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

Part of the “Franchisor Basics” Series

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Own a Big Brand without a Big Investment.

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

Own your own business in as little as 90 days.

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

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

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

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

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

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

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In certain "franchise sales settings" franchisees are sometimes led to believe that modifications cannot be legally made to their franchise agreement.  That is, to induce a franchisee to sign the franchise agreement - without the benefit of any negotiations or review by a franchise attorney - the franchisee is led to believe that the franchise agreement is a "standard agreement" (signed by everyone) and that legally the franchisor is not allowed to make any changes.  The implication: you might as well just sign the agreement and not waste time or money since "we can't change the franchise agreement even if we wanted to".  

Sadly this misstatement / "myth" leads to a false sense of security and sometimes some big mistakes by prospective franchisees.  To be clear:

• Franchise agreements are negotiable;
• It is not illegal for a franchisor to modify its franchise agreement; and
• It is extremely common for franchisees to negotiate certain aspects of the franchise agreement.

Understanding these facts keep in mind that the extent to which a franchisor may be willing to negotiate the terms of its agreement varies depending on the negotiating power of the parties - one major factor includes the financial resources of the franchisee.  Also, certain core provisions of a franchise agreement - such as the royalty rate, methods of operation and use of proprietary products - usually are not and should not be subject to change.  

Some of the critically important franchise agreement terms that you should be evaluating and potentially negotiating, include:

• Scope of your protected territory;
• Grace periods regarding the commencement of royalty obligations;
• Liquidated damages and liability for early termination;
• Renewal rights;
• Transfer rights; 
• Cure periods for alleged defaults; and
• Potential "rights of first refusal".

Depending on your circumstances and concerns there are many other issues that, as a prospective franchisee, you should be considering.  However, it is critical that, as a prospective franchisee, you recognize that you have the "right" to negotiate the terms of your franchise agreement.  This "right" must be taken seriously.

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Recently, in my article "Avoid the Hype when Buying a Franchise: Focus on Specifics and Not Overall Industry Trends"  I discussed what I believe to be the improper and harmful methods for promoting franchise sales, i.e.,  generic statements and promises that may lead to inaccurate and unrealistic expectations by a franchisee.  These statements are bad for both franchisors and franchisees and my advice, basically, was to disregard and avoid this type of promotion.

This afternoon after speaking with a client about a franchise that he was evaluating - a franchise that he explained would provide him with a great "return" -  I took a look at the franchisor's website and, there it was, the pitch:

[_________________] is a proven franchise system with low start-up costs and high returns.

While I readily admit that I am a franchise lawyer and not an accountant, if I were a prospective franchisee or even legal counsel to the franchisor making this pitch, I would have the following questions:

• How High of a Return?  2%,  5%, 10%...?;

• A "Return" Based on What? Start-up costs, overall investment?  

• Is the Return Measured / Based on Gross Sales or Net Income? Before Royalties or after Royalties? Before debt service or after debt service? and;

• What type of return should I expect?

The reality is that this franchisor probably does not (and cannot - without subjecting itself to potential litigation exposure) offer an answer to these questions and even if it did there would (I hope) be an extensive number of disclaimers.  For the prospective franchisee recognize that franchisors cannot guarantee success (that is not their job), so before you make an investment decision based on "vague" statements about "profits" and "returns", start asking questions.

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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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If you are considering the purchase of a franchise it is critical to recognize that your "investment" goes beyond - well beyond - initial franchise fees and startup expenses. While franchise fees and start-up expenses (such as equipment purchases and "build-out") are critical expenses that must be evaluated, they only tell half the story.  That is, when signing a franchise agreement you will be committing yourself to a serious of legal obligations that will involve the commitment of your time, future financial resources and legal obligations for many years to come.  

So when evaluating the "cost" of a franchise, in addition to franchise fees and initial start-up costs, give some serious consideration to:

(a) Reserve Capital. Additional funds that you may be required to invest in your business/franchise during periods of unprofitability and negative cash flow.  As with any business you may very well encounter periods of unprofitability and losses.  When faced with losses and cash flow shortages you will be required to invest additional assets and resources to sustain the operations of your franchise;

(b) Your Time. The extensive time that your will be devoting to operating and managing your new franchise.  Your time is valuable and when operating your franchise you will be foregoing income and opportunities from other sources of employment.  Although obvious, this expense / opportunity cost is commonly overlooked. If your franchised business does not work out remember that your losses include missed opportunity costs and income that you would have otherwise earned. 

(c) Post-Termination Restrictive Covenants and Fees. As a franchisee in most instances you will be committing yourself to long-term obligations and restrictive covenants.  These covenants and obligations have a cost, especially when they restrict what you can and cannot do if you elect to shut down your franchise.   This is of special concern to current business owners with established reputations within a community who - for legitimate reasons - decide to become a franchisee of a national company.  

For Example - If you are a carpenter with a long established reputation within a community and you elect to purchase and become a franchisee of a national "repair" or "handyman" franchise what happens if your franchise relationship does not work out and you cancel your franchise agreement?  Will you be precluded from operating your own repair business - a business that you operated many years before becoming a franchisee?  The answer is that it all depends on the restrictive covenants contained in your franchise agreement - covenants and obligations that you should review and discuss in detail with your franchise lawyer "before" signing a franchise agreement.

So when considering the "cost" of your franchise investment you must go beyond "out of pocket" expenses and fees and evaluate the substantive impact of the long-term legal obligations that you will be committing to.

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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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For the first time franchise or business purchaser "due diligence" is critical.  Although the term "due diligence" may sound odd or out of place, it simply refers to the "pre-purchase / pre-investment investigation" that you undertake before signing a franchise agreement  or business purchase agreement.  In his article "What is Due Diligence in Business Acquisitions" Ney Grant provides an excellent overview of this process.  In my book I describe a purchasers "due diligence" obligations, as follows:

A prospective purchaser must approach "due diligence" as a constant and continuing information gathering and evaluation process respecting each and every aspect of the prospective business and the business purchase transaction.

As the prospective purchaser of a franchise "due diligence" investigation should not be viewed as a mere formality but rather an important "life line" standing between you and the possibility of making a bad decision.  Keep in mind that that a good decision and a good due diligence evaluation may lead you to the conclusion that the franchise that you believed to be "perfect" and a "great opportunity" may not be right for you. Unfortunately the decision is not an easy one to make and, as a franchise lawyer, I advise my clients that you must check your emotion at the door and be prepared, if necessary, to "walk away from a deal".  From my clients perspective sometimes the best deals are the ones that never happen.

As a future entrepreneur there will be many opportunities available to you - take your time and make sure that you select the one that fits you and offers you an opportunity for success. If you are considering the purchase of a franchise and considering the steps that should be undertaken in the "due diligence" process, I strongly recommend that you review our due diligence articles.

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Recently I came across an article written by an attorney discussing the benefits of buying a franchise in the current economic climate.  The assertion raised in the article (an assertion that I completely disagree with) was that now is a good time to invest in a franchise because "in today's economic climate many franchisor's are willing to negotiate and discount their franchise fee".

If you are buying a franchise because of a "discounted franchise fee" you are making a mistake - a big mistake.  Why? the decision to purchase and invest in a franchise requires a  detailed evaluation of the franchisor and the quality of the franchise system.  "Discounted" franchise fees or a franchisor's willingness to negotiate its franchise fee should not be viewed as an "incentive" to purchase a franchise but rather a "red flag" to question the franchisor's  commitment to the long term stability of its franchise system.  Franchise fees represent a significant source of short-term revenue for franchisors.  As a franchise system expands adding "discounted franchisees" a franchisors ability to support its expanding franchise base and business systems may be severely diluted.  

In today's economic climate dedicated franchisors focused on the long-term success of its franchisees should not be focused on short-term revenues (generated through the sale of discounted franchises) but rather the continuing development of quality training programs and business systems.  Discounted franchise fees are typically accompanied by the addition of unqualified franchisees and the dilution of the overall franchise system.

So if you are considering the purchase of a franchise don't be swayed by any alleged discounts or bargains.  Focus on a due diligence process that places an emphasis on a franchisor's commitment to its "business systems" and the overall profitability of its franchisees.  Keep in mind that your overall "franchise investment" goes well beyond an initial franchise fee.

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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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