CAUTION: STATE RISK – Caution must be applied when evaluating the fractional franchise exemption because – separate and apart from the federal law – certain states, including Hawaii and Washington do not recognize the fractional franchise exemption.  Also, certain states, including New York and California, define fractional franchises differently.  Also, fractional franchisors are nevertheless also required to file annual registration exemption filings.

• CAUTION: DUE DILIGENCE REQUIRED – Prior to proceeding with a fractional franchise exemption, due diligence is required.  Evaluation of the prospective franchisees current business and sales will be required.  Also, you must evaluate and discuss with your franchise lawyer the impact of state specific franchise laws applicate to the franchisor's place of business, the franchisor's state of incorporation, the state wherein franchise negotiations occurred, the state where the franchisee resides and the state where the franchised business will be located.

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When working with start-up and established franchisors, once critical FDD development issue that we frequently consider relates to "FDD and Franchise Agreement flexibility".  That is, as a franchise lawyer, I have learned long ago that franchise systems develop and evolve so, over time, today's franchise system will look very different four, three and even two years following the initial franchise launch.  One franchise system component most susceptible to change being regional and national promotion and marketing incentives.  So, when it comes to developing an FDD, frequently we look to the implementation of "Collective Action Clauses" to serve as a sort of net to catch unanticipated advertising and marketing needs.

Collective action clauses, permit a franchisor to implement unanticipated marketing programs and fees where the particular marketing initiative is put to a vote by franchisees and where majority approval is obtained.  Once approved, all franchisees (including the ones who voted against the action) are bound to the new measure.

To give you a better feel about what I am talking about, the following is an example of a collective action marketing clause:

Special Advertising and Promotional Programs

In addition to Marketing Fund contributions set forth in Sections __ and ___ and Franchisee’s local advertising and Area Cooperative obligations under Sections ___ and ____, Franchisee agrees to participate, during the Term of this Agreement, in any national, regional, or local advertising or promotional programs that have been approved by a majority of [Franchisor’s] franchisees operating within the particular geographic area and, to the extent there are insufficient monies in the Fund or one or more Area Cooperatives available for or allocated to such programs, to promptly remit the required funds to an advertising account to be maintained by [Franchisor] for such purpose.

Consider that Collective Action Clauses, when structured and implemented properly, add significant flexibility to franchise agreements and the development of a franchise system.  Does your franchise agreement contain a collective action clause?

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As a franchise lawyer you would think that I am used to this by now, but I am not.  What I am referring to is the inadvertent (at least I hope so) disregard of the franchise laws and regulation by extremely successful and well intentioned business owners who have expanded their brand through license agreements that are nothing other than a disguised franchise.  These business owners (none of which are my client) have adopted "license agreements" that – other than avoiding the actual word "Franchise" - are absolutely franchise agreements.  That is, these license agreements:

1. Establish a continuing commercial relationship;
2. Grant a license to use certain trademarks and intellectual property;
3. Permit the "licensor" to exert a significant amount of control over the "licensee's" operations, i.e., all goods and products must be purchased from the "Licensor" and the "Licensee" must conform to the "Licensor's" standards for operation; and
4. Involve payment of a fee.  These fees are sometimes hidden in product cost and other required purchases but they are still, nevertheless there.

Not only do these "license agreements" create a road map that would lead a regulator to absolutely conclude that a franchise relationship has been established, they actually take it a step further and include agreement language whereby the "licensee" agrees to obligate itself to assist the Licensor in converting the Licensee's "licensed business" into a franchise, should Licensor later "apply to become a franchisor".

Judging by the number of proposed "license agreements" that I have seen recently, I question and ask you to question the following:

• Are lawyers actually drafting these license agreement and, if so, do their clients really under the significant exposure that they may be subjecting themselves to in the future, i.e., when you have a disgruntled "licensee" who consults with an experienced franchise lawyer or contacts the attorney general?
• If you have a successful business and you wish to expand, you must understand that for all but an extremely limited number of situations you will be required to satisfy the franchise laws and regulation.
• If you are a successful business owner that is looking to disguise a franchise as a license due to a lack of capital for preparation of a Franchise Disclosure Document and other franchise compliance activities, I can assure you that the cost savings is just not worth the future litigation risk and exposure.  Worse, when you do eventually decide to franchise your business, I can assure you that your license agreements will constitute nothing other than expensive problems that you will be required to address.

MY RECOMMENDATION: When it comes to franchising, there are no shortcuts.  "Dressing up" your franchise as a license, in the long-term, will not work and is not worth the future cost or risk.

For additional information as to the distinction between licensing and franchising, see, "The Unintentional Franchisor: How a License Agreement May Subject You to Franchise Regulation".

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When working with clients to establish and launch their franchise system, the issue of existing and potential future “investors” frequently comes up.  That is, I am either advised that my client already has investors who purchased stock in his or her existing company or that he or she would like to sell a minority interest of stock in the franchise company that we are about to form.  I certainly understand that certain clients may wish to raise additional capital to cover expenses and investments associated with establishing a franchise system.  However, to raise capital and sell stock in your business, you must be aware that, in most instances, your stock sale (even though you may be a small start-up franchisor with a few investors comprised of family and friends) will subject you to various federal and state securities laws and regulations.   Consider that, many times, the sale of stock in your franchise company will require that you issue and disclose information contained in a prospectus / disclosure document to be delivered to your prospective investors.  A securities prospectus is similar to a Franchise Disclosure Document in that the prospectus is designed to contain specified information to inform prospective investors about the business they may invest in and the risks associated with such investment.

Although I am a franchise lawyer and not a securities lawyer, the issue of stock sales comes up often and, as such, it is important that you be aware of the following general points / overview:

• Even though your franchise company will be a small closely-held company / entity, the sale of stock / equity will be deemed the sale of a security under Federal and State Law.
• Two of the many issues to be concerned with when selling stock / equity in your franchise company, consist of: (1) registration of the securities offering with a regulatory agency; and (2) providing investors with a prospectus (a disclosure document similar to an FDD).
• Section 4(2) of the Securities Act of 1933 (the “Securities Act”) provides certain exemptions from “registration” respecting “private stock offerings” that do not involve “general solicitations” or “marketing” respecting the sale of equity.  In particular, for certain private stock offering, Rule 506  provides the primary factors / “safe harbor” that must be satisfied to qualify for the Section 4(2) private offering exemption.
• The Rule 506 safe harbor exemption identifies and is limited to two classes of investors comprised of (a) an “Accredited Investor” (typically institutions and high net worth individuals, i.e., individuals with annual income of $200K in each of the two most recent years), and (b) a “Sophisticated Investor”(a sophisticated investor being an individual that must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment).  Stock / equity cannot be sold to anyone other than an Accredited Investor or Sophisticated Investor and qualifications must be carefully evaluated to ensure that the investor is sophisticated.

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For franchisors (especially start up franchisors who have not implemented a properly drafted forum selection clause in their franchise agreement) the issue of multi-state litigation is always a concern when faced with franchisee disputes.  Without an enforceable forum selection clause, franchisee litigation may pull you into courtrooms throughout the United States.  When it comes to state based litigation and whether or not "jurisdiction exists", consider the following:

• Whether or not the franchise agreement contains a forum selection clause;
• The geographic location of the franchisees territory and business;
• The state of the franchisor's corporate formation;
• The state of the franchisor's corporate offices;
• The state where franchise sales negotiations took place;
• The location of the franchisees attorney;
• Other contacts that a franchisor may have with a particular state, I.e., if the franchisor is conducting business in the state or if there are existing franchisees in the state.

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Yes…but you must proceed with caution and a precise plan.

• (1)  The franchise model is focused on franchisees who are licensed physicians;
• (2)  The franchise model is focused on providing franchisee physicians with a marketing plan and system focused on distinguishing and branding that physicians services;
• (3)  The franchise model is focused on elective procedures and preventative care that does not, necessarily involve third-party payers; and
• (4)  The franchise model is focused on a fixed fee royalty structure that is not tied to the physicians revenues. 

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Time and again I am reminded of the critical importance of the FDD preparation "process" and why the quality of the FDD preparation "process" will substantively impact the quality of your eventual franchise system.   

• What does your protected territory look like?
• Royalty structures need not be based on a "fixed" percentage of gross sales.
• How important is social media to your business?
• How will your FDD and Franchise Agreement deal with web procurement and distribution of products and services.
• Must every franchise unit conform to uniformity requirements or can you "localize" and "individualize" franchised units?]

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This morning, in speaking with a client regarding the development of her franchise system (a system based on a well tested and unique service and business model) we discussed “what the right franchise term should be, i.e., 5 years, 7 years or 10 years”.

The answer to this question is one that must be unique to the franchise opportunity and one that is focused on the franchisee and the franchisee’s potential return on his or her investment. That is, “what is a fair franchise term that will permit a franchisee to generate a solid return on his or her franchise investment?”

As a potential franchisor, you must discuss with your franchise lawyer the start up costs that will be incurred by your prospective franchisee, the potential for profits and a sufficient time period for the franchisee to generate an acceptable rate of return. Just selecting an arbitrary time period (2, 5, 10 or 15 years), without any further analysis, may result in a mistake that shortchanges either yourself or your franchisees.

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A core component to Franchising is the inherent trademark license granted from franchisor to franchisee. In a “perfect IP world” the franchisor’s principal trademarks are registered with the USPTO and FDD Item 13 discloses the registration information.

Since nothing is ever perfect, many times, franchisors will fail to obtain registration of their primary marks. There are many reasons for a USPTO registration denial, including, the claimed mark being “descriptive” or “confusingly similar” to an existing mark that previously obtained registration.

Failure to obtain registration at the federal level does not render a tradename or trademark valueless or one that, necessarily, needs to be abandoned. One example being a trademark that has acquired common law protections and rights resulting from a franchisors use of that mark within certain geographic areas or regions.

So, when faced with disclosure of your unregistered trademarks, what information must be disclosed in Item 13. The FTC Compliance Guide is extremely instructive on this point:

First (Disclaimer): The following disclaimer must be stated in Item 13:

We do not have a federal registration for our principal trademark. Therefore, our trademark does not have as many legal benefits and rights as a federally registered trademark. If our right to use the trademark is challenged, you may have to change to an alternative trademark which may increase your expenses.

Second (Explanation): Explanations are permitted. A franchisor is permitted to disclose common law rights that a franchisor claims to an unregistered mark. The FTC Compliance Guide does a good job of illustrating a potential disclaimer. The following is a portion of the sample qualifying disclosure contained in the FTC compliance guide.

We grant you the right to operate a shop under the name “Belmont Muffler Shop”. You may also use our other current or future trademarks to operate your shop. By “trademark,” we mean names, trademarks, service marks and logos used to identify you shop. We registered the trademark on the United Stated Patent and Trademark Office principal register on May 11, 1993, as Number 379286.

 You must follow our rules when you use these marks. You cannot use a name or marks as part of a corporation name or with modifying words, designs, or symbols, except for those which we license to you. You may not use Belmont’s registered name in connection with the sale of any unauthorized product or service, or in a manner that we have not authorized in writing.

 On June 4, 2003, the United States Patent and Trademark Office rejected Belmont’s application to register the mark “Super Mufflers” because the mark was found to be confusingly similar to a previously registered mark.

 Our inability to register this mark on the federal level permits other to establish rights to use the Super Mufflers mark. Such use of the Super Mufflers mark does not occur in areas where our franchisees are operating or advertising under the mark, or in the natural zone of expansion for Belmont’s shop. In addition, others outside the Belmont system who use the Super Mufflers mark must act in good faith and without actual knowledge of out prior use of the mark. However, if others establish rights to use the Super Mufflers mark, we may not be able to expand into these areas using that mark.

Caution should always be taken when proceeding with an unregistered trademark. However, if you are faced with this situation there are options.

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Time and again when working on a franchise project - preparing the FDD and establishing the structure for a client's franchise system - I am always reminded of one critical fact:  That when it comes to franchising, every business is different.  Quite frankly, if there is nothing unique about your business, what you offer clients and how you deliver what you promise then, you should not be looking to franchise your business.

However, if you can identify the unique factors and advantages associated with your business and what you offer, it is critical that you consult and work closely with your franchise lawyer to ensure that your FDD and Franchise agreement reflect and, more importantly, protect these unique business factors.  I am tired of reviewing generic agreements that, many times, leads to litigation and disruption of what could have been a great franchise system.  So when working with your franchise lawyer, consider and discuss:

• What are the core business assets that your franchisees will be utilizing;

• What systems and procedures can you put in place to ensure that franchisees conform and follow your franchise system.  What I am talking about here is not the typical litigation clauses contained in the franchise agreement but rather integrated business systems that force or, at least ensure, that franchisees have every possible incentive to comply with system requirements;

• What are the core assets, services and/or products that will be delivered to your clients and how can you integrate your business systems into your FDD and franchise agreement to ensure that you maintain control over the delivery of your products and services.

There are many other factors and considerations.  However the key point here, I believe, is that you must identify the unique components and characteristics of your business and ensure that your FDD and franchise agreement reflects same. 

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When a franchise agreement expires, franchisors and franchisees, many times, enter a decision making period to determine, discuss and negotiate whether or not the the franchise agreement will be renewed.  Although not preferred, this post-termination negotiating period is sometimes necessitated by on-going negotiations and delayed decisions.  During this critical negotiating period - one where the franchisee is, most likely, operating the franchised business without a franchise agreement - franchisors, many times, unnecessarily jeopardize the protection of their trademarks and trade dress by failing to require the Franchisee sign what should be a mandatory acknowledgment.

• The Scenario - Franchise agreement expires and franchisor and franchisee negotiate the potential renewal.  During the "post-termination negotiations" the franchisee continues to operate the franchised business and continues to utilize the franchisor's trademarks and trade dress.  Although the Franchisor does not expressly acknowledge the franchisees continued operation, the franchisor does not continue with the enforcement of the franchise agreement's post-termination restrictive covenants. 

• The Problem that Arises - By permitting the franchisee to continue operations - without the benefit of an on-going franchise agreement - the franchisor is legally acquiescing to the franchisees technical infringement of the franchise systems trademarks and trade dress.  In doing so, the franchisor weakens its marks and makes later enforcement of the franchisee's post termination restrictive covenants more difficult.  While this "problem" is, typically, not fatal, it is nevertheless costly. Especially where negotiations break down and the franchisee continues to violate the restrictive covenants.

• The Solution - During this gap negotiating period, insist that the franchisee sign an agreement whereby the franchisee acknowledges that the franchisor is withholding enforcement of the post-termination restrictive covenants for a limited period of time, i.e., two weeks

The foregoing "problem" is not that great but it is an issue that "muddies the water" in franchisor and franchisee litigation and results in unnecessary legal fees and time.  That is, rather than advancing the franchisors right to restrict the former franchisees future business operations, the franchisor is exposed to the frivolous defense that, somehow, the franchisor acquiesced and waived its right to enforce the post-termination covenants.

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