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

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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For the start-up and established franchisor alike, as your franchise system evolves continuous consideration must be given to your franchise agreement and "the legal rights that you reserve for your franchise system".  That is, basic to every franchise agreement are the "reservation clauses" identifying and  establishing alternative channels of distribution and legal rights  that are not granted, conveyed or licensed to your franchisees.  These reserved rights typically address alternative channels of  distribution and markets that are expressly reserved to the  franchisor.  Examples include internet sales, mail order sales, captive market accounts and licensed products sold through alternative sales channels.

Chances are that your "existing franchise agreement" contains reservation clauses.  However, have you recently reviewed these legal provisions?  Are the reservation clauses contained in your franchise agreement generic, or do they account for your future plans for expansion? When evaluating your franchise agreements and future plans for expansion, discuss with your franchise attorney and staff:

• Potential distribution and sale of private label products;
• Potential expansion and development of alternative franchise systems;
• Licensed distribution and sale of signature products and services through non-franchised outlets; and
• Your current and future plans for internet and/or mail order based sales.

There are other points but they are all based on the fundamental fact that you must be constantly evaluating your franchise agreement to ensure that it matches where your franchise is today and where it may be ten years from now.  Avoid the generic.

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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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From a franchisors perspective litigation is a critical "cost factor" that must be contained and mitigated.  When consulting with franchisors (both start-up and established) one issue that provides good reason for concern is the ability of "franchisee associations" to sue you directly.  Traditionally, the issue of "standing" - that is the right to sue another individual or company - requires that, in commercial transactions, the parties possess a direct relationship and "privity" with one another.  When dealing with certain associations (including franchisee associations) the courts have expanded the concept of "privity" and have afforded certain associations the right to sue even where a direct relationship may not exist.  That is, although you may have no dealings or contractual relationship with a "franchisee association", the "association may nevertheless possess the legal right to sue your company.  Considering the significance of this issue and to better address the question of - why? - that franchisors rightfully ask, the following is a brief review and summary of some of the case law involving a franchisee association's right to sue (My comment follows at the end):

[Guest Post: Kenneth A. Goss, Esq.] 

Franchisors that have experienced litigation from franchisee associations may wonder how a franchisee association has a right to bring a lawsuit against a franchisor. Here is the brief answer.

First, a little background and let's assume we are only talking about federal court, where many franchise cases are brought. Under Article III of the United States Constitution and applicable federal law, a franchisee association must have standing to bring a lawsuit against the franchisor. Standing simply means that the franchise association has the right to file a lawsuit under the particular facts of the case. In the franchise relationship, franchisees themselves may have standing to sue a franchisor because of privity of contract. Privity of contract simply means that a franchisee can enforce its franchise agreement by a lawsuit against the franchisor and vice versa. However, a franchisee association may be a separate entity, not a party to a franchise agreement with the franchisor and, therefore, not in privity of contract with the franchisor. How then can a franchisee association bring suit against a franchisor?

The simple answer is that courts have said they can. Courts have held that an association, which otherwise itself would lack standing to sue, nevertheless has standing to bring suit on behalf of its members when (1) its members would otherwise have standing to sue in their own right; (2) the interests it seeks to protect in the lawsuit are germane to the association's purpose; and (3) neither the claim asserted nor the relief requested requires the participation of the individuals in the lawsuit. See, for example, Clark v. McDonald's Corporation, 213 F.R.D. 198 (2003). If a franchisee association meets this test, then it can bring suit against a franchisor on behalf of its members.

[My take on this issue:  When evaluating the factors as to a franchisee association's "standing to sue", one serious point of attack in challenging the association's "right to sue" or, at least, limiting the relief sought by the association exists in the third factor - point (3), above. That is, although franchisee association's possess a "right to sue" this right is limited to claims and relief "that do not require the individual participation of your individual franchisees".  If the franchisee association's claims extend to "monetary damages" - a claim that "requires the participation of individual franchisees - then the association may have exceeded its legal standing.  Claims that fall within the association's standing typically involve claims where the association seeks "declaratory judgment and injunctive relief.  When faced with association litigation, franchisors must challenge standing at every reasonable opportunity.]

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Below are five steps / factors / issues that you should be considering and evaluating before investing in a franchise.  There are many more than five, but the following is a start.

(1) Due Diligence is Critical – If you are considering the purchase of a franchise it is critical that you conduct an in depth evaluation of both the franchisor and the potential franchise opportunity. Far too many franchisees just assume that if a franchise system has multiple franchisees, good looking stores and trade dress, that the franchise opportunity must be profitable. However “profitability” is not guaranteed and all franchises are not created equal. You must research and evaluate the franchisor, the franchise system and whether or not the franchise opportunity is a good fit for you.

(2) Thoroughly Examine the Franchisor’s FDD with a Qualified Professional – If you have already contacted a franchise company to inquire about your potential purchase of a franchise opportunity, chances are that you have been handed, mailed or emailed an extensive document referred to as an “FDD”. FDD stands for “franchise disclosure document” and is the legally mandated disclosure document that a franchisor must provide to you at least 14 days prior to your execution of any agreements or your payment of any money. The FDD is an important document that will serve as a significant resource to enable you to more thoroughly examine the franchise opportunity that you may be considering. The FDD will contain information about the franchisors management team, the franchisors “estimate” of the start-up costs that you should expect to incur and the royalties and on-going fees that you will be required to pay. FDD’s are important and before investing in a franchise you should hire an experienced franchise lawyer to review this document.

(3) Contact Existing Franchisees – One of the biggest resources that a prospective franchisee should consider is the opinion and experiences of existing franchisees. When evaluating a franchise opportunity, take some time to politely contact existing franchisees (choose a franchisee in another state or someone that you will not be in competition with), let the existing franchisee know that you are considering the purchase of a franchise and that you would appreciate it if they would speak with you about their experiences and satisfaction with the franchisor and the franchise system. Don’t just contact franchisees recommended by the franchisor – seek out the advice of as many independent franchisees as possible. Item “20” of the FDD titled “Outlets and Franchisee Information” should include a list of the existing franchisees and their contact information, so use the FDD as your starting point to identify franchisees that you should contact.

(4) Understand that Franchise Agreements are Negotiable – When a franchise opportunity is presented to a prospective franchisee, many times, the prospective franchisee is advised that the franchise agreement is “not negotiable”. Some franchisors and their sales staff may even take this approach a step further and advise that even if they wanted to change the franchise agreement that it would be illegal for them to do so. However, before you simply sign a franchise agreement and pay a franchise fee, you must understand that franchise agreements are indeed negotiable. It is not illegal for a franchisor to negotiate the terms of your franchise agreement. While you must be reasonable with your expectations about the franchise agreement terms that a franchisor may or may not be willing to negotiate, review the franchise agreement with your franchise lawyer and develop an approach to address and negotiate some strategic points that may enhance your rights as a franchisee. Some of the critically important franchise agreement terms that you should be evaluating with your franchise lawyer and potentially negotiating, include:

(a) Scope of your protected territory;
(b) Grace periods regarding the commencement of royalty obligations;
(c) Liquidated damages and liability for early termination;
(d) Renewal rights;
(e) Transfer rights;
(f) Cure periods for alleged defaults; and
(g) Potential "rights of first refusal".

(5) Sometimes the Best Decision may Be to “Walk Away” - It is critical that you remain “honest with yourself” during your due diligence investigation and the consulting with your franchise lawyer. That is, the franchise that you once believed to be a great opportunity (one that you were previously excited about and told your family you were purchasing) may turn out not to be what you expected. Sometimes in the excitement of this entrepreneurial venture you may be inclined to discount or overlook warning signs that should serve as a red flag. Understand that walking away from a franchise transaction, sometimes, may be the best business decision. 

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In the current economic climate there are many news reports discussing franchise failure and the harsh economic realities faced by some well intentioned and hard working franchisees.  These articles typically feature a struggling franchisee and then proceed with a discussion as to the economic difficulties that the franchisee is experiencing.  When reading many of these articles - especially the portion where the franchisees express what he or she believes is causing the failure in the franchised business - I am concerned that many franchisees (including prospective franchisees reading the article) may be missing some critical points.

In Eilene Zimmerman's CNNMoney.com article, "Trench Warfare in the Franchise Field", Rita's franchisee Tish Reisman discusses some of the difficult circumstances that she is currently experiencing.  While it certainly appears that Ms. Reisman is a hard working and well intentioned individual, I am concerned that the points she raises (as to the possible causes for her business losses) may be off the mark.  In the article Ms. Reisman, raises the following points that she attributes to her losses:

(a) Encroachment:  "A competing Rita's opened five miles away";

(b) Time Consuming Promotions:  "A corporate marketing campaign required her to stand in front of Wal-Mart and Kmart stores handing out coupons, sucking up time and resources she couldn't spare";

(c) Product Introductions:  "Rita's requires her to sell every new flavor it introduces for 24 days - even if it tanks"

While the issues raised by Ms. Reisman are certainly issues of concern, are they the actual cause of the "franchise failure" that she seems to be experiencing?  Here are some of my thoughts:

• Encroachment - Encroachment is an extremely serious issue for franchisees and indeed a major contributor to franchisee failure and diminished profits / losses.  However, in Ms. Reisman's case we are advised that the competing Rita's franchisee is located 5 miles away.  When dealing with the "local nature" of ices and similar quick serve products is this really an encroachment issue?  Five miles sounds quite reasonable and could actually serve as a benefit to Ms. Reisman in terms of economies of scale that may be created through possible joint marketing efforts and brand penetration.  While encroachment is a serious issue for all franchisees, I am not certain that this is a significant factor for Ms. Reisman.

• Time Consuming Promotion - I am not sure if I buy this issue at all as a contributing factor.  Having a franchisor interested in market promotion is a good thing and, quite frankly, Ms. Reisman could have paid some teenagers to hand out coupons - as opposed to doing it herself.  

• Product Innovation - many times franchisees complain, and rightfully so, that the franchisor is not actively engaged in product innovation and development.  So, here to, I would not criticize Rita's for its constant product introduction.  However, to the extent that franchisee's are experiencing higher levels of waste (due to poor sales of new products) there should certainly be a royalty adjustment for the franchisee.  This is certainly an issue for Ms. Reisman, but, again is this a substantial contributor to her unprofitability?

While Ms. Reisman may be experiencing other issues not addressed in the article, I can not  help but believe that she needs to be addressing and evaluating some serious additional factors.  For both Ms. Reisman and any individual considering a franchise investment, here are some other factors that I would be considering:

• Debt Service - The issue of debt service is not mentioned in the article but could be playing a substantial factor in the economics experienced by Ms. Reisman.  Did Ms. Reisman borrow money to establish her Rita's franchise and, if so, how much?  Too many times prospective franchisees do not consider the substantial impact that debt service will have on their bottom line.  Is Ms. Reisman over levereged? 

• Expectations - When purchasing her Rita's franchise what were Ms. Reisman's expectations about profitability.  My only point here is that when evaluating something as a success or failure , a lot depends on your expectations.  Did Ms. Reisman have the right expectation when she purchased her franchise?  Did she base her expectations on solid "due diligence" involving discussions with existing franchisees, a thorough evaluation of the FDD and her legal obligations?

There are many other factors that are of extreme relevance to understanding the unfortunate circumstances that Ms. Reisman is facing.  It is not enough to simply blame the franchisor and, quite frankly, Ms. Reisman needs to thoroughly assess her current circumstances and implement some immediate corrective measures.  Unfortunately, if Ms. Reisman's  due diligence or expectations were off, going forward, the Rita's franchise may not be the correct business for herself and her family.  

UPDATE:

In a comment Paul Segreto of Franchise Essentials links to his excellent and "honest" post "Fear and Consequence of Failure: A True Story".  If you are a franchisee definitely read what Paul has to say as I believe that the advice he offices speaks from experience.  If you are a struggling franchisee consider what Paul has to say - especially the part of considering an exit strategy.

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

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

OR

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

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

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

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

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

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Recently 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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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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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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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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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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(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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This weekend, driving back to New York from an an exceptional legal  conference in Virginia my partners and I came across one of my  childhood heroes (maybe not really a hero but a pretty cool guy):  "Bob's Big Boy". Meeting up with "Big Boy" reminded me, once again,  of the critical importance of trademarks and trade  dress to a franchise  system.  By the way "Bob's Big Boy" is a registered trademark of Big Boy Restaurants International, LLC.

For the prospective franchisor who would like to start a franchise or believes that franchised expansion may be in the future of his or her business, it is critical that you evaluate and protect your trademarks now.  Why is this so important?  Because trademarks and trade dress  are one of the most fundamental and critical assets of a franchise  system.  So, well before you start a franchise (where you will be  licensing your trademarks to franchisees) make sure that you consult    with a franchise lawyer or trademark lawyer (even if you are years  away from starting a franchise) and evaluate the following factors:

• Are your trademarks legally protectable?  Among many other factors,  your trademarks must go beyond "descriptive" terms and involve unique terms that have become associated with your business.

• Does your Trademark Actually Infringe on the Mark of a Third Party? It is quite possible that the mark you are using may actually infringe on the trademarks and intellectual property of a competitor.  Even if you never heard of the third-party competitor, depending on issues involving State and Federal trademark registration, your use of a trademark in one state, i.e., New Jersey, may actually infringe on the registered marks of an unknown competitor in California.

These points apply for any successful business - even if you never intend to start a franchise.The process for evaluating and registering your trademarks is not a complex process and may be accomplished cost effectively by a business and franchise lawyer.  Before you even contact a lawyer, you can conduct a basic and preliminary trademark search on your own by visiting the website of the United States Patent and Trademark Office (Click on the "Trademarks" Tab and then "3. Search TM Database").

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