So You Want to Franchise Your Business?

Business format franchising offers the business owner the means to expand operations rapidly without a commensurate capital outlay. The seller of the franchise ("franchisor") finances new development using money from the buyer ("franchisee"). The franchisee pays royalties and fees to the franchisor in return for the right to operate the franchised business.

This article from Franchise Direct suggests:

The core ingredients for a good franchise are that it is easy to learn, tried and tested commercially and capable of replication. The best way to find out if these characteristics exist is do a pilot run with the concept, to start it up and operate it as if it were a decentralised, franchised unit. This is an excellent method of assessing suitability in a variety of areas such as operations, equipment, advertising, cost, geographical position (ie does it need to be on the high street or could it be run from secondary premises at a lower rent?). Ideally, two or three company-owned pilots should be operated for at least a year to determine franchise viability.

It is virtually impossible for a new franchisor to prepare a franchise package in the absence of a pilot experience. The franchise package is an amalgam of the lessons learned from the pilot and then distilled into a series of arrangements and procedures for transferring the concept to the partner network. While the package will vary depending on the type of franchise, there are components common to all franchises, as follows:

1. The use of the franchisor's trademark and copyright materials - while giving franchisees the right to use these for the defined business, the franchisor's undisputed rights to them will have been protected through registration or copyright.
2. Operating procedures - documented in the operating manual, a key tool for the franchise.
3. Know-how relating to site selection - assistance in the selection of appropriate premises (where applicable).
4. Training - initial and refresher training in the running of the business and upgrades in the product or service.
5. Territorial rights - an agreement about the specific territory in which the franchisee has exclusive rights.
6. Product supply - where bulk purchasing from nominated suppliers is in place.
7. Personnel procedures - training and advice on recruitment, staff training, administration and payroll.
8. Accounting - a common accounting system for franchisees may form part of the package.
9. Marketing - the range of marketing, promotional and advertising supports provided by the franchisor for the brand.
10.Ongoing services - the partner relationship is a long-term one, so ongoing support by way of advice and field assistance, meetings and seminars, performance monitoring and training will be part of the package.

Ancillary procedures may also be documented concerning such issues as sales lead generation, the design and outfitting of premises where applicable, vehicle livery, staff uniforms, equipment, display and merchandising techniques, and business stationery."

In the United States, the offering and sale of franchises is highly regulated. This entrepreneur.com article provides that "the federal definition of a franchise includes a business relationship that has three elements:

1. The use of a common trademark ;
2. The provision of operational support or assistance, training or the exercise of significant operating control;
3. The payment of a fee of over $500 in the first six months of operation. This definition includes initial fees, royalties, advertising fees, training fees or fees for equipment. In fact, the lone exception is for goods sold to the franchisee at a bona fide wholesale price for resale to their customers.

If a company has those three elements, it is a franchise. It doesn't matter what you call it. It doesn't matter how you try to disguise it. If it looks like a duck and quacks like a duck ...”

If a franchise exists, the franchisor must comply with FTC Franchise Rule and any applicable state regulations. The FTC Franchise Rule provides:

A. General: The Rule imposes six different requirements in connection with the "advertising, offering, licensing, contracting, sale or other promotion" of a franchise in or affecting commerce:

1. Basic Disclosures: The Rule requires franchisors to give potential investors a basic disclosure document at the earlier of the first face-to-face meeting or ten business days before any money is paid or an agreement is signed in connection with the investment (Part 436.1(a)).

2. Earnings Claims: If a franchisor makes earnings claims, whether historical or forecasted, they must have a reasonable basis, and prescribed substantiating disclosures must be given to a potential investor in writing at the same time as the basic disclosures (Parts 436.1(b)-(d)).

3. Advertised Claims: The Rule affects only ads that include an earnings claim. Such ads must disclose the number and percentage of existing franchisees who have achieved the claimed results, along with cautionary language. Their use triggers required compliance with the Rule's earnings claim disclosure requirements (Part 436.1(e)).

4. Franchise Agreements: The franchisor must give investors a copy of its standard-form franchise and related agreements at the same time as the basic disclosures, and final copies intended to be executed at least 5 business days before signing (Part 436.1(g)).

5. Refunds: The Rule requires franchisors to make refunds of deposits and initial payments to potential investors, subject to any conditions on refundability stated in the disclosure document (Part 436.1(h)).

6. Contradictory Claims: While franchisors are free to provide investors with any promotional or other materials they wish, no written or oral claims may contradict information provided in the required disclosure document (Part 436.1(f)).

The FTC recently amended the franchise rule which amendment, the FTC describes as follows:

The amended Rule has a phased-in effective date: as of July 1, 2007, franchisors may follow the amended Rule, or they may continue their current practice of complying with the original Rule or individual state franchise disclosure laws that require an Uniform Franchise Offering Circular (“UFOC”); but by July 1, 2008, they will be required to follow the amended Rule only.

The Franchise Rule gives prospective purchasers of franchises the material information they need in order to weigh the risks and benefits of such an investment. The Rule requires franchisors to provide all potential franchisees with a disclosure document containing 23 specific items of information about the offered franchise, its officers, and other franchisees. Required disclosure topics include, for example: the franchise’s litigation history, past and current franchisees and their contact information, any exclusive territory that comes with the franchise, assistance the franchisor provides franchisees, and the cost of purchasing and starting up a franchise. If a franchisor makes representations about the financial performance of the franchise, this topic also must be covered, as well as the material basis backing up those representations...

The Rule amendments bring the FTC’s Rule into much closer alignment with state franchise disclosure laws, which are based upon the UFOC Guidelines, developed and administered by the North American Securities Administrators Association (“NASAA”). Although the amended Rule closely tracks the UFOC Guidelines, in some instances it requires more extensive disclosures – mostly with respect to certain aspects of the franchisee-franchisor relationship. For example, the amended Rule requires more extensive disclosures on: lawsuits the franchisor has filed against franchisees; the franchisor’s use of so-called “confidentiality clauses” in lawsuit settlements; a warning when there is no exclusive territory; an explanation of what the term “renewal” means for each franchise system; and trademark-specific franchisee associations.

In a few instances, the amended Rule requires less than the UFOC guidelines – for example, it does not require disclosure of so-called “risk factors,” franchise broker information, or extensive information about every component of any computer system that a franchisee must purchase.

A good summary of the changes from the perspective of the franchisor is found in this article from Nixon Peabody.

The heart of any franchise relationship is the Franchise Agreement. This FranchiseInfo.ca article provides a good summary of the types of matters treated in a typical franchise agreement, providing in part:

In addition to the many operational and management issues that must be considered by someone who intends to franchise his/her business, there are a number of legal issues that must be resolved prior to granting the first franchise. To someone who is new to franchising, these legal considerations can include the corporate structure, applying for registrations of trade names and trademarks by which the public will know the franchise system and ensuring compliance with any applicable provincial franchise laws. Along with many other legal issues, a start-up franchisor must consider a form of franchise agreement that details the obligations and responsibilities of both the franchisor and the franchisee.

Franchise agreements are usually extensive documents that contain provisions that can sometimes be confusing to someone who has little or no experience in franchising. As a result, anyone who is about to franchise their business should seek the advice and assistance of a lawyer who is experienced in preparing franchise agreements. By working closely with a lawyer experienced in franchise matters, a start-up franchisor can avoid some of the common franchise pitfalls by building a franchise agreement that properly protects the franchisor's rights and obligates the franchisee to operate the franchise according to the franchisor's standards and procedures.

In building a franchise agreement, a start-up franchisor needs to make a number of decisions that will impact the franchisor in the future. While no two franchise agreements are identical, there are a number of common issues covered in most franchise agreements.

The article goes on to address typical contract items such as fees,term, termination, location, territory, services and product limitations,compliance with standards, advertising requirements and obligations and reporting. The article concludes:

By taking the time, energy and money it takes to prepare a well-organized, thoroughly considered and clearly drafted franchise agreement, a start-up franchisor can avoid some of the common pitfalls faced by those who are new to franchising. While the first step in building a franchise agreement is to retain a lawyer who is experienced in franchise matters, franchisors must realize it is only the first step. A franchisor must be prepared to expend the time and energy necessary to build a franchise agreement that works for their particular system. Although it is not a substitute for proper management and monitoring, a quality franchise agreement can often reduce the need for redrafting provisions as the system grows, reduce negotiation and amendments sought by franchisees and increase tools available to the franchisor to develop its franchise system.

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