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 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 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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When purchasing a business or franchise, your lease agreement will serve as one of the most influential factors in determining the profitability of your new business.  In states such as New York and New Jersey where rents are higher, paying particular attention to your rent factor is critical.

When the business that you are purchasing is a franchise, some additional lease agreement "due diligence" factors that you should consider, include:

• Is the Lease a Sublease. Whether or not the lease for the business premises is transferred to you directly (as the purchaser of the business and the new franchisee) or if the lease is held by the franchisor (as the direct tenant) and then to you, indirectly, as a subtenant. This is important because in instances where the franchisor has direct control of the lease, it is possible – if you breach or terminate the franchise agreement – for the franchisor to attempt to “step in” and take over the operations of the business that you are purchasing. Again, this concern only comes about in instances where you breach the terms of the franchise agreement;

• Is there a Lease Management Fee. Whether or not the franchisor charges a monthly lease management fee. This applies mostly in instances involving the franchisor’s sublease of the business location and constitutes, typically, an administrative monthly fee charged to you by the franchisor for being identified as the direct tenant on the lease;

• Restricted Lease Use Clause. Whether or not the leased business location may be converted to a non-franchised business location in the event of a termination of the franchise agreement; and

• Protected Territory. Whether or not the franchise agreement includes a protected territory (i.e., a specified geographic radius or map located within a certain proximity to the business location) within which the franchisor will not sell any additional franchises.

Your lease will serve as one of the most critical business assets that you will be acquiring, so you must get the terms right.  If the business that you are purchasing is a car wash or gas station in New York, Long Island or New Jersey your lease agreement due diligence must also include an assessment of the property for potential environmental conditions.

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