A few weeks ago, my colleague Chuck Modell discussed the necessity of developing a “fair but firm” franchise agreement that is designed to work with your particular franchise system. His suggestion that new franchisors avoid using “form franchise agreements” (I would also recommend avoiding consultants who do not meet with you to discuss your system) and instead tailor their agreements specific to their system struck a chord with me. Continue Reading Writing Your Franchise Agreement – A Litigator’s Perspective
Most startup franchisors – and established franchisors for that matter – receive inquiries from prospective franchisees looking to buy a franchise. Some may be merely kicking the tires, whereas others are bona fide entrepreneurs who could be the next great addition to your growing brand. After receiving an inquiry to purchase a franchise, usually through the franchisor’s website or brokers, the franchisor will often schedule an initial telephone conference with the prospective franchisee so that both the franchisor and the franchisee can gauge their interests in selling and purchasing a franchise. If there is mutual interest, the franchisor will send a franchise disclosure document, a legal document that a franchisor must provide to the prospective franchisee.
For the franchisor, this initial conference will be an important tool to determine whether the prospective franchisee is a bona fide franchisee who can be a profitable addition to the franchise system. Franchisors need to determine the business experience of the prospective franchisee, the financial strength to support the startup or build-out costs, and the long-term goals of the prospective franchisee vis-à-vis the franchise system and brand. Some of the common questions franchisors ask, or should ask, include:
Within every industry, from quick-service restaurants, to hospitality, to fitness and health, there are a multitude of franchises that a prospective franchisee can pick from. There are several thousand franchised brands currently offered in the United States. Franchisors will ask why the prospective franchisee is choosing this industry, and within that industry, why this brand. Sometimes answers like “I tried your cupcakes and they were so good, I just had to open a cupcake shop next to my house” may be enough, but not always. Franchisors will want to see that the prospective franchisee is gung-ho about the brand and industry.
How much capital do you have to invest and what is the source of funding?
Purchasing a franchise will require the franchisee to spend thousands of dollars on initial franchise fees (payable to the franchisor) and on build-out costs and the purchase of inventory or equipment. These initial investments, which are summarized in Items 5 and 7 of the franchise disclosure document, can often be $100,000 to $1,000,000, depending on the business. Franchisors will want to know that the prospective franchisee has liquid cash to purchase the franchise and to fund its opening. Just as important as determining the net worth and liquidity of the prospective franchisee is determining the source of the funds. Like non-franchised businesses, franchised businesses may not turn a profit in the first year or so of operation. Therefore, franchisors will want to know whether the prospective franchisee has sufficient liquid net worth, or whether it has or will obtain financing from lenders.
Do you have experience in this industry?
In theory, experience is not necessary to purchase a franchise if the franchisor provides sufficient training and support to teach its franchises the system of operation. Some franchisors, however, favor franchisees who have business experience in the same industry. Others prefer hardworking and adaptable franchisees who can learn the franchisor’s way of operation. Either way, franchisors should determine the prospective franchisee’s previous business. Likewise, franchisors may ask whether the prospective franchisee has prior franchise experience (even in another industry) to determine whether he or she understands the franchise relationship.
When do you want to open?
Franchisors need to make sure the expectations of franchisees line up with their schedules. Before an entrepreneur can open a franchised outlet, he or she must be given a franchise disclosure document (which must be registered in at least 14 states). He or she must also be allowed the applicable waiting period to review the documents, complete an initial training program while, obtain a location for the franchised outlet and build it out per the franchisor’s specifications. This process can often take a few months. Further, from a strategic standpoint, a franchisor may have goals on how many outlets it wants to sell in a particular geographic market within a certain timeframe – therefore the franchisor will need to understand whether the prospective franchisee’s expectations line up with the franchisor’s goals.
How hard are you willing to work?
Some prospective franchisees may be passive, whereas others will actually be working the business from behind the cash register. Most franchisors are looking for the latter. Franchisors will ask whether the prospective franchisee has or intends to operate other businesses or work another job simultaneously with ownership and operation of the franchised business. Opening a franchised business requires hard work, long hours (well above a 40-hour work week), and little to no profits initially, so franchisors will want to see whether the prospective franchisee is ready to get his or her hands dirty.
What are your long-term goals?
Are the franchisor’s goals (often, growing the brand) consistent with the prospective franchisee’s goals? Or is the prospective franchisee merely looking to “buy a job” after being out of work? This question will help franchisors determine whether a prospective franchisee is a cultural fit within the franchisor’s system. Some franchisees may be looking to purchase one franchise at the moment, with the long-term goal of acquiring additional units, and passing these businesses down to heirs.
For startup franchisors looking to sell their first, second, or third franchises, finding the right franchisees is critical because the franchise system may not yet have the size or weight to weather poor fits or poor performers. Asking the right questions up front will save the franchisor time and money and possible headaches down the road.
“How much can I make?” That is typically the first question a prospective franchisee asks when evaluating a franchise opportunity. If you are considering franchising your business, ask yourself whether you have financial information you can, and want, to provide to prospective franchisees that will answer this question.
By law, a franchisor can only give financial information to prospective franchisees in its franchise disclosure document. The information you provide can be actual, historic results, or it can be projections. However, in either case, the information must be based on actual results from your system. Thus, it is not permissible to simply give a hypothetical, such as “if you sell only $400,000 a year, here is what you will make,” unless you actually had an outlet that had $400,000 of revenues. You can use the results of company-owned outlets, so long as you show the differences, like royalty payments, that would have occurred had the outlets been operated by a franchisee.
From a practical standpoint, you can present financial information to prospective franchisees even if you have only one operating outlet. However, if that one outlet turns out to be an aberration, you are likely to have unhappy franchisees when they cannot replicate the success of that outlet. Thus, it has always been our advice that a company has financial information from at least two outlets before including financial results in their disclosure document.
If you want to franchise your business and do not have any company-owned operations, you can still offer franchises, but you will not be able to answer a prospect’s questions about what they can make. That will put you at a competitive disadvantage with other franchisors who provide this information to prospective franchisees. Indeed, the majority of franchisors now include financial information about their individual outlets in their disclosure documents.
There is one last question to ask yourself, perhaps before embarking on a developing a franchise program. Assuming you have results to show prospects, ask yourself whether the results of your existing operations would entice prospects to acquire a franchise from you. If your past results are weak, you may want to focus on strengthening your brand before embarking on franchising. After all, franchisees are buying into your success, and you want your franchise program, and your initial franchisees, to get started on the right – i.e. profitable – foot.
The Rhode Island Department of Business Regulation Securities Division (the “Department”) has amended its Rhode Island Franchise Investment Act, 19 R.I. Gen. Laws § 19-28.1-1 et seq., to eliminate its requirement that franchise advertising materials created or used by the franchisor be filed with the state and to change the waiting period for delivering a franchise disclosure document (“FDD”) to a prospective franchisee to 14 calendar days. The Department issued Franchise Bulletin Number 2016-1 [PDF] summarizing these changes.
Franchisors should be aware of these changes if they offer or sell franchises in Rhode Island, as the changes will not only affect the offering and selling of franchises (by no longer requiring advertising be filed with the state and changing the delivery period), but the receipt pages of your FDD may need to be updated to account for the 14 calendar day delivery period.
Effective June 27, 2016, Rhode Island has eliminated the franchise advertising filing requirement by amending 19 R.I. Gen. Laws § 19-28.1-12. Previously, franchisors offering or selling franchises in Rhode Island had to typically file their advertising materials with the state and pay a filing fee at least 5 business days prior to using or publishing the advertisement. Rhode Island has eliminated this filing requirement and its associated fee. 19 R.I. Gen. Laws § 19-28.1-12 now reads:
§ 19-28.1-12 Advertising.
No person may publish in this state any advertisement offering to sell a franchise required to be registered under this act unless they maintain the advertising materials for five (5) years, consistent with § 19-28.1-13.
Franchisors must still keep required records of their Rhode Island advertising materials for 5 years, consistent with 19 R.I. Gen. Laws § 19-28.1-13.
Delivery of FDD
Also effective June 27, 2016, franchisors are required to provide the FDD to prospective franchisees at least 14 calendar days prior to the signing of any binding agreement by a prospective franchisee or at least 14 calendar days prior to the direct or indirect receipt of a franchise fee, whichever comes first. The 14 calendar day requirement is consistent with federal law under the Amended FTC Rule. Previously, Rhode Island required franchisors to provide the FDD to prospective franchisees at least 10 business days before signing the franchise agreement or accepting a franchise fee, or if earlier, at the time of the franchisor’s first personal business meeting with the prospective franchisee. 19 R.I. Gen. Laws § 19-28.1-8 now reads:
§ 19-28.1-8 Delivery requirements.
(a) It is unlawful to sell any franchise in this state without first providing a copy of a disclosure document reflecting all material changes together with a copy of all proposed agreements relating to the sale of the franchise, unless otherwise provided in subsection (b), to the prospective franchisee, not less than:
(1) [Deleted by P.L. 2016, ch. 153, § 2 and P.L. 2016, ch. 159, § 2].
(2) Fourteen (14) calendar days prior to the execution of an agreement or payment of any consideration relating to the franchise relationship.
(b) The delivery requirements in subsection (a) do not apply to the offer or sale of a franchise which is exempt under § 19-28.1-6(2), (3), (6), or (8).
The change to Rhode Island’s delivery requirement will make it easier for franchisors offering or selling franchises in the state, as they do not have to juggle between the 10 business day/first personal meeting rule on the one hand and the 14 calendar day requirement under federal law on the other. However, franchisors should review the receipt pages attached to their FDD to revise any references to Rhode Island’s previous delivery requirement prior to making their annual renewals this year.
For more information on these changes, see Franchise Bulletin Number 2016-1 [PDF] issued by the Department or contact your franchise attorney.