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

The maintenance of a "current and updated" FDD represents one of the primary regulatory requirements imposed on a franchisor.  Failure to maintain a current FDD and/or renewed state registration will result in either lost franchise sales (since franchises cannot be sold) or litigation exposure (in the event that sales are made during a period of non-compliance).  Although the timing of the FDD updating process is well understood (and not often disputed) it is nevertheless important for franchisors and their management team to recognize the significance of maintaing a "current FDD" and the timing of when an FDD must be updated.  

Starting with the premises that the information and disclosures contained in a franchisor's FDD must be current, under the federal franchise rule, Franchisors are required to update their FDD under the following three circumstances:

• Annually (Mandatory).  Franchisors must update their FDD no less frequently than annually.  Annual revisions and updates to an FDD must occur within one hundred and twenty (120) days from the close of the franchisor's fiscal year;

• Quarterly (If Material Change Occurs). If events or circumstances materially change information or disclosures contained in the FDD then the FDD must be revised.  The revisions will be attached to the current FDD and must be reported "within a reasonable time" from the close of the franchisors most recent fiscal quarter;

• Immediately (When dealing with Item 19). When providing a prospective franchisee with a disclosure document a franchisor must also immediately notify the prospective franchisee of any and all material changes that the franchisor knows or should have known about respecting any Item 19 financial performance representations contained in the FDD.

Knowing when to update your FDD is not a complex process, however it does require organization and the implementation of safeguards to ensure that your financial performance representations (if any) are continuously monitored and that your management team discusses and evaluates the status of your FDD disclosures on a regular basis. 

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(Part two of a two part series)

Franchise agreements drafted for common law countries tend to be longer and more comprehensive than franchise agreements used in civil law countries. Franchisors based in the United States often use their common law agreements in civil law countries without localization, reasoning that a more comprehensive agreement is all that is needed to protect them in a civil law system. However, when considering this approach, franchisors and their counsel need to be aware that a more comprehensive franchise agreement alone may not be enough to protect them in a civil law system. Recently, when discussing this issue with Kenneth A. Goss, Esq., in house counsel to a franchisor experienced in franchising in countries under common law, civil law and Islamic law systems, Mr. Goss explained some general principles common to many civil law systems from the perspective of a common law practitioner. The following is the second of Mr. Goss' two part guest post on this important topic:

Common Law Franchise Agreements in Civil Law Systems

As discussed in Part I of this series, courts in civil law systems are not bound by precedent, may look only to statutes as the source of law applicable to a franchise relationship and may go beyond the plain meaning of the terms of a franchise agreement to ascertain the parties' intent. As a practical matter, this means that franchisors should expect courts in a civil law system to apply certain mandatory rules regardless of whether the parties have negotiated and agreed to different terms in their common law franchise agreement. Additionally, courts may apply by analogy rules the legislature intended to govern contracts other than franchise agreements if the legislature is silent on an issue or the court otherwise deems it appropriate. In each case, courts in civil law systems typically will not recognize that a common law franchise agreement contains the complete agreement between the parties and may look beyond the four corners of a franchise agreement to ascertain the parties' intent.
Mandatory Rules

Civil codes typically delineate general rules of contract construction that are applicable to all contracts including franchise agreements. Examples of terms that are often mandatory in civil law systems relate to the definition of a contract, whether or not parties have the capacity to enter into a contract, the object of the contract, the formalities for creating the contract, the evidence a court will use to determine the parties' intent and the legal effect of the contract. Such are analogous to the boilerplate terms found in contracts in the United States. However, unlike boilerplate, parties cannot agree to opt out of mandatory terms provided by civil codes. In other words, courts in civil law countries will simply substitute mandatory terms for conflicting provisions of a franchise agreement, even when to do so is contrary to the express intent of the parties. Therefore, franchisors should be prepared to accept the mandatory terms of a civil code of the target country as part of their franchise agreement.

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Inherent to every franchise system is the license of intellectual property rights that, for good reason, has been (and should remain) focused on the trademarks and trade dress associated with the franchise system. While trademarks, logos, and trade dress are critically important intellectual property ("IP") assets, an additional (and possibly overlooked) IP asset may exist in the form of "design patents" issued by the United States Patent and Trademark Office. Design patents relate to the "novelty" and "ornamental appearance" of a product and may add a supplemental layer of IP protection for franchisors. When evaluating your IP portfolio and whether or not you are maximizing the legal protection of your IP assets, consider the following:

• Design patents relate to the protection of the "ornamental design" of a product and may include the "surface" design and appearance of products and equipment.

• "Utility patents" protects the way a product is used and works, while "design patents" protects the way a product looks;

• The elements of a "design patent" must be limited to the "ornamental appearance" of a product (i.e., how the product looks) and not thef unctional aspects of the product (i.e., how the product works); and

• Examples of design patents include, the layout of buttons on the "Google" search page, the original Coca-Cola bottle, the exterior surface design of custard vending machines and the ornamental appearance of numerous other products and equipment - many of which may appear quite ordinary.

When managing the legal protections to be afforded to your intellectual property, it is critical to recognize that design patents could very well play an important role in your IP strategy. By branding and acquiring design patents in the ornamental designs associated with the equipment, displays and products offered by your franchise system, you will be adding a valuable layer of IP protection. One valuable strategy to consider is to evaluate the overall trade dress associated with your franchise system and determine whether or not design patents maybe applied to certain products, equipment and designs associated with your system. Dont overlook this IP asset.

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Many times, "start-up" franchisors (and, too often, some established franchisors) overlook the necessity of maintaining a thorough operations manual that is both "current and relevant" to the particular franchise system. That is, many times operations manuals are viewed as an "afterthought" or a"generic" obligation to be sourced out to third party vendors.

Much more than a "generic resource", your operations manual must be drafted, updated and maintained as an integrated extension of your franchise agreement and FDD disclosures. Recognizing the critical importance of a properly prepared and integrated operations manual, startup and established franchisors should consider the following:

• Franchise agreements are typically drafted and structured to integrate and obligate franchisees to abide by both current "and future" operational requirements set forth in the operations manual. If the franchise agreement is drafted properly, the operations manual should create "contractual flexability", allowing the franchisor to modify elements of the franchise system through amendments and supplements to the operations manual.

• Your operations manual must serve as a thorough blueprint to provide franchisees with detailed "how to" information respecting each and every administrative and operational element of the franchise system.  

Examples of "administrative obligations" include (a) the franchisees royalty and financial reporting obligations, (b) franchisees financial record retention obligations, and (c) system requirements for point of sale systems. 

Examples of "operational obligations" include (a) franchisees obligations respecting the management of the franchise business, (b) requirements for management and control of inventory and supplies, (c) building and construction plans and specifications, (d) training programs and obligations, and (e) operational elements respecting the day-today management and operation of the franchised business.

• The preparation of your operations manual cannot be a task that you simply "outsource". While it is prudent to obtain the advice and input of a qualified consultant (including your franchise attorney), the operations manual must directly reflect and embody "your" direct understanding and knowledge about the franchised business. "You" must be the primary contributor and driving force behind the preparation and development of your operations manual.

• Your operations manual must be consistent with your franchise agreement and FDD. Review with your franchise lawyer the content of your operations manual to ensure that there is consistency with your franchise agreement. Ensure that your training programs are extensively identified in the operations manual and properly disclosed.

• Your operations manual should be constantly updated, refined and clarified to reflect the constant and continuous evolution and growth of your franchise system. 

Your operations manual is critically important to the long-term success of your franchise - treat it as such.
 

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Has the United States economy changed?  Are we in a "new economy"?

Yes, undoubtedly yes.   In fact there are so many new facets to our economy - some good, some questionable and some bad - that you don't need me to tell you that the economy has changed.  Ultimately, where our economy "ends up" is still undecided and, in large measure, will be decided by political and economic factors yet to be determined. But, no matter where we end up, one thing is clear: our economy has been and will remain fundamentally altered. 

So, what are some of the characteristics of this evolving "new economy" and what do franchisors need to know?

• Opportunity Still Exists - Although there are elements of economic turmoil - opportunities still exist.  For the start-up franchisor the current  level of economic instability may indeed constitute a competitive advantage and opportunity to level the playing field and compete with the "big players".   More than ever, technology is abundant and relatively cheap. Competitive tools such as the internet, automated database systems, point of sale systems and social networking have created the opportunity for small competitors to compete at the highest levels and take on much larger competitors who may be distracted by franchisee defaults, litigation and over leveraged balance sheets.

• A Renewed Focus on Franchisee Profitability is Critical.  Prior to the current economic cycle (and the 10 years prior to that) capital was abundant with consumers and prospective franchisees being afforded access to easy credit.  In many instances, franchise system sales and franchisee investments were, in large measure, fueled (or at least inflated) by consumers and franchisees who simply spent more than they could afford.  System growth was focused on the incremental "gross sales and royalties" generated by franchisee expansion.  Insufficient resources were placed on franchisee profitability (compared to gross sales) and, in the current economic cycle, franchisee default rates are increasing at a substantial rate. A renewed focus on franchisee profitability (even if it comes at the expense of gross sales) is more critical than ever as consumers and capital markets remain in retreat. 

• Other Factors. As you are well aware, there are many other facets to this "new economy", including the impact of the declining credit markets on franchisee financing.  In our future and continuing posts about franchising and the new economy we will discuss franchisee financing and other issues that franchisors are confronting.   

This story is evolving rapidly...

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In a comment to a recent post - "5 Things to Know before Buying a Franchise" - the Franchise King, Joel Libava, raises the critical issue of maintaining "uniformity" in franchise agreements.  That is, the insightful Mr. Libava, challenges the propriety of promoting negotiated modifications to franchise agreements.  The point raised by Mr. Libava is a legitimate and genuine issue that must be evaluated by both franchisors and prospective franchisees.  

From a franchisors perspective uniformity is a critical factor that must underly the franchisors  legal relationship with its franchisees.  Similar to the uniform standards and procedures inherent in franchise systems, franchise agreements must also maintain consistent levels of uniformity.  Such uniformity will, at a minimum, serve to reduce litigation exposure and foster a consistent platform for the management and growth of the overall franchise system.  

From a franchisee's perspective, uniformity in franchise agreements may be a positive factor (i.e., a franchisor committed to its franchise agreement and systems) if the proposed franchise agreement is "balanced" and the franchisor possesses a substantive track record.  So how do you determine if the franchise agreement is "balanced" ?  You do your research, review the franchise agreement and FDD with a qualified franchise lawyer, speak to qualified franchise consultants and conduct the necessary due diligence.  Chances are that there will be "imbalances" in your proposed franchise agreement - there always will - but you must honestly evaluate the impact of this relationship.

So how do I put all this together, i.e., "franchisors perspective", "franchisees perspective", "balance", "imbalance"? Here are my thoughts:

1.  If you are a franchisor, focus on the development of a balanced franchise agreement that fosters the maintenance, protection and growth of, both, your franchise system and business interests of your franchisees.  Once this is achieved - really achieved - then stick to your franchise agreement and be prepared to "walk-away" from potential franchise sales;

2. If you are a prospective franchisee and you have viable questions or concerns about a potential franchise investment (after you have conducted the necessary due-diligence and evaluated the legal implications of the franchise agreement) then be prepared to "walk away" . 

The real issue comes down to a "third scenario" involving  a "franchisor not prepared to walk-away" or a "franchisee not prepared to walk away".  These are the situations where negotiations and targeted franchise agreement modifications come in.  For that prospective franchisee I would much rather obtain targeted franchise agreement modifications that I know will have a substantive impact on the prospective franchisees rights.   I think that Mr. Libava's position would be that  there should not be a third scenario?

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Customer promotions / "sweepstakes" are a popular marketing tool for promoting franchise systems sales and growth. However when considering the implementation of these marketing programs, franchisors and lawyers need to be aware of "hidden pitfalls" and regulations associated with both federal and state regulation.   Recently when discussing this issue with Kenneth A. Goss, Esq. - an in-house franchise to a national franchisor - Mr. Goss raised some interesting points that I believed would be helpful to our readers.  The following is Mr. Goss'  guest post on this important topic:

(Guest Post: Kenneth A. Goss, Esq.) The issue of franchise system promotions involving "consumer oriented" sweepstakes is an issue that franchisors and franchise lawyers must carefully evaluate and are a powerful and effective marketing tool franchisors often used to increase franchise system sales of its product. However, a franchisor that does not comply with applicable law risks possible litigation, administrative action and criminal penalties if,  for example, the franchisors seemingly innocuous sweepstakes turns out to be an illegal lottery governed by state gambling laws.  The following is a brief overview of some of the important factors that franchisors should consider before conducting a sweepstakes.

A sweepstakes is defined by federal law as a game of chance for which no consideration is required to enter. Typically, franchisors use sweepstakes to incentives consumers to buy a particular product by offering customers a chance to win a prize. There is no single uniform law applicable to sweepstakes. Instead, franchisors interested in conducting a nationwide sweepstakes face having to comply with both federal law and the law in each state where the sweepstakes will be conducted.

A starting point in evaluating a sweepstakes is the federal Deceptive Mail Prevention and Enforcement Act (the "DMPEA"). The DMPEA applies to sweepstakes entries sent through the mail, which, in most cases, is necessary to satisfy the "no consideration" element of a sweepstakes. The DMPEA states that any sweepstake entry is deemed "non-mailable" if it does not "clearly and conspicuously" disclose certain information including, among other things, the terms and conditions, the sponsor and sponsor's address, the odds of winning, and all relevant particulars about the prize(s) being offered. The DMPEA gives district courts the authority to enjoin a franchisor that fails to comply.

After evaluating the DMPEA, franchisors and franchise legal counsel must evaluate applicable law in each state in which the franchisor intends to conduct the sweepstakes. While state law will vary, at a minimum, franchisors will be required  to issue official rules and disclose the terms and conditions of the sweepstakes. Florida, New York and Rhode Island each require sponsors of sweepstakes to register with the state if the total retail value of all the prizes is greater than a certain dollar threshold. Florida and New York also require the posting of a bond and submission of winner lists. California and Texas regulate sweepstakes to the point where compliance in those states may be cost prohibitive to most franchisors. In each case, records must be kept in accordance with applicable law.

State laws applicable to sweepstakes vary widely from state to state. The good news for franchisors is that many of the requirements overlap, meaning that a franchisor with a properly structured sweepstakes can be compliant in more than one jurisdiction and realize the marketing benefits that sweepstakes can have for a franchise system. 

Information about Kenneth A. Goss, Esq. and Disclaimer.

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At the New York Franchise Law blog we have been fortunate to receive insightful and instructive comments from our readers.  Many of our readers are franchisors, franchisees and some extremely experienced franchise consultants and professionals.  Basically, our readers have a lot of good information to share.  So, recently my staff had the opportunity to interview and speak with Bob Harper, an existing franchisor.  Mr. Harper, has posted some informative comments on our site and has shared his experiences as a "start-up" franchisor.   Mr. Harper's franchise provides bookkeeping services in the United Kingdom under the "Crunchers" trade name.  In his interview Mr. Harper shares some insights and experiences that prospective franchisors should consider before making the leap from "business owner" to "franchisor".  A portion of Mr. Harper's interview and some of my comments follows: 

Q: What is the Crunchers business all about?

A: Crunchers is a bookkeeping solution provider – we give clients the choice of doing their own books using our software as part of a managed service (where we become the bookkeeping manager) or we do the books for them.  

Q: How did you Get involved in the bookkeeping business? 

A:  My background is a tax accountant, having trained with Price Waterhouse in Windsor UK. After leaving in 1991, I set-up and ran my own accountancy business and from this had the idea to develop my own bookkeeping software because my micro and small clients struggled with the off the shelf [bookkeeping] packages. 

Comment: One interesting point that Mr. Harper brought up in his interview is that his franchise involves the license of certain book keeping software.  Mr. Harper considered expanding his business through a "license structure" only but ultimately decided to proceed with the establishment of a franchise system.  When evaluating a licensing structure as an alternative to franchising there are a number of factors that should be considered, including the fees that will be charged and the degree of control that will be exercised over the franchisees / licensees.

Q: Are your franchisees required to have Prior Experience with Accounting or Bookkeeping?

A: We decided to franchise about two years ago offering 350 territories in the UK. The first franchisees are accountants who have launched Crunchers on the side of their accountancy practice. We also have a few bookkeepers and are now offering the franchise to [individuals without an accounting background].

Comment: This is a critical issue for the start-up franchisor and established franchise systems - that is, what is your criteria and requirements for selecting a qualified franchisee.  Be selective, set clear guidelines as to the types of franchisees that you will approve and reject those that do not meet your select criteria.  Selecting / approving an unqualified franchisee is  costly mistake that creates a number of legal and business issues that will drain the resources of your franchise system.  

Q: What advice would you give to successful business owner about starting a franchise?

A. Running a franchise business is a separate and probably a completely different business to the business they are thinking of franchising. So, treat it as such and make sure you have the right funding, skill set team, systems and resources.

• Look at all other options of expanding so you can justify franchising as the best option because it is not easy.

Comment:  As to this point the advice of  Mr. Harper is extremely instructive for those looking to start a franchise.  Prospective franchisors must recognize that once you "start a franchise" your primary obligation becomes that of a "franchisor" and you are no longer the operator of a business.  Keep in mind that the "franchise business" is very different that the underlying business that you are franchising.  In Mr. Harper's case once he established a franchise system he stopped operating a "bookkeeping business" and became the operator of a franchise system.  Another major point that Mr. Harper mentions is "funding"  when establishing a franchise system, simply preparing and registering your "legal documents" is not enough.  You must possess the necessary capital and resources to establish the systems, products and procedures necessary to support your franchisees and to manage the development and growth of your franchise system. Franchise consultant Joel Libava offers some great pointers and information about this issue (what it takes to establish a franchise) in his article "Do you Really Want to Franchise your Business".

 Thanks to Bob Harper for sharing his experiences with us and, as always, I look forward to hearing from Bob in the future.  If you are a start-up franchisor it would be great to hear about your experiences on these topics.

Disclaimer:  Please note that our reference to a particular franchise should not be viewed as an endorsement of a franchise or a franchise opportunity.  At the New York Franchise Law Blog we do not recommend or solicit the sale of franchise opportunities.

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While "franchisee failure" may be inevitable for a select percentage of franchisees and, in may cases, may have nothing to do with the franchise system (i.e., a franchisee who refuses to roll up his or her sleeves and commit to hard work), one thing that this economic downturn has exposed is the fact that many franchisees (too many) are not "raving fans" of the franchise system(s) in which they operate.  In speaking with franchisors and franchisees over the past number of months, one critical issue that appears to be adding to this disconnect may be franchisor implemented policies designed to generate additional franchisor revenue through "non-franchisee" channels of distribution.  When evaluating your franchise system and the potential for generating additional system revenues, one critical resource that is often overlooked is "existing franchisees".  Recently, after reading Ken Blanchard and Sheldon Bowles  insightful book, "Raving Fans - A Revolutionary Approach to Customer Service", it became clear to me that too many franchisors are overlooking a critical asset and opportunity: revenue growth generated by existing franchisees who are converted to "raving fans".

Again, while not all franchisees are right for every franchise system and while certain franchisees may never "get it", as a franchisor, I believe that you must develop the systems, procedures and policies that will turn your franchisee base into "raving fans".  Following the advice of Mr. Blanchard and Mr. Bowles, you should start by assessing and understanding:

(a)  What you expect from your franchisees;

(b)  What your franchisees want from you; and 

(c)  How to deliver what your franchisees want "plus" an extra one percent.

Evaluating and understanding these factors / answering these questions, can only help to further refine and improve your franchise system.  The incremental sales (in terms of franchise unit growth and gross revenue) that could be generated by franchisees that are "raving fans" could prove substantial and, in my opinion, represents a critical resource that many are overlooking.  If you have not read "Raving Fans", I strongly recommend it.

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If you are a successful franchisor or entrepreneur (of a non-franchised business), chances are that you place great priority on the development of your "intellectual property" such as your trademarks, trade designs and innovations that may be the subject of a patent. While successful business owners and entrepreneurs are great at innovating and creating "intellectual property", sometimes, mistakes are unnecessarily made respecting the protection of your "intellectual property.

When evaluating the development and protection of your intellectual property, the following are some factors that you should be aware of and considering as you manage your critical intellectual property assets:

Intellectual property is a "Two-Sided Coin" and is not limited to just "One Thing".  That is, your view toward your intellectual property assets should be expansive and involve the recognition that you are not just limited to "trademarks" or "patents".  Many of the key intellectual property assets that comprise your business may be afforded an array of protections involving trademarks, patents and a  broad array of "common law" protections associated with "trade secrets", "customer lists", "production sources" and other confidential components that drive your business.  The key is to properly structure your legal approach to these assets and afford them the maximum protection possible.  For example:

- Have your key employees with access to confidential information about customers and production sources signed limited but enforceable confidentiality agreements;

- Do you review with your corporate counsel the current usage of your trademarks to ensure that your trademark registrations are current and that supplemental applications are not warranted;

- Have your production sources signed off on confidentiality agreements respecting key components or processes involved in the production of your proprietary products and supplies; 

-Have you evaluated key product designs to determine whether or not your product may benefit from a "design patent.

As you are certainly aware there are many more issues and considerations concerning the protection of your intellectual property assets.  However, the basic and extremely limited point I wish to convey that the creativity that you put into developing the unique intangible assets that drive your business should also be applied toward the active management and protection of these assets.  Set a plan and actively discuss the protection of these critical assets with your corporate counsel. 

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For both (a) franchisees deciding on the right franchise investment and (b) franchisors establishing a solid franchise system, the right "mindset" is critical.  That is, it is critical that your understanding of franchise opportunities and franchise systems go beyond the generalized and  involve a  detailed understanding and evaluation of the overall mindset that a successful franchisor brings to the table. Reflecting on "some" of the critical points that my clients have raised over the years, the following is my take on some of the factors that you (whether a prospective franchisee or franchisor) should be considering in evaluating a "franchisor's mindset":

• Focus on Franchisee Training is Paramount - Smart franchisors, that is franchisors that are focused on the "long-term" are focused franchisee training.  That is, the long-term road to franchise growth and the development of a valuable franchise system must be premised on the consistent development and training of its franchisees and not just a quick sale of a franchise unit.  Is the franchisor focused on evaluating franchisee qualifications and and developing systems for for both initial and on-going training?  

• Franchise Growth Must be Planned and Controlled - Somewhat related toward a franchisor's "training mindset" is the franchisors "mindset toward growth".  Franchise systems that grow to "fast" (i.e., at a rate that is not readily supported by expanded training, system development and market evaluation) are bound to fail.  Is the franchisor focused on controlled growth and growth that takes place only after developing the necessary support and brand development systems?

• Product Development must be Ongoing - One of the primary advantages of becoming a franchisee (in the right franchise system) is leveraging off of the franchisors centralized efforts in constantly developing, refining and improving the products and services that its franchisees offer.  Product and brand development is a constant and on-going process and is critical to the continuing success of a franchise system. Is the franchisor focused on systems and a  process that continuously reinforces and refines its brand and the products and services offered to its customers.

There are many, many more points and steps that successful franchisors follow.  However, key to every franchise is a franchisor and franchise management team that approaches each day with a "mindset" focused on controlled growth, franchisee development and product development.

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Short Answer:  Avoid lawsuits.  That is, work on and establish with your legal counsel "legal systems and procedures" that is designed to avoid unnecessary litigation. (Slightly longer answer follows)

While the advice that I am offering here may sound obvious and, possibly, even a little self-serving, it is nevertheless an honest and critical point that far too many franchisors and business owners overlook.  That is, in most (but not all) litigation once your are involved (either as a plaintiff or defendant) the advantages and benefits that may or may not stem from the outcome of the litigation will, many times, be outweighed by:

(a) the legal fees that you will incur,

(b) lost productivity associated with your focus on the lawsuit (as opposed to building your franchise systems), and

(c) the uncertainty that is inherent in all litigation - no matter how strong your case is.  

Faced with the inherent costs in all litigation, the best course of action for both start-up and established franchisors is to establish with your legal counsel open channels of communication focused on cutting-down and mitigating your "litigation exposure".  That is, in addition to the critically important task of managing your regulatory requirements and disclosures as a franchisor, you must discuss and establish with your legal counsel a fair and flexible relationship and system focused on the management and monitoring of your day-to-day legal activities. Some of these activities should include:

(a) The review of vendor agreements,

(b) The establishment of standardized franchisee communications and compliance notices;

(c) The quarterly evaluation and review of your trademarks and the filing of supplemental trademark applications and affidavits;

(d) The establishment and maintenance of a specified and well documented "encroachment policy" respecting the grant of additional franchises;

(e) The establishment of a clear and concise policy respecting the negotiated modification of your franchise agreements;

(f) The maintenance of strategic employment agreements with your key employees that are focused on the implementation "enforceable" restrictive covenants;

While establishing an on-going day-to-day working relationship with your legal counsel may be more expensive than "doing nothing", the value of this planning process will far outweigh the cost associated with unnecessary and avoidable litigation. Once tasks become standardized and well establish, my experience has been than many activities may be incorporated into the tasks of your "in-house" staff and, over time, serve to reduce your long-term legal fees.

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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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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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Recently I received some interesting and insightful comments from an  individual commenting on issues involving franchisee rights.  Her main point of contention appears to be the disparity of bargaining power and legal rights between franchisors and franchisees.  While this is certainly an issue of concern, I believe that her comments may be giving a "free pass" to franchisees who don't take the time to conduct the appropriate pre-purchase franchise due diligence.  The following are some of the commentators insightful points:

On Franchise Agreement Liquidated Damages:

Isn't it true that most franchisees don't understand that the "optional" liquidated damages terms in the contract are premeditated to give the franchisor the advantage when the franchisee fails to thrive? The failure fee is hidden within the contract from the view of franchisees.

Do attorneys point this "failure fee" out to their clients?

My Take on this Serious Issue:  As I have previously discussed, "liquidated damage" provisions in franchise agreements - especially those that kick-in when a franchisee "closes his or her doors" have the potential to inflict serious financial harm on a franchisee who already may have lost a substantial investment.  However, these provisions may be negotiated by franchise attorneys and are exactly the types of "legal issues" that a franchisee should be discussing with a franchise attorney before signing a franchise agreement. Liquidated damage clauses can be negotiated.

On Franchisees Reading and Negotiating their Franchise Agreement:

While it may be true that franchise agreements may be legally negotiated with the franchisor by individual prospective franchisees, isn't it true that most of the mature franchisors don't or won't negotiate changes and will acknowledge that pre-sale, their contracts are not negotiable. Don't they acknowledge this to the courts, when asked?

My Take on this Serious Issue: Franchise agreements are negotiable and even "mature" franchisors are willing to make reasonable modifications.  However, even if we assume that a particular franchisor will not make changes why would a prospective franchisee invest his or her livelihood in a franchise and sign a franchise agreement without first reviewing, understanding and evaluating each and every right and obligation contained in the franchise agreement.  Look,  there are many times where I believe that franchisees need an advocate but franchisees cannot  get a "free pass" when they neglect to conduct even the most basic due diligence.  

In the end, you do not have to sign a franchise agreement and, sometimes, even with successful franchise systems, not signing the agreement might be the best course of action for you. No one is forcing you to sign the agreement.  Likewise you must know that no matter how many other franchisees may have signed the franchise agreement you - personally - must understand and evaluate what you are signing.  Your livelihood depends on it.

For franchisors, a policy that permits limited but targeted franchise agreement modifications may actually strengthen the enforceability of your franchise agreements when faced with litigation. 

My thanks to Ms. Cross for some really insightful comments.

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Driving into the office this morning I listened to a radio commercial that I found to be repulsive . The commercial was not political, did not contain any profane language and, quite possibly, did not contain any false statements.  Nevertheless, the information conveyed in this commercial (really just a bunch of self-serving platitudes) could do harm to the unprepared.  

So what was this commercial about?  The sale of franchises for a national mall based / strip-center consumer video game franchise.  You see, the commercial was not promoting the operations of their retail stores or franchisee operations but rather the sale of "franchise opportunities".  Since I don't have the actual text of the commercial (I am basing this post on my memory of 5 minutes ago) I will not disclose the name of the franchise.

What Do I think is So Wrong about this Commercial? the fact that rather than promoting existing franchisee sales and informing consumers about the advantages of their stores (compared to competitors) they offered a generic pitch about buying their franchise.  Their "franchise sales" pitch followed the following formula:

• Make a generic statement about "becomming your own boss";
• Offer generic information about  "industry growth trends"; and
• Imply, with even more generic information, that you - as a franchisee - can benefit from this opportunity by utilizing their "proven and powerful" systems.

Basically, alot of hype and platitudes - many words but little, if any, information.  

Points for Prospective Franchisees: (1) Just buying a franchise does not make you your own boss; (2) Just because an overall "industry" is growing and profitable does not mean that as a "retail franchisee" your business will also be profitable; (3) Before buying a franchise give serious thought about what makes them "unique" and the "added value" that they bring to the table.  Most importantly, when you hear a franchisor brag about "proven and powerful systems" ask specific questions about those "systems" and what makes them "proven" and "powerful".  Don't wait until after you pay a franchise fee and invest in build-out.

Some of the many internet resources to consider include: The Franchise King, Franchise Essentials, Blue MauMau, Franchise Pick, WSJ Small Business. 

Points for Franchisors:  Advertising franchise sales is no a bad thing and, in fact, may be a key component to overall system development and growth. However, the ads should be based on the unique and fundamental characteristics of your particular system and the advantages that you offer.  If these "unique characteristics" are not readily identifiable then you are doing something wrong and you should be focusing on true "system development" and not unit sales.  Significantly, the witnessed success of existing franchisees is the best source of growth for a franchise system.

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The definition of a franchise and the factors utilized to evaluate the existence of a franchise have important implications.  That is, does the business arrangement providing for the multi-unit expansion of your business qualify as a franchise and thereby subject you to franchise regulations and disclosure requirements?  The answer to this question depends on the "substance" of the business relationship and an evaluation of both federal and state law.  

For the "New York franchisor" (comprised of any business - based in any state - seeking to offer or sell a franchise in the State of New York) the definition of what constitutes a "franchise" is more expansive that the federal definition.  Under the Federal Franchise Rule "trademarks" and "trademark licenses" are primary and critical components of a franchise system. Without the license of a trademark, under federal law, a "franchise" does not exist.  Under New York law however, the existence of a franchise is not dependent upon the existence of a trademark license.  That is, although your "business arrangement" does not involve a trademark license and therefore does not qualify as a "franchise" under federal law, you may nevertheless be subject to New York's franchise regulations and disclosure requirements if your "business arrangement" is based on a written or oral agreement providing for:

• (i) A Proscribed Marketing Plan or System: The offer, sale or distribution of goods or services under a proscribed marketing plan or system; and 

• (ii) Payment of a Franchise Fee: The direct or indirect payment of a "franchise fee". What qualifies as a "franchise fee" is also expansively defined and may include license fees and other charges associated with the business transaction.

Additionally, New York offers an alternative definition of a franchise replacing the "proscribed marketing plan" requirement (point (i) , above) with a "trademark license".  

So, under New York law, unlike federal law, although the existence of a  "trademark license" may give rise to a "franchise relationship" it is not mandatory.  In the State of New York franchises and franchise relationships are not dependent upon the existence of  trademarks and trademark licenses.  

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The typical franchise agreement is representative of the disproportionate bargaining power between the franchisor and franchisee.  That is, franchise agreements favor franchisors.  One such favorable clause contained in franchise and license agreements relates to "liquidated damages".

The typical franchise agreement will contain a "liquidated damages" provision whereby the franchisee agrees to pay, as damages, a fixed sum or a sum based on a fixed formula in the event of a court's finding of a breach of the franchise agreement.  If the franchisor is successful in a lawsuit against a franchisee, the liquidated damages provision may clear a path for a Court (without any further detailed inquiry) to award substantial monetary damages.  Similarly, when dealing with trademark license agreements, licensees may be subject to severe damages based on the liquidated damages clause contained in the license agreement.

Although presumptively valid in most jurisdictions, the enforcement of liquidated damage clauses is not universal and courts in states such as New York and New Jersey will make an inquiry as to the "reasonableness" of the liquidated damages and the "bargaining power" between the parties at the time of contracting. 

So what do franchisors, franchisees and licensees need to know:

• Franchisors:  For franchisors, liquidated damage provisions are critical components to your franchise agreement and serve as a significant tool when faced with franchisee litigation. When drafting liquidated damages into your franchise agreement insure that the method of calculating damages is not arbitrary, based on tangible factors and is not inconsistent with your royalty structure.  

• Franchisees: recognize that a possible "liquidated damage" clause in your franchise agreement may expose you to substantial liability should the franchisor prevail.  When negotiating your franchise agreement discuss the liquidated damage clauses with your franchise lawyer and try to cap your financial obligations and the accrual of royalties and other fees after any alleged event of default and the termination of the franchise agreement.

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If you are researching the benefits of franchising, buying a franchise or starting a franchise, chances are that you have come across articles and promotional materials discussing the benefits of a "proven franchise system".  That is, prospective franchisees are advised that if they become a franchisee of  a particular franchise they will benefit from a "proven system".  While this vague term is used often and claimed by almost all franchisors, not every franchisor possesses legitimate systems and not every franchise system is "proven".

So, what is a "proven franchise system"?  While this question is subject to a broad range of interpretation, the following is some fundamental information about "systems" and "franchise systems" that must be considered by prospective franchisees and franchisors:

• "Systems" - are simply the procedures and tasks undertaken by business owners and managers in connection with the day-to-day operations of a business.  Every aspect of a business including, advertising, financial controls, production of goods, employee management and customer service can all be boiled down to a set of procedures and "systems".  Not every business is successful and not every "system" is effective or beneficial.

• Franchise Systems - are the procedures and tasks itemized and detailed by a franchisor (typically disclosed and detailed in the franchisor's operations manual) in connection with the operation of a franchised business.  A franchisors business systems typically include tasks and procedures focused on (a) Marketing, (b) Customer Service, (c) Employee Training, (d) Production of products and (e) Methods for delivering services.

• Proven Franchise Systems - Are the "franchise systems" that have been "previously" implemented (presumably by the franchisor and other franchisees) and have been demonstrated to result in successful and profitable operations of the franchised business.

Considerations for Prospective Franchisees:  

Effective and legitimate "systems" are critical for the successful operation of a franchised business. Don't just assume that a franchisor's "systems" are "proven" or "effective".  Ask the franchisor's representatives detailed questions about what makes their "systems" unique, effective and profitable and recognize that the "proven" nature of a start-up franchisor's "systems, in most cases, may be extremely limited.

Considerations for Prospective Franchisors:

Successful franchise systems depend on successful franchisees.  The mere act of preparing franchise disclosure documents and registering disclosure documents does not create a franchise. Strong franchises require thought out and tested business "systems" and procedures that have been tested and proven successful.  During the start-up franchising stage controlled growth (with limited franchise sales) may be necessary to will permit the necessary monitoring and refinement of your business systems. 

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Although the State of New Jersey is not a Franchise Registration State, over the years, the New Jersey State legislature has implemented laws pertaining to and affecting the legal rights between franchisors and franchisees.  The New Jersey Franchise Practices Act (NJSA 56:10-1)("NJFPA") adopts an extremely "paternalistic" approach to the franchisee / franchisor relationship and implements a number of legislated rights designed to benefit franchisees.

Both franchisors and franchisees with operations in the state of New Jersey should be aware of the NJFPA and its legislated rights, including NJFPA's  extremely vague "prohibition" against "unreasonable standards of performance".

Franchisor Standards of Performance must be "Reasonable".  Under the NJFPA franchisors are prohibited from imposing "unreasonable standards of performance on franchisees". This extremely vague "prohibition" is open to a broad range of interpretation and is designed, among other things, to prevent the termination of franchisee rights under the pre-text of "non-compliance".  

Relevance to Franchisees: This provision of the NJFPA, essentially, imposes a "reasonableness" standard when evaluating a franchisors attempted termination of a franchise relationship.  Under the NJFPA lawyers for the "terminated franchisee" are afforded the legal right to challenge, question and have the court evaluate the "reasonableness" of the franchisor's standards.

Relevance to Franchisors: Even if your system standards are well thought out, balanced and fair (as is typically the case with "successful" franchisors) when dealing with New Jersey franchisees, franchisors and their legal counsel must recognize that your system standards may be subject to interpretation and evaluation in a judicial proceeding.  To avoid unnecessary litigation costs and expenses, before terminating a franchise relationship take extra caution to document and communicate your performance standards and issues of non-compliance. 

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The licensing of Intellectual property serves as one of the most fundamental rights granted in the franchisor / franchisee relationship.  Successful franchises and franchisors require strong trademarks (and sometimes, patents) that are both recognized by consumers in the marketplace and capable of protection under federal and state law.  When a franchise is granted, the franchisor undertakes a serious responsibility and obligation to defend and preserve the marks that it is licensing.  

When a franchisors trademark is challenged by a competitor or third party, the franchisor must vigorously defend its interests, and indirectly, the interests of its franchisees.  When counseling and advising clients as to intellectual property planning and litigation strategy, the potential purchase of "Intellectual Property Infringement Defense Insurance ("IPIDI") is sometimes raised as a means of defraying what may be substantial legal fees typically incurred in IP litigation.

What is IPIDI - basically it is an insurance policy that covers your legal fees in the event that you are sued for infringing on the trademarks or patents of a third party.  The exact nature of this insurance varies between insurance companies and will be defined by the express terms of the proposed insurance agreement.  So when considering this insurance and comparing premiums, it is critical to have your lawyer evaluate the express terms of the proposed policy.

Should IPIDI be Considered by Franchisors - Yes, but it is critical to recognize that this insurance is typically limited to only those instances where you are sued and not where you are suing a competitor for infringing on your trademarks or patents.  Also, remember that this policy only covers "legal fees" and if you lose the lawsuit (i.e., found to have infringed a competitors IP, insurance will not cover monetary awards or judgments issued against you.

Some of the Important Factors to Consider - When considering this form of insurance, you should discuss with your franchise or business lawyer some of the following issues:

• Does the policy exclude declaratory judgment lawsuits;
• If the policy excludes "intentional acts of infringement" from coverage, how does the policy define "intent;
• Does the policy require frequent opinion letters from legal counsel as to the subject trademarks and patents;
• How does the premium compare to historical and possible future IP "defense" legal fees. 

Like any insurance, Intellectual Property Infringement Defense Insurance does not offer a complete solution, but, depending on the terms of the policy and the cost of the premium, should be considered as a supplement to your intellectual property strategy and planning.

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If you are a successful business owner and entrepreneur, chances are that you have considered or, at least, thought about expanding your business through the establishment of a franchise system. That is, taking the trademark(s), services and business systems that you have created and licensing them to third parties (franchisees) who will then devote their own time and capital to expanding your business concept and, hopefully, benefit from the experience and success that you have achieved to date.  No doubt, franchising is a popular and extraordinary vehicle (when done correctly) to achieve the multi-unit expansion of a business.  However, the franchising is not right for every business or entrepreneur.  Before "starting a franchise", consider the following 4 questions to evaluate if franchising is right for your business:

• Franchise Question No. 1 - "Do you have Business Systems?"  

Franchising is all about duplication, consistency and uniformity.  That is, recreating, in each store / each franchisee's business, the unique qualities and customer experience that has made your business a success.  To recreate this success and franchise your business you cannot leave anything to chance and you must be able to identify, articulate, teach and recreate the "business systems" that "you" use to successfully operate your business. For example, the "business systems" that I am referring to will include your methods and procedures for (a) operating the business, (b) addressing and responding to customers/clients, (c) advertising, (d) preparing products or delivering services, (e) managing staff and (f) administration.  There are more and these "systems" will vary from business to business.  The good thing is that, as a successful business owner, deep down if you take an objective look at the things you do every day in operating your business, identifying your "systems" should be a straight forward task. But keep in mind that you must be able to quantify these systems (i.e., write them down), simplify them and teach them to your future franchisees.

• Franchise Question No. 2 - "Can your Systems be Taught to Franchisees?"

Once you have identified your "systems" (See, Franchise Question No. 1) the next question is whether or not your "systems" may be taught to franchisees and carried out by them consistently on a day-to-day basis.  Consistency is key and to establish a successful franchise your "systems" must be capable of duplication by your franchisees - to do this, your systems cannot be complex and must be "boiled down" to a set formula.  If your business "systems" are extremely complex (a) your business may not be an appropriate model for franchising or (b) your franchise may require extremely experienced franchisees with industry experience similar to yours. 

• Franchise Question No. 3 - "Do you Have a Strong and Protectable Trademark?"

One of the primary and core elements of a franchise and franchise system is its trademark(s). As a "franchisor" one of the primary assets that you will be licensing to your "franchisee(s)" is the right to use your Trademark(s).  So you need to make sure that your trademarks are unique to your business and be capable of obtaining legal protection - that is your trademark cannot be a generic term, cannot be a name that is currently used by others and must be capable of registration with the United States Patent and Trademark Office. For a more detailed discussion of the importance of trademarks to a franchise, check out "Trademarks Matter: Evaluate your Trademarks Often and Early Before Starting a Franchise."

• Franchise Question No. 4 - "Will your Business be Profitable for Franchisees?"

Right now I am certain that you can pinpoint the profits of "your business" on a monthly, if not weekly or daily basis.  To franchise your business you must first ensure that (a) your own business possesses a consistent track record of profitability and growth and (b) that your franchisees (if they follow your "systems") will possess the opportunity for profitable growth. When making this "profitability analysis", unlike your own business, you must take into account (i) the royalties that the franchisee will be paying to you on a weekly or monthly basis, (ii) the fact that the franchisee may have higher operating costs than your established business, and (iii) the franchisee may be servicing debt obligations used to establish its business.

For additional and insightful information on this topic check out Demir Barlas' article "How to Franchise Your Small Business" and Joel Libava's article "Does it Shout "Franchise Me!"?".  For a franchisees perspective as to what makes a good franchise system Sean Kelly's article "10 Criteria for Assessing a Franchise" provides some excellent insight.

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