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

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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Every once and a while I get comments to posts on this blog that I refuse to publish.  These are not comments that are critical of my posts  (frankly, I appreciate critical comments that offer informative and different viewpoints) but rather generalized comments by individuals who are just looking to attract attention to a franchise or business opportunity that he or she is attempting to sell.  What bothers me the most is that these "comments" almost always involve an erroneous (and almost fraudulent) sales pitch where the prospective business purchaser or franchisee is "advised", basically, that franchises don't fail.  These improper and erroneous sales pitches, incorporate the following theme:

During tough economic times you should buy a ______________ franchise because the chances for failure are much lower with a _________ franchise than starting a business from scratch because you will benefit from a proven system.

While there are many benefits to franchising (benefits that I value and believe in) the reality is that, like any business, franchises do fail and that not every franchise opportunity is the same.  That is, there are many franchisors that possess neither a proven track record nor a tested business model. The key for the prospective business purchaser and franchisee is to find the right business model for you and, when purchasing a franchise, to be selective and find the right franchisor, that is a franchisor with a tested and well established model.  Good franchisor's are out there but you must do your research, speak with qualified franchise advisors (they are out there) and consult with a franchise lawyer to review the FDD and other information before you signing any agreement or pay any money.

The information is out there, but you must be an "active" purchaser and discount sales pitches that "guarantee success".  In business there are no guarantees.

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The purchase of a franchise represents a substantial investment that will have longstanding implications for both you and your family.  Prior to selecting a franchise and deciding to move forward, you must engage in an active "due diligence" evaluation of the franchise system and determine if its is right for you.  As discussed in "Contact Existing Franchisees before Signing a Franchise Agreement" existing franchisees are excellent sources of information when evaluating a potential franchise investment.  Three "initial" questions that you should be asking existing franchisees, include:

1.  Were you Satisfied with the Franchisor's "Pre-Opening" Training and Support?  One of the advantages of purchasing a franchise, in theory, should be the support and training provided by the franchisor.  The training and support that you receive prior to opening your franchise will be critical to launching a successful franchise. If current franchisees are not satisfied with the pre-opening training and support provided buy the franchisor, seriously question whether this is the right franchise for you and speak to your franchisor lawyer about adding specific training guuarantees to your franchise agreement should you decide to go forward.

2.  Are you Satisfied with the Franchisor's "On-Going" Training and Support?  While many franchisees open their business to a successful launch and impressive sales, on-going support is crucial.  A good franchise system is characterized by constant communication and support between the franchisor and its franchisees.  If current franchisees are not satisfied with the on-going support offered to them, again, you must question whether or not this is the right franchise for you.  Certainly raise this issue with the franchisor's sales people and your lawyer.

3.  Do the Numbers Make Sense? In other words, after paying royalties, advertising fees, product costs and operating expenses does the business earn a profit?  This is an apparent and critical question that too many prospective franchisees fail to consider and evaluate. When focusing on this issues ask as many questions as possible and speak to as many franchisees as you can.  Gather information and then discuss this issue with both your business accountant and franchise lawyer.

In addition to these initial questions you should have many others focused based on the particular franchise that you are considering.  I suggest that you write down a list of your expectations and then - prior to signing any franchise agreement - seek out and obtain as much information as possible to determine whether or not the franchise that you are considering is right for you.  Your decision should also be based on a candid discussion with your franchise lawyer and a thorough evaluation of the franchisor's disclosure documents.

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If you are a successful business owner and thinking about franchising your business, it is critical to recognize that with the benefits of franchised expansion come both federal and state regulation - regulation that is manageable and, actually, helpful if approached correctly.  While Federal Law provides an overriding framework regulating the offer and sale of franchises throughout the entire country, fifteen states have enacted their own franchise laws that, supplement and add additional regulations to be followed by franchisors. In Twelve of the states, registration of the franchisors Franchise Disclosure Document (FDD) is required. 

States that have Enacted Supplemental Franchise Laws and Require Registration of a Franchise Disclosure Document:

• California
• Hawaii
• Illinois
• Indiana
• Maryland
• Minnesota
• New York
• North Dakota
• Oregon
• Rhode Island
• South Dakota
• Virginia
• Washington
• Wisconsin

In these states, in addition to complying with the Federal Franchise Rule, franchisors must file and register their franchise disclosure document (FDD) prior to offering or selling a franchise.  Like a stock or security that must be registered with the Securities and Exchange Commission before offering or selling a franchise in these "registration states" your FDD must first be registered with the appointed state regulator.  For example in New York, FDD's must be registered with the New York Attorney General.  In California FDD's must be registered with the California Department of Corporations.  Since New Jersey is not  registration state, although FDD's are still required and must be disclosed, they are not registered with a state entity.

States that have Enacted Supplemental Franchise Laws but do not Require Registration of a Franchise Disclosure Document:

• Michigan (only notice)
• Oregon (no filing)

In these states there are supplemental regulations (in addition to the federal regulations that apply throughout the entire United States) that must be followed. Although Michigan and Oregon do not require "registration" of a franchisor's FDD, these state require the filing of a notice with each respective state advising of your proposed offer and sale of franchise.

Always remember that the "state" regulations are a supplement to the Federal Rule and that, at all times prior to offering and selling a franchise you must have a prepared and updated FDD. Your FDD must be disclosed and delivered to your prospective franchisee at least 14 calendar-days before the prospective franchisee (i) signs a binding agreement with you, or (ii) makes any payment to you or any affiliated entity or person.  If you are considering a "licensing system" as opposed to a "franchise system", check out "The Unintentional Franchisor: How a License Agreement may Subject you to Franchise regulation". For important information and insight into the new Franchise Rule and the FDD disclosure requirements definitely read attorney Rush Nigut's post on the New Franchise Disclosure Document. 

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(Great, a lawyer answering a question about whether you need to hire a lawyer)

Answer? Yes - but not right away.  

The competent advice and guidance of a franchise lawyer will serve as a valuable tool (one of the many "tools" that are required) to be utilized on your road to entrepreneurship and the purchase of a franchise.  The advice provided by your franchise lawyer should be based on practical experience and involve a detailed review of the proposed franchise agreement and franchise disclosure document (FDD) and be followed by negotiatios with the franchisor.  However, while hiring a franchise lawyer is critical, it should not be your first step.

So what do I mean by "not right away"?  The process of buying a business is not a "sprint" (at least it should not be) but rather an "endurance event" that will require you to seriously evaluate your individual needs, business skills and expectations.  Once you have made this assessment, you will be faced with the challenging task of finding a business that is both profitable and right for who you are and your skill sets.  This is no easy task and will require that you do significant research (tons of resources available on the web), communicate with other business owners, communicate with existing franchisees (to do this, see "Contact Existing Franchisees before Signing a Franchise Agreement") and, possibly, seek out the advice of franchise professionals.  Don't just pick or get stuck on one particular franchise model or limit your research to the information provided to you by the franchisor's salesperson.  Remember, first and foremost, what matters most to a successful franchise investment are "profits" that will be  measured by your ability to take home money to your family each and every month.  So question everything.  If the franchise sells soup, then question how you will earn "profits" in the summer.  If the franchise sells ice cream, understand how "profits" are generated in the winter.  If the franchise appears to draw long lines or generate large revenues, then question what percentage of  those long lines and revenues are converted into "profits". 

Once you have completed your own internal analysis and "business review" , thats when the legal advice and analysis becomes critical.  The franchise agreement that you will sign will serve as the blueprint and road map for your business for many years to come.  As such, there are many, many critical issues that you must address with your franchise lawyer.  Some of the many issues that you must discuss and evaluate, include:

• The franchise fee that will be charged;
• The continuing royalty that you will be paying on a monthly or weekly basis;
• Advertising fund fees that you may or may not be required to contribute to;
• Approved vendors and suppliers of the supplies and products critical to your business;
• The protected territory that you may or may not be granted;
• Buildout and lease obligations that you will be required to undertake;
• Many, many other issues.

In many instances, (contrary to statements by a franchise sales person that their franchise agreement is "non-negotiable") your franchise lawyer will be able to negotiate and implement modifications to your franchise agreement that will have a substantive impact on your franchise investment and increase the odds for your success.  In today's economic climate, my experience has been that franchisor's are more willing than ever to negotiate with new franchisees.  Even things like deferring "royalties" for a number of months.  

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You have identified a franchise concept that you are extremely interested in.  You have met with the franchisor’s sales staff, completed an application and are impressed, so far, by what you see. However, before taking that next step, before paying a franchise fee or signing a franchise agreement, contact existing franchisees to get the “inside track”. 

Where do you get existing franchisee information?  In the franchisor’s disclosure  document (also known as the “FDD” and formally known as a Uniform Franchise  Offering Circular) that must be provided to you by the franchisor at least 14  calendar days prior to you signing a franchise agreement or paying any fee to  the franchisor.  The FDD is an extensive document and, quite frankly, one of the few “life-lines”  that will be available to help you make a true assessment of the franchise opportunity that you are considering. The legally mandated information contained in the FDD, and thereby disclosed to you as a prospective franchisee, is extensive, extremely relevant and should be reviewed with both a franchise lawyer and business accountant.  However, sticking to the point of this article, that is obtaining information from existing franchisees, please know the following:

• Item “20” titled “Outlets and Franchisee Information” should contain extensive information about (a) existing franchisees - including their names, addresses and contact information, (b) the number of franchise outlets in operation (at least as of the date of the FDD), (c) the number of franchise outlets that are expected to open within the next fiscal year, and (d) the number of franchise outlets that were closed, sold or terminated in the last fiscal year;

• Contact existing franchisees (not just the “star” – multi-unit franchisees who the franchisor suggests you speak with) and politely ask them about their experiences as a franchisee, the support given to them, the quality of the product (or service) and, if possible, the cash flow and profitability of the business;

• Pay particular attention to the number of franchise outlets closed, terminated or sold during the past year.  If there are a significant number (relative to total overall outlets) of closed, terminated and/or sold outlets, proceed with caution and ask lots of questions. Please keep in mind that while it may be inevitable to have a few closed outlets due to a “franchisee’s mismanagement or lack of effort”, look out for a pattern of closings, terminations and outlet sales and do not just accept an explanation blaming a closed outlet on a franchisee’s lack of effort.  In many cases, a closed outlet may be a function of neglect by both the franchisor (in terms of support and product development) and the franchisee; and 

• If the franchisor is projecting a significant increase in the number of projected outlet openings (a projection that should be included in Section 20 of the FDD) question whether or not the franchisor possesses the managerial staff and infrastructure to properly support all of these new outlets.  

When purchasing a franchise, there is a lot to consider and, inevitability – like every entrepreneur, you are bound to make mistakes. However, by contacting existing (and terminated) franchisees you can learn from some of their mistakes and cut down on your own.

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