EVALUATING FRANCHISE OFFERINGS AND COUNSELLING PROSPECTIVE FRANCHISEES
Introduction
This article will examine some of the legal and business counselling issues presented when evaluating franchise offerings and counselling prospective franchisees. These articles are intended to provide an overview to the practitioner who does not regularly practice franchise law or is unfamiliar with regulations concerning the offering, sale and franchise relationships in the states at issue. Should specific issues arise relating to franchise law, we strongly urge our readers who do not concentrate their practices in franchise law to seek out competent co-counsel familiar with the crazy quilt of state regulation that may affect the structuring of these franchise offerings.
All Franchise Offerings Are Not Created Equal
There can be no legitimate doubt that franchising has been successful as a distribution method. One of the reasons why many franchise systems have been so successful is that, in franchising, individuals are allowed to function as entrepreneurs without having to go at their businesses alone. Additionally, franchising creates business synergies. Operating under one trademark, franchisees can achieve levels of brand awareness, market penetration and purchasing power that they could not achieve as individual business people.
However, while there are many examples of successful franchise systems, purchasing a franchise presents business risks. While franchising is widely considered to reduce investment risk by enabling a businessperson to associate with an established business system, each year there are franchise failures, both on the part of franchisors and franchisees. Moreover, there remains a certain level of fraud (although it has been reduced significantly from past decades) and sales puffery in the franchise marketplace. Indeed, both long and short memories of franchise expositions past are full of “the next McDonald’s.” Because there is no guarantee of success when purchasing a franchise, it is critically important for prospective franchisees and their counsel to understand and evaluate the franchise offering.
When selecting a franchise, it is important for the prospective franchisee to carefully consider a number of factors. Those factors include the demand for the products or services to be offered, the existing and anticipated competition, the franchisor’s management team and track record of performance, and the franchisor’s established infrastructure and level of field support.
It is important to remember that choosing a franchise system to associate with can be viewed as similar to making a long-term stock pick. Thus, buying a franchise from a start-up company presents generally more investment risk and potential reward than buying a franchise from an established company. A new start-up franchise may offer a prospective franchisee the opportunity to get in on a franchise system’s ground floor. At the same time, however, a start-up franchise system’s business model may not be fully developed or, worse yet, fatally flawed.
Similarly, while buying a franchise from an established company may reduce investor risk, such offerings may only be available at a cost that does not present an attractive potential rate of return. Finally, sometimes established companies are “hot” and their franchise offerings are quite expensive and offered only on less than favourable terms. And, when those same established companies experience down times, it may be possible to secure their franchise rights upon much more attractive terms.
Understanding the Franchisor’s Offer and System
The Federal Trade Commission’s Franchise Rule requires franchisors to provide prospective franchisees with a disclosure document containing important information about the franchise system (the “UFOC”). When it comes to understanding the franchisor’s offer and system, there is no more critical document than the UFOC. In counselling prospective franchisees, the legal advisor and client should review the franchisor’s UFOC, which should contain as exhibits the actual franchise agreement and financial information regarding the franchisor.
One critical information resource contained in the UFOC is a list of all franchised operators and their locations. Prospective franchisees can learn about their prospective franchisor by contacting franchisees that have been involved in the franchise system. Prospective franchisees should strive to poll enough franchisees to determine the answers to such critical questions as: whether the franchisor follows through on its commitments; whether franchisees receive adequate training and operational support; whether the franchisees’ businesses are profitable; and if the overwhelming majority of polled franchisees would buy the franchise again?
While the UFOC contains the minimum amount of information deemed necessary by the Federal Trade Commission for a prospective franchisee to make an informed investment decision, a franchisor’s UFOC is not the only source of potential information regarding a franchise system. Additional information may be obtained through the franchisor, franchisee associations, other regulatory authorities and the Internet. Before making an informed investment decision, a prospective franchisee would be wise to learn as much as possible about the franchisor, the franchisor’s management team and the franchise system’s place within the market template.
Understanding, and Then Hopefully Negotiating, the Franchise Agreement
The franchise contract is ultimately the document that controls and defines the franchise relationship. As a result, the prospective franchisee-client and the legal advisor should review the disclosure document in conjunction with the franchise contract. Prospective franchisees and their clients should not assume that the UFOC and franchise contract are seamless. Additionally, based upon the types of disputes litigated frequently in a franchise context, particular areas of interest should include: site selection and protected marketing areas; alternative methods of distribution reserved to the franchisor; the existence of registered trademarks and the franchisee’s trademark rights; renewal rights; termination and its consequences; sources and pricing of essential and branded products; and restrictions on transfer of the franchise or ownership interests in the franchisee.
Franchisees often have some ability to negotiate certain terms of the franchise agreement, particularly in the case of franchise systems in a growth mode. Where such opportunities exist, counsel to potential franchisees may assist their clients with such issues as the negotiation of protected territories or the negotiation of a post-termination covenant against competition. Franchisors with established systems and strong brands may not be willing to negotiate the form of franchise agreement.
Form of Ownership of the Franchise
Prospective franchises should consult with the franchisor about different ownership forms for the franchise business. Usually, a franchisor will permit the franchise agreement to be undertaken by a corporation or other business entity, but may require personal guarantees from the principals, upon whose credit analysis the franchisor’s decision to grant a franchise was initially made. Although the formation of a corporate entity adds another expense to the franchisee’s start-up costs, operating the franchise in a corporate format may insulate the franchisee’s personal assets.
Financing the Acquisition of a Franchise
Franchisors conduct typically credit analyses to establish the financial capability of potential franchisees. Private bank financing may be available to a potential franchisee that has significant business experience or personal assets to pledge as security. Franchisees who seek private bank financing may need to consider the subordination of security interests as between the financing bank and the franchisor. The Small Business Administration (“SBA”) may agree to guarantee a portion of the funds loaned by a lending institution. From time to time, the SBA has circulated proposals to create rigorous new terms for franchisors whose franchisees receive SBA loans, including the requirement of a “specific territory.” Some SBA proposals also would place limitations on the franchisor’s ability to terminate, or to refuse to renew, franchise agreements.
Conclusion
Franchisees are required to relinquish significant control over their business destiny to their franchisors. Accordingly, prospective franchisees should carefully consider how much money they have to invest, their abilities and their goals prior to investing in a particular franchise system. Prospective franchisees and their counsellors also must study the franchisor’s offering circular thoroughly. Because acquiring a franchise involves usually a significant investment, prospective franchisees should have an attorney review the franchisor’s disclosure document and franchise contract and have an accountant review the company’s financial disclosures. Finally, prospective franchisees must take the time to speak with as many of the franchisor’s current and former franchisees as possible regarding their experiences within the franchise system. Such conversations can serve to validate an investment decision. At the same time, such conversations can also serve to chill a prospective franchisee’s desire to enter a system, especially where deep operational or cultural difficulties are revealed.
More information. For more information on franchising in Canada, the United States and internationally, please contact Peter Macrae Dillon, head of Siskinds Franchise Law Group. Peter is the author of the annotated Ontario Franchise Disclosure Act and the annotated Alberta Franchises Act and over 30 other publications on the subjects of franchising, licensing and distribution. He is licensed in Ontario and New York. Peter can be contacted at 800-816-9596 ext. 7818 or by email at peter.dillon@siskinds.com. Please visit our website at www.franchiselaw.ca The information contained in this note is for general reference only, and should not be relied upon as constituting legal advice.
peter macrae dillon Siskinds franchise franchisor franchising lawyer attorney Toronto Ontario Canada www.franchiselaw.ca
Evaluating Franchise Systems - To learn more about this author, visit Peter Macrae Dillon's Website.
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Peter Macrae Dillon
(Visit Peter's Website)
Peter Macrae Dillon is one of North
America’s leading and most-respected
franchise attorneys. He is licensed to
practice law in Ontario and New York. He
specializes in advising start-up
franchisors in the conversion and early
stages of franchising. His group
represents mature Canadian and American
franchise systems operating in Canada, the
United States, and internationally. Email
Peter at pe
ter.dillon@siskinds.com or visit his
website at: www.franchisel
aw.ca
peter macrae dillon franchise franchisor
lawyer attorney Toronto Ontario Canada www.franchisel
aw.ca
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