Overview of Franchising

On This Page:

• Federal & State Regulation
• The Franchise Disclosure Document (FDD)
• Key Components to a Successful Franchise
• Factors in Selecting a Franchise or "Is This For Me?"
• Why Buy a Franchise?
• Pitfalls to Avoid
• Advice

Federal & State Regulation

The Federal Trade Commission Rule

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.

State Regulation

16 states have franchise laws requiring the registration of a franchise offering prior to their offer or sale. These states are:

States marked with (R) are registration states requiring review by an administrator as a condition of registration.

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 franchisee'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.

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
  
• A good marketing program
  
• Commitment to continued product or service development
  

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
  
• Brand 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
  
• Successful business model
  

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
  
• non-competition (in-term and post-term)
  
• adherence to a system with little or no flexibility
  

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.