Franchising is essentially a method to distribute and sell goods and services but different from distributorships, dealerships, licensing and company chains.
The Regulatory Landscape
In the United States, because of the complex relationship between franchisees (Zees) and franchisors (Zors), the government has determined that the sale of franchises should be regulated (i.e., registration and disclosure required). Often missed is the fact that both the Federal Trade Commission (FTC) and various states play a role in the regulation. Although the FTC does not require registration, several states do require registration and disclosure before any offer or sale can be made. The FTC only requires certain disclosures be made to a prospect before a Zor can offer or sell a franchise. This disclosure is provided in the form of a document entitled Franchise Disclosure Document (“FDD”).Consequently, a FDD is required to be provided to every prospective Zee in every state. Those registration states may have disclosure rules that are more protective of Zees than the FTC (and vice versa). Further, the states themselves differ in the difficulty of registering and types of disclosures. As a result, a Zor wanting to sell throughout the U.S. will need to register in about 14 states and use a FDD for every sale in every state and the District of Columbia.
The FDD is a long and complex document consisting of three major segments:
(1) The disclosure portion is written in layman’s language and has 23 different topics, such as the resumes of key people, the Zor’s history of operations, trademarks, required suppliers, financial statements and others; (2) The franchise agreement, which is the main contract between the Zor and the Zee; and (3) all the various exhibits such as a list of all the existing Zees, confidentiality agreements, outline of the operations manual and so forth. Many of these exhibits are additional agreements between the Zor and the Zee.Developing a FDD is a large project and usually involves the Zor and its attorney working closely together over several months. If a consultant is used he or she can provide a range of services from as little as developing a modest marketing plan to a complete analysis with recommendations for each aspect of the business.
Once the FDD is completed the Zor and its attorneys will then file for registration and address the comments that the government makes two to three weeks after filing. This process can extend from a couple of weeks to months. Overall, the Zor can expect that preparing the FDD and getting registered, in at least one state, will take on the average four to five months, depending on how quickly drafts are turned around.
The cost can vary even more, with some consultants charging $100,000 for a complete package, which can include analyzing the concept, preparing a marketing plan, creating an operations manual, designing systems, filing the registration, etc. On average Zors can expect to spend $20,000-$35,000 in legal fees, not including any consulting fees or additional franchises such as an area-developer program. Occasionally a Zor itself will draft a FDD based on an existing FDD of a franchise that is in the same business, but ultimately it will need to incur some legal fees to assure governmental compliance and tailor the provisions and disclosures to the franchise system.
The FDD must be filed with each registration state in which the Zor intends to sell franchises. Although there is a host of topics that must be included in the FDD, the following two subjects often pose difficulty for many Zors:
When a Zor (usually a new one) does not have adequate net worth or income, it must put all of the initial franchise fee received from the Zee into an account at a bank that won’t release it to the Zor until the franchise opens for business. The regulators require this because the weak financial condition indicates that the Zor may not be able to supply to the Zee all agreed products and services through the date of opening of the business. This can be financially difficult for a new Zor as it will not have access to the initial franchise fee (which on the average runs about $40,000) while it is incurring significant startup expenses.
Zors often want to turn over the selling of franchises, in a large area, to a third party. This method can take different forms and names, so for example an area developer may simply be like a unit Zee except have several locations to open in a given territory. Alternatively, a Zee may act more like the Zor and perform most of the duties of the Zor in selling and servicing Zees. If the area developer provides too many of the primary Zor duties, the regulators will deem it to be a sub-Zor and require it to register just like a Zor, with the same registration and disclosure requirements. Being labeled a sub-Zor can significantly slow the development of the franchise system.
Often the starting point for an existing business is to determine if it would be considered a franchise under state or federal law. A business may be selling licenses or selling distributorships and would be content to continue doing so. Unfortunately, it is relatively easy to fall within the franchise trap. Although there are at least two general definitions in the United States of a franchise, one requires that (i) a fee be paid, (ii) a trademark or servicemark (mark) of some type be involved, and (iii) that marketing is offered as part of the system. Some other states focus on the requirement of a community of interest between the Zor and Zee and look at a variety of elements. To top it off, the FTC has its own definition. The result is that many companies which believe they are not franchises may be and will be subject to civil and criminal action.
The best advice for a business owner who is concerned that it’s business might be selling franchises is to have its system reviewed by a professional advisor, and if necessary drop some aspect of the system that clearly takes it out of the franchise definition, or alternately go ahead and register and make the best use of the broader rights and controls that a Zor enjoys with its Zees than the business owner does under its current system.
New Zors often do not appreciate that once they start selling franchises they are no longer in the same business of selling the products and services of their pre-franchise business. This is important since the new franchise business requires a different skill set, including screening prospective Zees, marketing the franchise products and services for its Zees on a larger scale than before, training, locating real estate, reviewing leases, providing ongoing assistance and product development.
Content Of The FDD
The following are some of the more difficult and lengthy subjects which are covered in the FDD (both in the Disclosure and the Franchise Agreement).
This is a controversial area and the majority of Zors do not disclose in their FDD any past income or profit of their Zees (or Zor-owned locations). There are several reasons for this, including (i) the lack of an adequate history of operations, (ii) the fear of liability due to reliance by Zees on figures that are not reproduced in the future, and (iii) the rigorous format required in the FDD. The result is that most Zors cannot make any statements about income or profit whatsoever, and so prospective Zees are not able to learn what profit the franchise might generate except by contacting existing Zees (who may not always fairly represent the whole system) and investigating outside sources.
This is usually the longest section of the Disclosures in the FDD as it covers, among other items, marketing, training, pre- and post-opening assistance, equipment, technology and so forth.
There are many issues, some obvious and some hidden, when providing a territory for the Zee. Often a territory will be exclusive which can create more complexity in analyzing possible protected area disputes with other Zees or the Zor.
Zors and Zees have battled, over the years, as to whether the Zor can restrict the purchase of certain products, equipment or services. Generally, Zors will require all of its Zees to purchase certain products or services from approved vendors which meet certain requirements (whether sold by the Zors or other vendors). Also, the Zees usually have the right to acquire the same items from other vendors but that vendor must first be approved by the Zor. If a Zor has a large vested interest in the required product, the Zees may be concerned that the products are not being sold at the lowest price. The Zor may take the position that the proposed new product or vendor does not meet its requirements and will diminish the quality of the system. The debate may continue from there.
This has been a hot topic of late and covers situations where a Zor sells in a way that intrudes into a Zee’s territory, or sells similar products or even uses new sales techniques (e.g., the Internet) to compete with the Zee. Specific language is critical to make sure the extent of the Zor’s rights are clearly described. The revised FTC rule requires certain new disclosures in this area.
Most franchise agreements detail types of terminations and the results (for example, if a Zee fails to submit its royalty statements, this can result in the termination of the Zee’s franchise). Most of the different categories relate to whether any notice is required to be given to the Zee versus whether an opportunity to cure is provided.
The operations manual is usually an extensive document or multiple documents that describe, in detail, all the requirements, standards and methods used in operating the business. For example, a restaurant franchise may describe how its employees are to greet customers while a truck bed lining franchise describes the techniques used in applying a unique protective coating to truck beds. One aspect that is often lost on new Zors is the flexibility that the manual allows regarding those matters not addressed in the FDD. Although the FDD requires extensive disclosures, it simply can’t address all operational aspects nor the changes that are inevitable. This gives the Zor the opportunity to alter certain aspects of the system that do not require an amendment to the FDD nor re-filing with the state.
There are several important regulations which apply after registration of the franchise. For example:
There are explicit timing rules as to when a Zor must deliver the FDD to a prospective Zee before it can accept money or have the contract signed. This period is usually based on a certain number of days before signing or payment. Missing this requirement by one day can result in the recession by a Zee of the business, a costly problem.
Zors must follow various regulations regarding the content of all forms of advertisements, including those made on the Internet.
Franchise Relations Acts — Termination and Nonrenewal
Most states, even nonregistration states, have rules that prohibit certain types of unfair terminations or nonrenewals. In years past, it was not uncommon for a Zor to terminate a franchise without reasonable notice to cure the problem or to deny a renewal at the end of the term of the franchise, either of which could result in disastrous economic consequences to the Zee. Almost all states and the FTC responded to this problem and passed laws addressing both of these issues, usually referred to as the Franchise Relations Act, which are separate from the registration and various other compliance laws.
Material Changes to the FDD
After registration, if the Zor makes a change to the FDD, it must file for a post-registration amendment, but only if the change is material. Whether the change is material is often a close call, and in that case most lawyers will advise the Zor to file the change with the state or states. So if the Zor is registered in 14 states it must file amendments in all of them, although the process is normally not very expensive (as to legal time and filing fees) unless the changes are extensive or pose new and objectionable issues.
Challenges From the Zor’s Point of View:
The Concept — This is the heart and soul of the franchise.
Not only must the Zor really believe in the concept, but it must be tested in some fashion so that a Zee can be relatively confident it will be accepted in the marketplace.
Ideally the Zor will have already opened and operated several locations to determine if the concept is viable and can be adopted by a Zee. Without this process the system is at risk of never being validated and failing at an early stage.
This is an obvious issue but so important. It is important during the entire life of the franchise system, for example, to finance the development of the FDD and registration, then to hire salespersons and trainers and at a more mature stage, to develop a strong financial position. Zors should try to arrange multiple back-up sources of capital such as banks, real estate, financing, loans, relatives, friends and retirement accounts.
If the wrong Zee’s are chosen, the system will be weak. It is time consuming and expensive to properly screen candidates, but it may be the difference between success and mediocrity or even failure.
Marketing — Not a simple subject
It takes smart Zors, consultants and Zees (willing to pay their fees) to create a good marketing plan and execute it. Zees expect that the Zor will develop a recognizable name, but without great marketing it won’t happen.
There are many reasons for a Zee not to buy from a new Zor. Some are lack of a track record, untested management, low financial strength, untested concept, etc. How do you overcome these concerns?
Some Techniques Are as Follows:
Make sure the facilities look professional, including the décor and the dress for all employees and owners, especially those who will be seen by or meet the prospect. Impressions count.
Lead with your best people-oriented staff. Be knowledgeable, upbeat, smart and courteous. Zees often comment on connecting with owners or executives of the Zor, which can substitute for a short track record.
Practice the response to all possible questions from prospective Zees. Zees are getting more and more experienced in shopping for franchises and Zors need to be able to show that they really know the system and that they have anticipated most future business issues.
You will need to be dedicated to contacting and meeting with Zees exactly as promised. It impresses the Zee and keeps them moving along toward purchase.
Stress technology, especially if it gives the Zee a leg up on the competition. As our society becomes more technological, Zees will expect computerized and electronic tools with the newest software programs to speed up, facilitate and manage all aspects of their business.
To stay ahead of your competition you may have to provide more favorable terms, such as lower the initial franchise fee, royalties and advertising fees as well as other important provisions.
Absolutely make any company store look great and operate well.
Explain Key Contract Provisions
If you know your contract has provisions that the Zee (or the Zee’s attorney) may object to, consider explaining their purpose before the Zee reviews the FDD (there is a risk in this suggestion because the Zor might emphasize a point not otherwise of concern to the Zee).
Don’t Grow Too Fast
Don’t sell more franchises than you can comfortably service. Otherwise your service level will drop and disgruntled Zees will do all sort of things, not necessary favorable to the Zor, like complain, form Zee association (not always bad) or even sue you.
Too Many Hats
Make sure you can do all the things you promised, otherwise get some help, such as hiring a realtor to find locations or arranging with a quality builder to be available to Zees for tenant improvements.
Assistance by Zor
Keeping your commitment to provide quality ongoing assistance may be the most important item of all. After the initial fee is paid, training is finished and the business has opened, the Zee will be expecting ongoing assistance in running the business, in developing new products and services, upgraded technology and other system improvements for the life of the franchise term.
Listen and consider any suggestions from Zees and respond in a meaningful way. If the Zees have established a franchise association, stay as involved as possible.
Change is going to happen; it’s just a matter of when. Anticipate it and obtain some consulting help. Prepare your Zees, well in advance, for any major change in the franchise system or relevant market.
Challenges From the Zee’s Point of View
If you’re thinking of, or in the process of looking for a franchise to purchase, it’s important that you determine what you should expect from your Zor in order to improve your chances of success. With so many franchises you will have a wide range to choose from and there are sure to be many differences between them. Despite the differences, any franchise you purchase should at least provide the following:
The Zor should have a successful system that can be easily transferred. If the system isn’t successful or proven, the chance of success decreases. Also consider if you are paying for the Zor to learn the franchise process on your time.
The Zor should be glad to answer your questions and spend the time necessary to do so.
Although a Zee is not marrying the Zor, there are some similarities. The Zee should feel comfortable and compatible with the Zor. The Zee should feel confident that the Zor can successfully make the changes as the need arises and the system evolves. This usually requires asking questions about the future plans of the Zor’s.
The best way for a Zor and Zee to work together to be successful is on a partnership approach. Make sure the Zor takes this approach. Ask other Zees how they are treated.
Newer systems may be able to grow faster but established ones with names that can be recognized may be safer. You need to find a system that provides one of these or a good combination compromise.
Technology is changing at a rapid rate and every year more of it is used in franchise systems. Make sure the Zor is technologically capable and expresses how it will be used in the future to help the system.
Although the screening process may not be pleasant for the Zee, it will protect the franchise system and maintain a high quality of Zees. Discuss the criteria of a Zee with the Zor and how he or she implements the screening process.
The Franchise Agreement
The franchise agreement should be fair. Almost all franchise agreements favor the Zor and they will have some legitimate reasons for this, usually that these provisions benefit the entire system. Further they will want to control various aspects of the system so all Zees can obtain similar benefits. In spite of this, there are several provisions that should be in the agreement for your benefit, such as fair and endless renewal rights, reasonable transfer provisions so you can sell your business in the future, protection of your goodwill, fair territories and protection from competition from the Zor.
The Zee should receive a quality level of training so it understands the business and marketplace. Check out the experience of the trainers and check with other Zees as to whether the training was adequate. Get the details on how future assistance is provided, who pays for it, where it is provided, and the extent and type. For example, will the Zee have to pay a large sum to train any new manager? The Zee should be able to obtain future assistance easily and for a reasonable amount.
Zors should help locate a good site for the business. Although some Zors will resist actually picking the site in fear of later claims that they were negligent in such selection, the Zee should obtain reasonable assistance from the Zor in the search. Ask questions of other Zees as to what assistance was provided to them. Also check the FDD. Let the Zor or brokers help with site selection, and the Zee should not rely on its own skills to perform this very important task.
The Zor should either be assisting and visiting you at the time of opening or shortly thereafter to work out the bugs.
Strong systems usually have involved and quality Zee councils or associations with the Zor participating in a meaningful manner.
One of the best characteristics for a Zor is to provide assistance when a Zee is in operational or financial trouble and even assist them with selling or moving out of the franchise, without a bitter fight.
Since Zees will be paying for training, operational and marketing assistance and so forth, the Zor needs to be capable of providing these services, which means it must be financially able or otherwise show what resources they have to do this.
Look for a Zor that knows how to avoid trouble including litigation. Most of the pertinent lawsuits involving the Zor and Zees are in the FDD and should be reviewed. Also try to determine the nature of the Zor when it comes to problems that might develop into more serious confrontation.