You may be considering franchising your business for a number of reasons. You may want to expand your business but don’t have the capital to open numerous additional locations on your own. You may have people approaching you about buying a franchise because they love your business concept. You may like the idea of the brand and business you have built opening up in locations all over the country. However you come to the point of considering franchising, there are some initial steps to take before you launch into establishing a franchise program.
Here are some initial questions to ask yourself:
- Can your business be replicated? Does it rely on your expertise or can you train and guide others to operate your business in the same manner?
Typically, you want to have an established track record of operating a profitable business before you consider franchising. Once you do, ask the question of whether the franchise business can be financially successful for both you as the franchisor and the franchisees. Franchisees will be paying royalties, marketing fund contributions and other fees to you that you don’t incur as an independent business. As a franchisor, you will have the expense of establishing and maintaining a staff to support the franchise system.
- Do you have something unique to offer the franchisees to give them a competitive edge against competitive businesses and to ensure that franchisees continue to see the value of remaining part of your franchise system, even after they have learned how to operate the business?
It might be proprietary business and marketing methods, unique products or services, proprietary business management software or all of the above.
- Are you willing to give up operating your business to be in the business of franchising?
Being a franchisor is a full-time job. You must have others on whom you can rely to operate your core business and you must be willing and prepared to operate a franchise company.
- Do you have the capital available to invest in franchising?
You will incur significant costs in establishing the business structures and in complying with franchise laws and regulations in order for you to launch a franchise program. While ultimately, your franchisees will be using their capital to expand the franchise locations, initially you need the capital to cover the costs of launching the franchise company and getting to the position where you can start selling franchises.
If you have given careful consideration to the question of whether franchising is right for you and are still ready to move forward, there are some initial steps that you need to take in preparation for launching a franchise program.
1. Begin drafting an operations manual and a training program that you would use to teach new franchisees to operate your business in the manner that you want them to operate to be a positive reflection of your brand. The operations manual should be as detailed as possible and cover both establishing and opening the business and its ongoing operation. The manual will be used in training new franchisees and will also be a reference for franchisees as they operate their franchise business.
2. It can be very valuable to engage an experienced franchise consultant. They can help you assess whether your business is franchisable as well as guide you through the process of establishing a new franchise system from a financial, operational and marketing standpoint.
3. Talk to people in the franchise industry. Even better, find a mentor who has experience establishing a franchise program.
4. Protect your service marks and trademarks. Your brand and the associated trademark or service mark is one of the cornerstones of franchising so you will want to know that you and your franchisees will have the exclusive right to use the mark throughout the country. This is done through filing an application for registration of the mark with the U.S. Patent and Trademark Office. We assist franchisor clients through this process.
5. Do some research on the franchise regulatory framework and have an initial conversation with an experienced franchise attorney. While you aren’t yet ready for preparation of the legal documents needed for franchising, you want to have an understanding of the franchise laws and how heavily regulated the franchise business is. We offer an initial complimentary meeting to prospective franchisors to discuss franchising and legal compliance.
What legal documents must be prepared in order for you to launch a franchise program?
Once you have addressed business issues to consider when deciding whether to franchise your business and made preparations before launching a franchise program you are ready to get more into the legal documents needed. At this stage, you have made the decision to franchise your business and you are ready to engage a franchise attorney to assist you with the legal compliance. The first step in legal compliance is to prepare a Franchise Agreement and the Franchise Disclosure Document required by federal and state franchise laws.
The Franchise Agreement is the binding contract between the franchisor and the franchisee. You will first need to determine what entity will be the franchisor. For a number of reasons, it is often best to set up a new entity that will be the company that offers and sells franchises and supports the franchise system.
A number of business and legal decisions need to be made by you about the structure of the franchise in order for your franchise attorney to draft the franchise agreement. These decisions are often made based on your knowledge and experience about the industry of the franchise business and in consultation with financial advisors, a franchise consultant and franchise attorney, each bringing different perspectives. At this stage, the franchise attorneys at Huck Bouma prepare a Franchise Agreement Preparation Questionnaire for our new franchisor clients to complete.
Decisions you must make include what fees will be charged (initial franchise fee, ongoing royalty fees, advertising fund contributions and other fees), whether a protected territory will be granted and what size it should be, what the length of the initial franchise term will be as well as requirements for renewal, what franchisor assistance and training you will agree to provide, purchasing requirements for the franchise business, and what operational requirements should be addressed in the franchise agreement (many more will be addressed in the operations manual). Other decisions to be made include the conditions for selling or transferring the franchise business, the grounds for termination of the franchise and how disputes between the franchisor and the franchisee will be resolved.
Once the Franchise Agreement is prepared, the Franchise Disclosure Document must be drafted. At this stage, the franchise attorneys at Huck Bouma prepare a second questionnaire for our new franchisor clients to complete which covers information needed for the Franchise Disclosure Document. When drafting this document, we must follow the format and disclosure requirements set forth in 16 CFR Part 436 – Disclosure Requirements and Prohibitions Concerning Franchising, known as the Amended FTC Rule. These federal disclosure rules are enforced by the Federal Trade Commission and apply to the offering of franchises anywhere in the United States.
There are 23 sections in the Franchise Disclosure Document (referred to as Items) in which the franchisor must address very specific disclosure requirements set forth in the Amended FTC Rule. The Franchise Disclosure Document provides information necessary for an investor to make a decision on whether to purchase the franchise. Generally, the documents includes information about the franchisor (its history, management and financial condition), the franchise system and its franchisees, the initial and ongoing costs involved in purchasing and operating a franchise business, and the terms and conditions that govern the franchise relationship.
In addition to federal disclosure requirements, the state franchise regulators have issued guidelines that we must follow in preparing the Franchise Disclosure Document so that the document will be in a form that will be acceptable to the regulators in the franchise registration states where you want to register your franchise. The franchise regulators will review your Franchise Disclosure Document as part of the franchise registration process. These guidelines are the North American Securities Administrators Association, Inc. (“NASAA”) 2008 Franchise Registration and Disclosure Guidelines. These guidelines are consistent with the federal disclosure requirements but impose some additional disclosures and registration requirements. NASAA has also issued commentaries on Financial Performance Representation and on disclosure of Multi-Units which supplement these guidelines.
State registration of franchises
In addition to the federal franchise law that requires that you provide certain disclosures to prospective franchisees in every state, there are 14 states, which are referred to as franchise registration states, that require that a franchisor obtain a franchise registration with the state before offering and selling franchises in that state or to its residents. Franchise Disclosure Documents submitted to the franchise registration states must comply with the federal franchise disclosure requirements in the Amended FTC Rule and the North American Securities Administrators Association, Inc. (“NASAA”) 2008 Franchise Registration and Disclosure Guidelines.
The following 4 states require only that a notice or application and fee (ranging from $250 to $500 for initial applications) be filed with the state agency along with a copy of the Franchise Disclosure Document (except for Michigan):
- Indiana
- Michigan
- South Dakota
- Wisconsin
The franchise registrations in these 4 states are effective upon the date of filing in the state.
The following 10 states require the payment of a fee (ranging from $250 to $750 for initial applications), and the filing of a registration application and the Franchise Disclosure Documents. Except for Hawaii, a franchisor cannot offer and sell a franchise in these states until the application and FDD have been reviewed and approved by the state regulator and a registration issued by the state.
- California
- Hawaii
- Illinois
- Maryland
- Minnesota
- New York
- North Dakota
- Rhode Island
- Virginia
- Washington
State franchise regulators may require that certain changes be made to the Franchise Disclosure Document before a registration is issued. These may be changes specific to the franchise laws of the state or based on the franchise regulator’s assessment that the franchisor’s Franchise Disclosure Document does not comply with the Amended FTC Rule or the NASAA Guidelines. Any deficiencies in the Franchise Disclosure Document will be cited in a comment letter issued by the state regulator and must be addressed by the franchisor by submitting to the regulator changes to the Franchise Disclosure Document before a registration will be issued. Depending on the state and the time of year, it may take two weeks to two months (or longer) to receive a response to the application from a franchise registration, and may take longer to resolve any cited deficiencies.
As a new franchisor, you are cautioned that you cannot conduct any franchise sales activities in the franchise registration states before a franchise registration is effective. This would include any advertising or promotion of the franchise opportunity in the state, having any discussions about the purchase of a franchise with residents of the state, and/or sending any information or materials about the franchise opportunity into the state.
The state franchise registration process is not a one-time event. As a franchisor offering and selling in a franchise registration state, you must renew your franchise registration each year. You also have an ongoing obligation to amend the Franchise Disclosure Document and file an amendment application when materials changes to the information in the Franchise Disclosure Document occur during the registration year.
Selling franchises in compliance with federal and state franchise law
Compliance with franchise laws as a new franchisor begins offering and selling franchises can be complex. In addition to franchise disclosure and registration requirements, the federal and state franchise laws cover actions that must be taken when offering and selling franchises and actions that are prohibited in the offer and sale of franchises.
The first step Huck Bouma recommends to our new franchisor clients is to have key management and sales personnel attend one of our franchise sales compliance training classes (we also hold refresher classes for more established franchise companies). It is critical that officers, managers, employees and agents of a franchise company have a general understanding of the laws that regulate franchise sales so that they can avoid violating any of the franchise laws.
Violations of franchise laws can lead to investigations by federal or state franchise regulators. Violations of franchise law can lead to a lawsuit being brought in the future by a disgruntled or unsuccessful franchisee. A regulatory action being taken against the franchisor and/or its personnel or a lawsuit filed against a franchisor and/or its personnel for franchise violations must then be disclosed in the franchisor’s Franchise Disclosure Document for 10 years. Also, it is likely that a franchisor will not be able to take enforcement action against a defaulting franchisee if it is discovered that franchise law violations occurred when the franchise was sold to this franchisee.
Here is a short list of some of the rules that govern franchise sales. (This is not intended to be an exhaustive list.)
1. You cannot discuss the offer of a franchise in a registration state unless you have first obtained a franchise registration (or exemption) in that state. Part 3 of the blog identified the franchise registration states. As a new franchisor, you often begin with registering in only a few of the franchise registration states. If prospective franchisees from other registration states contact you, you cannot discuss the offer of a franchise with them.
2. All information and materials provided to prospective franchisee must be consistent with the contents of the Franchise Disclosure Document. For that reason, you must be careful that the content of all franchise advertising and promotional materials, including your website, is consistent with the disclosures in the FDD. Also, franchise advertising must comply with the regulations of the franchise registration states, and in some cases, must be filed with the registration state before use.
3. All of the discussions that your sales personnel have with prospective franchisees must be consistent with and not contradict the contents of the Franchise Disclosure Document. For that reason, all sales personnel must thoroughly read and become familiar with the FDD contents.
4. You are limited in making any comments or providing any information on financial performance of company-owned, affiliate-owned or franchised outlets (or projecting how a new franchise might perform) to the information that you included in Item 19 of the FDD (Financial Performance Representations). If you do not include any financial data in Item 19 of your Franchise Disclosure Document, you cannot discuss any financial performance information with prospective franchisees. If you do include financial performance data in Item 19, you are limited to discussing what is contained in Item 19 of the FDD.
5. At some point in the sales process, you will provide the Franchise Disclosure Document to your prospective franchisee. The prospective franchisee must have the FDD for at least 14 calendar days before you can permit them to sign a franchise agreement or pay you any money. The first thing to be done when you deliver the FDD is to have the prospective franchisee date and sign the receipt at the back of the FDD and return it to you. Federal law requires that you keep this receipt in your records. You also want to keep it for proof that you did meet this 14 day disclosure rule.
6. If the prospective franchisee decides that they want to purchase the franchise after having the FDD, you must prepare a completed, execution copy of the franchise agreement and deliver it to the prospect. The prospective franchisee must have this completed franchise agreement for at least 7 days before signing or paying any money. (There is an exception to this rule if no material terms need to be filled in on the standard franchise agreement found in the FDD.)
7. The franchise laws require that the Franchise Disclosure Document be updated at least once each year. In addition, there is an ongoing obligation to update the FDD when material changes occur in the information disclosed in the FDD (the timing of when this must be done varies under federal law and the various state laws). If any changes occur during the year, the FDD must be amended and the amended FDD delivered to prospective franchisees before any additional sales are made.
8. Of course, the franchise laws also prohibit fraud and misrepresentation in the offer and sale of franchises.
While all of these rules may seem daunting, a good franchise sales compliance training program, the establishment of internal franchise sales compliance policies and procedures, and counsel from an experienced franchise attorney can go a long way to ensuring that you sell franchises in compliance with the franchise laws.