Overview of Franchising

History

Franchising is a concept which began in the 1950's with companies like McDonald's, Burger King, Dunkin' Donuts, Kentucky Fried Chicken, Holiday Inn, Midas Mufflers and Dairy Queen. 

Due to abuses in the sales process, in 1971 California became the first state to implement laws regulating the sale of franchises.  Since that time, 15 other states, including Michigan, have passed specific state laws regulating the sale of franchises and the franchise relationship.  In 1979, the Federal Trade Commission ("FTC") passed the Federal Trade Commission Rule (the "FTC Rule") requiring that franchise companies provide prospective franchisees with a  Franchise Disclosure Document ("FDD") containing specific information about the franchise being offered.  The purpose of the FTC Rule is basically two-fold:

  • To provide the prospective buyer with sufficient information upon which to make an informed investment decision; and
  • To ensure, pursuant to the 14 day rule, that the buyer has enough time to evaluate the decision to purchase before signing an agreement or paying any money. 

 

Thus, under federal law, a waiting period of 14 calendar days before a buyer/franchisee can be asked to sign an agreement or pay any money, is required.

The Franchise Disclosure Document

What is in the Franchise Disclosure Document?  The FDD contains 23 informational items enabling a buyer to learn about the history of the franchisor, the background of its key personnel, and the franchise system to help the buyer make a determination as to whether the program is right for it.  These items include:

  • The experience of the franchisor;
  • Litigation and bankruptcy history involving the franchisor;
  • Initial fees and continuing fees (such as royalties and advertising) the franchisee is required to pay;
  • A description of all fees to be incurred in the initial investment prior to and after opening the business;
  • The franchissee's obligations to purchase or lease from any designated source including the franchisor or its approved suppliers;
  • What, if any, financing arrangements are provided;
  • The obligations of the franchise company, both prior to and after the opening of the franchise business;
  • Whether or not any exclusive territory is provided;
  • What service marks or trademarks you will be authorized to use in the franchise business; and
  • What if any restrictions will be imposed on the types of goods and services to be sold.

Importantly, there will be a long section describing your renewal rights and the rights of the franchise company to terminate your franchise in the event of a breach of the franchise agreement.  In addition, attached as an exhibit will be the financial statements of the franchise company, which should be reviewed by an accountant to determine the "financial health" of the franchisor.

 

Definition of a Franchise

The common definition of 'franchise' contains three basic components:

  • The right to engage in a business offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by the franchisor;
  • The operation of the business in substantial association with a franchisor's trademark, service mark, trade name, etc.; and
  • The requirement that the franchisee pay, directly or indirectly, a franchise fee.

 

If a seller's program contains all three of these components, it is in fact a franchise.  Different types of franchises include 1) a single franchise for one unit, 2) an area development agreement whereby the franchise company grants to you an exclusive right to develop a particular geographic area, or 3) sub-franchising, master franchise, whereby the franchisee is granted both the right to develop a territory, but also to sell parts of the territory to others who may wish to operate franchises as well.

Key Components to a Successful Franchise

  • A product or service with an advantage over the competition
  • A standardized franchise system that has been time-tested
  • Franchisor support (training, R&D, etc.)
  • Adequate home office support staff
  • A solid financial base for the franchise company; and
  • A good Marketing Program.

 

Factors in Selecting a Franchise or "Is This For Me?"

  • How much can you invest/afford to lose?  What are your financing need?
  • Your abilities and qualifications (experience, education)
  • Your goals (interests, income needs)
  • Demand for the product/service
  • Competition
  • Operational/managerial abilities
  • Name recognition
  • Training and support
  • Franchising experience
  • Financial stability of franchisor
  • Research and development ability
  • Can you follow a system?
  • Family support
  • Success/satisfaction of other franchisees
  • Ready for hard work?

 

Why Buy a Franchise?

Benefits:

  • Desire to own your own business
  • Lack of extensive business experience or product expertise
  • Name recognition
  • Reduced risk
  • Access to business manual (management, accounting practices, hiring guidelines, other business practices, etc.)
  • Training
  • National or regional advertising
  • Cost saving bulk purchase capacity
  • Management support
  • Access to research and development/products and services.

Responsibilities:

   Costs

  • Initial franchise fee
  • Continuing royalty payments
  • Advertising fees
  • Premises upgrades/remodeling
  • Computer systems

   Controls

  • Site approval
  • Collateral Lease Assignment
  • Design/appearance standards
  • Restrictions on:
    • goods/services
    • methods of operation (hours, signage, bookkeeping)
    • advertising
    • termination/non-renewal
    • noncompetition (in-term and post-term)

 

Pitfalls to Avoid:

  • Underestimating working capital needs of the business.  At least 6 months of cash flow is suggested during the initial start-up phase.
  • Failing to understand legal and financial obligations contained in the Franchise Disclosure Document, the Franchise Agreement as well as any other Agreements that will be required to be executed.
  • Underestimating build-out, equipment and supply purchase requirements and other expenses, including but not limited to, leasehold improvements, employee training, advertising, insurance, etc.
  • Failure to provide for future capital needs, including equipment, technology, marketing, remodeling, etc.
  • Underestimating personal liability for execution of Franchise Agreement and Guaranties.
  • Understanding that the franchise rights are granted as a 'license'; the Franchisee does not have rights in perpetuity but only for the time period stated by the Franchise Agreement.
  • Underestimating the time commitment required to make the business successful, especially during the initial years of operation.
  • Failure to understand the significance of payments owing to the Franchisor, including royalties, advertising fees, rent, etc. and the impact it will have on the bottom line.
  • Failure to properly document business partnerships and relationships with co-shareholders to provide for adequate buy/sell provisions in the event of death or disability of a partner.

 

Advice:

  • Franchise laws do not:
    • Ensure the franchise company is competent;
    • Ensure that the program is viable;
    • Ensure that the franchise agreement is reasonable; or
    • Ensure that you will be successful.
  • Do your homework by talking to as many franchisees as humanly possible; hire a franchise attorney to review your franchise agreement and ancillary documents; and engage a C.P.A. who will work with you on an ongoing basis to evaluate your operation to maximize your profitability and minimize your expenses.

 

Sources of Franchise Information

  • Annual January issue of Entrepreneur Magazine
  • Michigan Attorney General, Department of Consumer Protection (517) 373-7117
  • International Franchise Association (202) 628-8000, www.ifa.com
  • Trade shows
  • Public library
  • Franchise Opportunities Guide
  • Friends/family
  • Franchise marketing companies
  • The Federal Trade Commission.