The first introduction to franchising received by most business owners is when a customer walks into their location, compliments the owner on the great business concept, and asks whether franchises are available. The owner dashes around the Internet, discovers that franchisees pay substantial initial fees and continuing royalties, and imagines he or she has found a great new source of easy money. The phone on my desk rings and a somewhat urgent meeting is arranged to explore what is involved in franchising the business. Sit in, please, as we review the checklist of items that this would-be franchisor must add to its To Do list.
Reality Check. It’s not easy money. It will be hard-earned money, and it will be generated in a business that is entirely new and unfamiliar to the owner. Franchising has its own style, its own rules of the road, and its own financial imperatives. The learning curve is not that steep – unless you’re in a hurry. An experienced counselor (and the owner may decide to bring in a franchise business specialist to help on this) will help consider whether the business is one that can and should be franchised. Almost anything can be franchised, but only an examination of the market, the competition, and the products and services of the business will tell you if it should be franchised. Does the business have well-defined systems, techniques, and processes that lend themselves to replication? A good read on this point is The E-Myth Revisited: Why Most Small Business Don't Work and What to Do About It, by Michael E. Gerber.
Operations Manual. The largest task on the checklist for the would-be franchisor is to create a comprehensive operations manual that can be used to train and guide new franchisees. Think three-ring binder with a couple hundred pages. Yes, it can be made available to your franchisees online (if password protected). Yes, it can be prepared by an outside writer, but it probably shouldn’t be. No, samples and forms are not available – this is a highly confidential document and franchisors and franchisees don’t treat them casually – but yes, the Tables of Contents of most operations manuals are publicly available, you’ll find one attached to just about every franchise disclosure document in the country.
Trademark. The company’s brand name needs to be registered with the U.S. Patent and Trademark Office. If it hasn’t been done yet, now is the time to begin the process. The company will have no business granting franchise rights to a trademark that has not been federally registered – state trademark registrations won’t cut it. We can discuss why in our next meeting.
Corporate Structure Planning. For a variety of reasons, not the least of which is liability protection for other parts of the business, it may make sense to create a separate legal entity to serve as the franchisor. This will require a detailed review of the current structure, of course, and a discussion of a few key ownership questions. Yes, the franchisor entity can be a limited liability company or a corporation. In our planning on this point we need to keep our eye on the new disclosure requirements imposed on some franchisor-parent entities – we don’t want disclosure surprises down the road.
The Bright Lights of Disclosure. Not all organizations are ready for the glare of public disclosure. The Franchise Disclosure Document (FDD) will require that the franchisor itself, its directors, partners, and executive managers reveal their criminal and civil litigation and bankruptcy histories, as well as a five-year employment history for individuals. If there is a rich mix of crimes and bankruptcies and/or nasty civil litigation in the organization’s background, consider early in the process the impact of disclosing it to all prospective franchisees and the public.
Financial Disclosure Planning. This is one of the most complicated items on the checklist. Basically, the franchisor must provide financial disclosure, and in most situations a CPA must audit its financial statements. If the franchisor entity is newly formed we will need to discuss the phase-in allowance under the Amended FTC Rule by which a new franchisor may not be required to audit its financial information, the appropriate level of capitalization, how the capital will be structured between equity and debt, and how state franchise examiners will eventually view the financial statement. In my experience, this takes a detailed plan, it will be costly (thanks largely to the exacting accounting standards after Enron), and completing the audit will take longer than anyone expects.
Franchise Agreement and FDD. Creating the documentation required of the new franchise program is the first item on many executives’ lists, but it is actually the final step in the process of becoming a franchisor. We will need to create two basic documents: a franchise agreement that is carefully tailored to your business plan and a completed FDD describing the franchise offering and the franchisor, its directors, and its managers in detail. Once the FDD is completed and the franchise agreement and financial disclosures are included, the company will be in a compliance position to offer and sell a franchise in most “nonregistration” states. Good news: The FTC doesn’t need to even see the FDD. Compliance with the requirements of the 14 franchise registration states will take a bit longer.
As you can see, this process will take some time as the accountants, the lawyers, and the company hit their assignments. Knowing what you need to do to sell franchises can help you determine whether or not this new phase of business is one you’re ready to undertake.
Andrew Caffey is one of the nation’s leading franchise legal specialists and he represents franchisors across the United States. Caffey served as General Counsel of the International Franchise Association, a member of the Governing Committee of the ABA Forum on Franchising, and Chair of the ABA Forum on Franchising. He also is a member of the bar in Maryland and the District of Columbia, and a member of the Panel of Neutrals of the American Arbitration Association.