Overview of Franchising

 Since graduating from the University of Georgia School of Law in 1985, I have practiced corporate/transactional law in Marietta. In that time, I have represented both Franchisors and Franchisees in many different businesses, including automotive repair, fast food, sit down restaurants, shoe repair, child care, financial services, sign making and printing, to name a few. Though I would like to be able to say that my clients were always successful in these ventures, the reality is that this is not the case. This paper is intended to provide a brief overview of the franchise system and discuss some of the things I have learned over the years. This paper will address representation of a potential Franchisee.

 

1. What is a franchise?

 A franchise is a system whereby a party owning the rights to a business system (the Franchisor), authorizes someone else (the Franchisee) to use the system for a fee. A Franchisee purchases the right to utilize the Franchisor's trademarks and operating system, usually for an up front franchise fee of $10,000-$25,000, plus a monthly royalty fee of 5%-7% of gross revenues. The royalty is based on gross revenues not net revenues, and thus the Franchisee pays regardless of whether there is any profit. The Franchisee is usually also required to contribute to an advertising fund, which is typically another 1.5%-3% of gross revenue. The Franchisor usually administers the fund, and there is no assurance that the advertising will be of any direct benefit to the Franchisee.

2. Advantages of Franchising.

 Franchising offers a number of advantages over starting an independent business. Some of these advantages are:
 

(a) Training. Any quality Franchisor will have a detailed training program that every Franchisee is required to successfully complete. The training program should be thorough enough that an average person with little or no business experience can learn how to successfully operate the franchised business. Franchise training programs are designed with the presumption that a new Franchisee will have no experience with the business in question. In fact, over the past 10 years many new Franchisees have been downsized corporate executives who have never owned their own business.

(b) A proven, successful business format. With successful units in operation, the Franchisor has shown that there is indeed a market ready and willing to purchase the product or service. This reduces the inherent risks of a start-up business. Statistics show that franchised businesses fail less frequently than independent businesses, and some Franchisees who fail have failed due to their own refusal to strictly adhere to the Franchisors operating standards. Reputable Franchisors do not want Franchisees to fail, not only due to the loss of royalty revenue, but also due to the damage to their reputation. Think about how few McDonald's you have seen that have gone out of business.
 

(c) Publicly recognized trademarks. The public often presumes that a business with numerous locations and heavy advertising is reputable and successful, and the public wants to do business with successful companies. Many in the public do not even realize that most franchises are owned by individual businesspeople who are essentially small business owners. A small business owner with an independent business could never afford the level of advertising that a franchise can provide.
 

(d) Site selection. Site selection is critical to the success of any retail business, and established Franchisors have experience in what types of sites work best with their particular product or service.
 

3. Disadvantages of Franchising.

(a) Significant control is retained by the Franchisor, and the Franchisee/owner must strictly adhere to the Franchisors system. This is a difficult concept for "free spirit" types who enter business for the freedom to make all of their own decisions. It is critical that a potential Franchisee understand that his business decision- making will be restricted by the requirements of the franchise, and the Franchisor is under no obligation to listen to any suggestions from the Franchisee. Franchisees must understand that a key element of a franchise is consistency among various locations. Be wary of any Franchisor that does not strictly enforce its operating standards. Poor performance by other Franchisees will damage the entire system.
 

(b) Franchise Agreements typically contain one-sided provisions concerning transfer and renewal. These provisions should be carefully reviewed and explained to the potential Franchisee. Though some states provide special protection to Franchisees in this area, Georgia law does not provide any such special protection.
 

(c) The Franchisor usually retains an option /right of first refusal to acquire the franchise in the event the Franchisee desires to sell, and upon termination of the franchise, though Franchisors rarely exercise those rights.
 

(d) High franchise fees which continue even when the Franchisor is providing little in the way of services. The Franchisor has very few ongoing duties under the Franchise Agreement. This is not an issue with the large franchises, such as McDonald's, since the value of the trademarks and products is sufficient to justify the fees. It is preferable if the Franchisor has a local office or a local or regional field representative who visits the area regularly. The acquisition of a franchise from a franchise company on the west coast with 50 satisfied franchisees in the west, that is just entering the Southeast with little name recognition in this area, will be a riskier investment than acquiring a franchise from a franchise company that is already established in this area.
 

4. What is the Uniform Franchise Offering Circular (UFOC)?

(a) This is an extremely important document for the Franchisee. The Federal Trade Commission requires that this document be delivered to the Franchisee.
 

(b) The UFOC contains a summary, in laymens terms, of the provisions of the Franchise Agreement.
 

(c) The UFOC is a good starting point for investigating the Franchisor. It contains background information on the Franchisor and its officers (prior bankruptcies, lawsuits, financial information). If a Franchisor has a significant number of lawsuits relative to its size, this is a red-flag that there are serious problems with the franchise system, and that Franchisor should be avoided. Another red flag is if the Franchisors key executives have been sanctioned or had any action against them by governmental agencies, such as the Federal Trade Commission or Securities and Exchange Commission. Some Franchisors have very good salespeople, and the potential Franchisee should be encouraged to investigate all claims, and assume that any claims that are not contained in the franchise offering documents are false. Some franchise salespeople are paid a commission based on the number of franchises sold, and some are contractors that are not even employees of the franchise company.
 

(d) The UFOC contains a list of current and former Franchisees. This is critical. I always advise Franchisee clients to call numerous current and former Franchisees, and to personally visit several existing Franchisees to find out what their experiences have been. This is the single most important part of the Franchisees investigation. When visiting existing Franchisees, this should be done without the involvement or "Assistance" of the Franchisor. A potential Franchisee should avoid any franchise whose Franchisees refuse to discuss their experiences. One question to always ask is whether, if they had it to do over again, they would purchase the franchise.
 

5. What is an Operations Manual?

(a) This is the confidential document provided to Franchisees which prescribes how the business is to be operated. This is usually quite detailed, and may be as specific as how the Franchisor wants employees to greet customers. This is not provided until a Franchise Agreement is executed, and therefore review of this document is not a part of the Franchisees investigative process.

(b) The Franchisee must follow the requirements of the Operations Manual, and failure to do so is a breach of the Franchise Agreement..

6. What is the cost to acquire a franchise?

(a) The required investment depends on the business - with some small service businesses, such as carpet cleaning, requiring an initial investment of only $20,000 - $30,000. As might be expected, generally the lower investment franchises will generate lower revenues than the higher investment franchises.

(b) Established franchises that can generate much higher revenues, like McDonald's, can easily cost $500,000 or more. Due to the strict net worth requirements to become a Franchisee of an established franchise like a McDonald's, those Franchisees must already be financially secure at the time they acquire the franchise.

7. Are Franchise Agreements subject to negotiation?

Generally no. Established franchise companies do not negotiate - agreements are presented on a take it or leave it basis. One reason is that the Franchisor wants to have uniformity in its agreements across the country.

8. Do Franchise Companies provide financing?

Most Franchisors do not provide financing, so the Franchisee will need to arrange his own, either conventional or Small Business Administration ("SBA"). Some Franchisors have special arrangements with certain recommended lenders, which can streamline the process.
 

9. What is a Development Agreement?

(a) The Franchisee purchases the right to open up new franchises within a certain territory. This is a way for the Franchisee to "lock in" an area for a period of time without having to open several locations at the same time.

(b) The Development Agreement will contain a schedule for the opening of new locations, and if the Franchisee does not adhere to the schedule he can lose the rights to any unopened locations. Default under the Development Agreement generally does not effect any locations already opened by the Franchisee. Unlike Franchise Agreements, Development Agreements are often subject to negotiation, especially with respect to the area covered and the development schedule.
 

(c) The Franchisee pays a non-refundable fee for the rights granted under the Development Agreement, usually a multiple of the number of locations covered, and may receive some credit against franchise fees as locations are opened.

10. Closing thoughts.

(a) A thorough investigation of the business in general, and the specific Franchisor in particular, is critical in the acquisition of a franchise. The potential Franchisee should not be complacent just because it is a franchise. Potential Franchisees should contact the Better Business Bureau, the Attorney General's office and the Secretary of States Office of Consumer affairs and inquire about any complaints or investigations of the Franchisor. If the Franchisor is not financially strong, the needed training and support will not be available, and the entire system may fail. This happened with the "Chop Chop" chinese food delivery franchise, which filed Chapter 7 bankruptcy, and many Franchisees lost their entire investment, due to no fault of their own. That particular franchise had experienced executives who were former Domino's Pizza executives, but unlike pizza delivery, the concept was new and unproven, and as a result the Franchisees were a part of the unsuccessful trial phase. The idea with a franchise is to reduce the risk, and if the Franchisor is not financially secure or its business concept has not been proven, the main advantage of a franchise is not present.
 

(b) Prospective Franchisees should contact the Franchisor to see if any existing franchises or company owned locations are available for purchase. One advantage of buying an existing location is that their will be a track record in the form of historical revenue/profit figures. A disadvantage is that the cost will generally be higher, since the Franchisee will be paying for "going concern" value.
 

(c) Due to liability concerns, most Franchisors do not provide any earnings claims or earnings data whatsoever, and potential Franchisees must get this information from existing Franchisees.
 

(d) I strongly advise clients to get their accountant involved in the process early on, to assist in analyzing the financial aspects of the transaction. The client should not rush into a franchise purchase, regardless of whether the Franchisor indicates that a particular location is about to be taken by someone else. It is better to miss out on a location than to acquire a bad one.
 

(e) Potential Franchisees should expect to initially work more hours than if they were employed by someone else, and initially will probably make less money. If a prospective Franchisee expects to simply hire a manager and get rich as an absentee owner, they probably should not purchase a franchise or, for that matter, be in business for themselves.
 

(f) It is critical that potential Franchisees look for franchises that are compatible with their personalities and self image, rather than based on how much revenue they think will be generated. Someone who is interested in a country club lifestyle should not buy a carpet cleaning or tool rental franchise, which requires some manual labor and mechanical skills, and working with and managing blue-collar employees.
 

(g) Franchise law is primarily governed by principals of contract law, and accordingly franchise matters should be handled by attorneys experienced in drafting and interpreting business contracts. In addition, there are issues involving set up and operation of the appropriate legal entity, which requires the input of an experienced business attorney.

By: J. Brian O'Neil
Moore Ingram Johnson & Steele, LLP
192 Anderson Street
Marietta, Georgia 30060
770-429-1499