Articles

Why You Should Never Become a Franchisor (Unless You Really Want To)

By Don Florman

There is a classic story about a Mom and Pop neighborhood store that sells home made pies. The pies, made from secret family recipes, are delicious, the decor is enticingly comfortable, and the coffee, additional foodstuffs, magazines, and complimentary hard goods all help to make the main product taste even better. A line of customers runs down the block with people coming from as far away as New Rochele. No one buys a pie without complimenting the owners who work behind the counter. Moreover, every fifth or sixth customer claims that he or she wants to open a store exactly like it. "Why don't you start a franchise?" the customers ask the owners. At some point Mom and Pop have no choice but to ask themselves, "Why don't we start a franchise?"

There is no classic ending to the story although I can give you a hint of its outcome: you see McDonalds' golden arches everywhere you go but I bet you have never seen a silver pie tin advertising "Mom & Pop's Homemade Pies."

The moral of the story is that successful franchising is difficult. It is different from making pies...or lubricating cars or teaching kids learning skills on a computer...which means that you have to be expert in two business, how to make the pies and how to be a franchisor. Franchising is highly regulated, requiring strict adherence to a plethera of confusing state and federal statutes and rules. Moreover, there is a natural tension between franchisor and franchisees that demands a franchisor's constant attention and activity both before a franchisee signs a license agreement and forever after. If it were not for the fact that a well run franchise network can realize a substantial amount of money and personal satisfaction for a franchisor (as well as his or her franchisees), I do not know why anyone would even consider becoming a franchisor. Which is why I advise clients that they should never become franchisors....unless they really, really want to; and even then, only after they understand the problems they are about to face. If they insist they are still interested, here are 12 steps that I offer to them.

1. Understand franchising regulatory requirements and use them to your benefit. Many who consider starting a franchise network cannot believe the extent that franchising is regulated by federal and state governments. Much of the regulatory scheme stems from a legislative belief that the relationship of franchisor and franchisee is one of unequals. As a result, governmental regulations impose disclosure and relationship requirements aimed at providing prospective franchisees with equal information and equal and fair treatment. While compliance is costly and time consuming -- disclosure documents must be up-dated at least once a year and sometimes more often -- it can be beneficial as well. Strict adherence to proper disclosures and procedures, supported by well drafted franchise and related agreements, are similar to a good insurance policy. If statutory requirements are adhered to broadly, a great many potential franchisee complaints can either be avoided or deterred. So instead of trying to circumvent compliance, franchisors should comply with applicable regulatory requirements and use them to their advantage.

Disclosure documents are regulated by state statutes as well as a rule of the Federal Trade Commission Rule (the "FTC Rule"). Approximately twelve states, including New York and California, have enacted franchise disclosure document (or offering circular) registration statutes. Additional states require the franchisor to file a notice or a copy of their offering circular. These so-called "registration states" require the franchisor to prepare a disclosure document that must first be registered with the state and then delivered to prospective franchisees. While most registration states allow franchisors who meet certain financial and experience criteria to be exempt from registration, the offering circular must still be delivered to each prospective franchisee. The form of the registration states' disclosure documents follows a uniform model, with some individual state variations, referred to as the Uniform Franchise Offering Circular ("UFOC").

The FTC Rule includes a disclosure requirement for franchises and business opportunities that applies throughout the entire United States. No registration is required but franchisors must prepare an offering circular that includes specified information in a format defined by the Rule that is somewhat different than the UFOC requirements. While the FTC Rule, as a federal regulation, would normally take precedence over the registration states' statutes, in an attempt to avoid unnecessary duplication the FTC permits a franchisor to utilize the UFOC disclosure document, with some reservations, rather than the FTC Rule format, both in registration and non-registration states.

While all of this may sound, and is, complicated, life becomes easier for a franchisor as soon as he or she understands that a carefully drafted offering circular - one that reflects the particular business being offered while complying with the regulatory scheme - must be prepared. If franchises are to be offered for sale in certain states, the document must be registered; regardless of registration, the document must be kept timely through regular revisions that occur at least annually and sometimes more often. Most importantly, the disclosure document must be delivered to each prospective franchisee upon the earlier of the franchisor's first meeting with the franchisee or a specified number of days prior to the franchisee's signing any agreement with or paying any money to the franchisor.

In addition to the disclosure requirements, numerous states have franchise relationship and termination statutes. These statutes vary considerably from state to state and cover, as their name suggests, issues that arise with respect to the franchise relationship and the termination of that relationship. As an example, some statutes provide that the franchisor cannot terminate a franchise relationship unless there is "good cause," an appropriate notice by the franchisor, and/or an offer to purchase certain assets of the franchisee.

2. Make your disclosure document reflect your business. The preparation of an offering circular requires information to be gathered and formatted on an almost formulaic basis. The disclosure document that best protects the franchisor happens to be the one that is most informative to a prospective franchisee. Instead of providing the barest minimum of information required by the formula, prepare a document that fully reflects the working relationship between the franchisor and franchisee by clearly describing what is expected of each on an on-going basis. There are franchise consulting companies that will prepare disclosure documents for a franchisor and provide other start-up services and guidance as well. It is important, if using a service company of this kind, that the end result is not a disclosure document in which the franchisor's business has been forced to fit the four corners of a page instead of describing the franchisor's business.

3. Strive to be accurate. To prepare a truly descriptive document requires careful analysis of each operational step of both franchisor and franchisee. Included are many facts about the franchisor and many estimates of costs to be incurred by franchisees. Inaccurate facts or estimates are violations of applicable statutes, may lead to the acceptance of unsuitable or under-financed franchisees, and can be used to the detriment of the franchisor in disputes with disgruntled franchisees. Additional time and resources spent to prepare competent disclosure materials can avoid costly and damaging disputes with franchisees and regulators.

4. Do not be afraid to disclose. Franchisors are not hurt by fully disclosing all information required and, to the contrary, benefit from full and complete disclosures. The goal is not only to comply with the requirements of the regulators, but to be able to respond to possible complaints of franchisees by pointing out that any matter at issue was fully explained in the disclosure document delivered prior to commencement of the franchise relationship.

5. File before you market. Determine whether a non-registration state requires a filing. Some states, like Florida, have statutes requiring a franchisor to file an initial or annual notice with a state regulatory agency. The filing procedures are usually relatively easy and inexpensive.

6. Open and operate a franchisor owned outlet. A good idea is not good enough. If at all possible, a pilot outlet should be opened and operating before you begin to franchise. A franchisor owned outlet should act as a laboratory for developing the business that is about to be franchised so that it is attractive to the consumer market, as well as prospective franchisees. By operating the business you will learn the day-to-day problems that will be faced by your franchisees. When you to solve those problems - or at least most of them - you are ready to begin thinking about offering franchises.

In addition, having a franchisor owned outlet will allow prospective franchisees to visit a working model, operating the way you want it to, rather than merely reading a disclosure document. Finally, the franchisor owned outlet can be used for on-site training (which should be combined with more extensive training at the Company's office) for new franchisees.

7. Define your business concept and how you will execute it. If you are offering franchises for a shop that sells pies, do not expect your franchisees to know anything about baking when they sign their franchise agreements. As a matter of fact, do not expect your prospective franchisees to know anything about running any kind of franchised business. While you will be pleasantly surprised at how much they do know, you must be prepare yourself to teach your franchisees everything.

Your disclosure document, discussed below, must describe in substantial detail, among other things, the basic nature of the franchise relationship (i.e., obligation and rights of the parties, who will market and sell the franchise, who will do what to locate a site for and lease, build and equip a franchised outlet, who will train the franchisee in opening the outlet, who will provide after-sale assistance field visits, etc.). A General Operating Manual - which is a franchisor's proprietary document and distributed only after a franchisee has signed a franchise or license agreement - goes further, spelling out exactly how a franchisee is expected to operate the business from the moment the door is opened in the morning until the lights are turned off at night.

To prepare a meaningful General Operating Manual you must first develop a well defined business concept and be capable of explaining how to reach it, point by point. While marketing material may be filled with catchy phrases and grand generalities, your General Operating Manual is all specifics, interesting to no one except those who want to learn how to operate the business. The document, which, by reference, becomes part of your franchise agreement and to a large extent dictates to the franchisee how the outlet must be operated, should be filled with specifics presented in a clear and orderly manner. In other words, in order to prepare a General Operating Manual you must know - and tell - precisely the business you are trying to sell.

8. Target your marketing areas. It is difficult and costly to market franchises throughout the entire United States . Choose specific states or regions where you wish to sell the franchise initially. As your sales effort succeeds, expand the marketing areas. If you intend to sell in registration states, start the registration process early. Depending on the state and the make-up and condition of the state's regulatory staff at the time of your application, registration can take anywhere from several weeks to several months and more. Most prospective franchisees do not have the patience to wait to purchase a license while the franchisor completes its registration. Choose which registration state or states in which you intend to market and register before you begin your sales effort.

9. Register a Trademark. The franchisor's trademark, trade name and/or logo should be registered in the United States as promptly as possible both to protect the name against competitors and because several states' regulatory statutes distinguish between a franchise and a business opportunity (an offer to purchase a specific type of business, usually without a trade name and requiring product to be bought from the offeror by the purchaser on a continuing basis, such as maintaining a route of video tape racks in local delis) based on whether the franchisor has registered a trademark in the United States. A failure to register a trademark may result in the franchisor having to comply with business opportunity statutes, which are often more strict and burdensome than the rules that regulate franchises.

10. Prepare Quality Agreements. Your disclosure document or offering circular must include copies of all agreements that are to be signed by the franchisee. These include the franchise or license agreement and, depending on the structure of the business arrangement, numerous other agreements (i.e.,, a sublease, a promissory note, a security agreement, an assignment of telephone numbers, the table of contents of a General Operating Manual and other documents not discussed in this article).

The franchise or license agreement (and other documents) should be well drafted to define all of the rights and obligations of both parties, making sure that it protects the franchisor's interests while providing a franchise arrangement that is attractive and saleable to prospective franchisees. In preparing your franchise agreement you must consider such issues as confidentiality, an indemnity, restrictive covenants, default and remedy provisions, and other matters, most of which are often drafted in a manner that is favorable to the franchisor. Quality documents, however, especially for a start-up franchise program, should protect the franchisor without being overly burdensome to the franchisee. Always remember that before the franchise agreement can be signed the franchise must be sold: the strongest pro-franchisor license agreement I ever reviewed was for a would-be franchisor that never sold a franchise.

11. Utilize a Professional Marketing and Sales Effort. There are sales people who believe that selling franchises is a matter of numbers: each thousand dollars worth of advertising will result in a certain number of telephone inquiries; a fraction of the telephone inquiries will result in personal meetings with prospective franchisees; and a fraction of the personal meetings will result, eventually, in executed license agreements.

That means that as a franchisor you must be capable of preparing advertisements that will attract the attention of prospective franchisees, placing the ads in venues that will be seen by prospective franchisees, creating an attractive and informative web site, making sure that telephone responses entice callers to visit or meet with you, and having an appropriate sales pitch when prospective franchisees visit. If you are expert in all of those areas you can save money by doing them yourself; if you are not an expert, you can lose money by believing that you are. In other words, do what you know what to do and hire experts to do what you cannot do.

Employing good marketing professionals may cost more but should result in a higher rate of new franchisees. While some start-up franchisors use independent franchise marketing organizations to sell franchises, often with short term savings and long term negative consequences.

12. Treat your franchisees as if they were your customers. There is a balance that is required to maintain good franchisee relationships. Successful franchising stems from the creation of mutually beneficial contractual relationships between independent parties. When it works well, the franchisee brings to the equation energy, capital, and an entrepreneurial spirit that benefit both sides.

The advantages to the franchisor are an ability to expand quickly with a minimum capital expenditure, the support of an energetic work force that is difficult, if not impossible, to match through traditional employees, and a large, continuing cash return on a relatively small investment. The greatest faults in the system derive from the same independent party relationships. When problems begin to arise, the franchisee often rushes to lay blame on the company's franchise system, generally becoming disputatious and litigious, sometimes claiming fraud and misrepresentation with regard to the sale of the franchise and a failure to train or provide services after the sale. Even successful franchisees can become creative in attempting to find ways to terminate the franchise relationship and end the royalty flow to the franchisor.

If you intend to operate a franchise network make sure that you understand your franchisees' point of view. The franchisee pays an initial franchise fee, continues to purchase products from the franchisor, and pays the franchisor an on-going royalty. The franchisee should believe that it is receiving value for those royalty payments. Of course, the easiest way to show value is to have a successful concept that attracts retail sales and earns income for the franchisee. The franchisor, however, can take additional steps by being available to help resolve franchisees' operational problems, developing and sharing new products and methods of doing business, increasing name recognition, maintaining a dialogue with franchisees both individually and as a group (i.e., at an annual meeting of franchisees), and, generally, creating an atmosphere where franchisees understand that the franchisor is seeking to benefit itself by benefitting all of its franchisees.

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