Every day future entrepreneurs dream of starting their own businesses. Their motivations may include a desire to be one’s own boss, the pride of creating a new venture, the wish to make a career change or the desire to earn more. Rather than starting business concepts from scratch, many new entrepreneurs choose franchising because it can offer features such as name and product recognition, national or regional advertising, purchasing power, established operating procedures, training and assistance with startup.
Generally a franchise is defined as a proven business format which offers specific goods or services and the franchisor offers significant assistance and exercises some degree of control over the business operations of the franchisee. Typically the franchisee will utilize the franchisor’s “trade dress” and business systems. In some instances, the franchisee is required to buy equipment and supplies from the franchisor, or the franchisor’s approved vendors. The franchisor derives income from various fees, which often include an initial franchising fee, advertising fees and royalties which are based on a percentage of the franchisee’s sales.
Great care must be taken to thoroughly investigate franchise opportunities. While many offer excellent business concepts, others are unproven, poorly managed or take advantage of unsuspecting franchisees. There are many resources available to help one determine if franchising is right for them, and if so, to help research the thousands of franchise offerings. Available resources include books, websites, print directories, industry organizations, seminars and trade shows. A few examples include The Small Business Administration (www.sba.gov) and Federal Trade Commission (www.ftc.gov) which offer information helpful in evaluating franchise opportunities, obtaining financing and the start-up and operation of a business. The Better Business Bureau (www.bbb.com) also has educational resources and information on complaints that have been lodged against franchisors.
In conjunction with evaluating franchise opportunities, there are key documents which must be closely analyzed by the prospective franchisee. These documents include a disclosure document and the franchise contract. The disclosure requirement is a product of federal legislation, which was enacted following a rash of fraudulent franchise schemes in the 1960’s and 1970’s. The Federal Trade Commission Act requires that the franchisor disclose certain information and specifies the format of the Uniform Franchise Offering Circular (“UFOC”) or a rarely used alternate FTC format. The disclosure must be provided to a prospective franchisee in advance of the execution of the franchise contract and prior to the payment of any money to the franchisor. By example, the franchisor must provide information about the business experience of its officers and directors, the company’s litigation history and bankruptcies. The UFOC must also disclose the initial franchise fees, royalties, other fees, the expected initial startup investment, available financing and the franchisee’s and franchisor’s responsibilities under the franchise system. The circular also requires information regarding ownership of intellectual property utilized by the franchise system, territories and financial information regarding the franchisor. The UFOC format also gives the franchisor the option of making earnings claims.
It is important to remember two things when considering the UFOC. First, although the information in the UFOC is required by federal law, the disclosures are not government approved, nor does the government make any effort to verify the accuracy of the information. Additionally, consider the fact that the franchisor uses the UFOC document for marketing purposes and may be tempted to paint a rosy picture of the franchise. Therefore, it is crucial to study the disclosure carefully and verify key information. A legal professional can assist with evaluating the disclosure and verifying information contained therein.
It is also crucial for prospects to speak with current and former franchisees in order to obtain a realistic picture of the franchisor and the operation of franchises under the system. The names, addresses and phone numbers of current and former franchisees are listed in the disclosure. Do not limit your inquiries to current owners that the franchisor recommends as references. Contact, or better yet visit, others on the list, especially those who are operating in a market similar to your own. Find out if the franchisor’s estimate of startup costs was accurate? Does the franchisor provide adequate support? Is the business as profitable as the current owner expected? Ask current owners if you can spend a day or two with them just to see what the day-to-day operation of the business is like. Some prospective franchisees have spent weeks working at an existing franchise, in order to develop a clear understanding of the business before committing to purchase a franchise. Do not forget to speak to some former franchisees to find out why they left the system. The disclosure also includes information regarding franchise turnover. High turnover rates or a number of disgruntled franchisees are signs of a problem.
Franchisors offer opportunities to visit their headquarters. Usually these visits are in the form of an open house or “discovery day.” Your visit should not be a high pressure sales presentation. If it is, be wary. While you are there, insist on meeting with some of the people that are involved in the day-to-day interactions with franchisees. How long have they been with the company? Do they seem truly interested in the welfare of the franchisees? What do the company’s offices look like? Does it look like a well-established business that is flourishing or a fly-by-night operation?
Another essential aspect of evaluating a franchise opportunity is determining the financial feasibility of your planned venture. Do not base the decision to go forward simply on the earnings claim made by the franchisor in the disclosure, or, for that matter, the experiences of other franchisees. A good way to estimate the profitability of a new business is to create a cash flow projection for the first three years of operation, taking into account the reasonable income and the various expenses associated with operating the business. Factor in expenses such as labor, real estate, insurance, utilities, financing and various fees associated with franchising. Some industries have a low profit margin and a franchise royalty fee, based on 5-7% of gross income, can have a tremendous impact on the bottom line. After the cash flow projection is prepared, review the figures with an accountant who can help determine whether your projections are reasonable.
If there is serious interest in purchasing a franchise, attention must be given to the franchise contract. This is a crucial document since it defines the legal relationship with the franchisor. Typically, a franchise agreement is a lengthy document which defines the specific obligations and rights of the parties. The agreement may require a personal guarantee and contain provisions which affect other legal relationships that the franchisee may enter into, such as the lease of real property from a third party for use as the franchise location.
The franchise contract controls, even if the franchisee was given different information in the UFOC, or in discussions with the franchisor. For this reason, the franchise agreement must be thoroughly reviewed and understood by the franchisee. As with any complex legal document, a potential franchisee will be well served to have the agreement reviewed by counsel. Franchise agreements are drafted by franchisors’ attorneys and are often very one-sided. Counsel can assist the prospective franchisee in understanding the ramifications of the agreement and negotiating more favorable terms. The agreement should clearly state the parties’ obligations, the length of the agreement, renewal provisions and the various fees and royalties payable to the franchisor. The agreement should also address issues relating to the franchisee’s territory, such as whether it is exclusive and lasts the duration of the term of the agreement. If the contract incorporates the terms of other documents, such as an operating manual, the franchisee should have an opportunity to review the manual before signing the contract. The franchise contract will also likely contain terms which address the resolution of any legal dispute that arises among the parties.
In addition to understanding and negotiating the franchise contract, there are other legal issues that need to be addressed in conjunction with starting any new business. A decision will need to be made on the formation of an appropriate legal entity to operate the business, such as a corporation, limited liability company or partnership. The new business will most likely need to purchase or lease a location. Consideration must also be given to applicable federal, state and local laws, such as employment laws, local health and building codes, zoning and other legal issues that must be addressed in conjunction with the start-up and operation of the business. With proper assistance and planning, these issues can be addressed and the owner can focus on opening and growing their new business.
Dan Berexa
Nashville, Tennessee
Copyright 2008 by Daniel P. Berexa. All Rights Reserved.
