EVALUATING FRANCHISE OPPORTUNITIES
By Andrew J. Sherman, Esq.

Owning and managing a profitable small business is never an easy road; franchising may make it an easier road to travel, but it will never be a free ride. This is primarily because franchising certainly mitigates but does not eliminate the risk of business failure.

It is critical to carefully study the strengths and weaknesses of each franchisor which you are evaluating, which can be obtained through a careful review of the Uniform Franchise Offering Circular, detailed interviews with the franchisor's team and existing (and former) franchisees and from general industry data which may be available from trade associations, industry groups and from surfing the Internet. Anyone considering the purchase of a franchise should begin by looking for a franchisor with an established reputation, sufficient capitalization, quality products and services and an existing network of satisfied franchisees. The franchisors which are among the final candidates for evaluation should be able to demonstrate to you that they have a strong foundation from which their franchising program was launched and is currently operating. The key elements of this foundation are as follows: 

• A proven prototype location which serves as the basis for the franchising program and that can be replicated in your target local market;

   

• A strong management team made up of internal officers and directors as well as qualified consultants who understand both the particular industry in which the company operates and franchising as a method of expansion -- look carefully at Item 2 of their UFOC to ensure that the franchisor has a balanced team;

   

• A strong balance sheet with assets and resources in place which are sufficient to provide initial and ongoing support and assistance to franchisees;

   

• A recognized protected and distinctive trade identity which includes federal and state registered trademarks as well as a uniform trade appearance and overall image; since it may be costly to change the name of your business if the franchisor loses its rights to the trademarks;

   

• A comprehensive training program (the length of which will vary depending on the complexity of the franchised business but generally runs for a minimum of one week to as much as eight weeks) for franchisees which covers all aspects of managing and operating the underlying business -- initially at the company's headquarters and on-site at the franchisee's proposed location, which includes comprehensive operations manuals;

   

• A field support staff who are available to visit franchisees at least once or twice per month and provide hands on assistance and guidance during these visits;

   

• A cooperative buying program which may involve volume discounts, preferred storage and shipping capabilities, reduced rate media advertising and other programs which allow the franchisee the opportunity to enjoy the economies of scale of being part of a franchise network;

   

• A demonstrated market demand for the products and services developed by the franchisor that will be distributed through the franchisees, which are not subject to fads or trends; and

   

• A set of carefully developed site selection criteria that are based on market studies and demographic reports and which can be secured at a reasonable cost in today's competitive real estate market.

Legal Aspects of the Franchise Relationship

From a legal perspective, franchising is a contractual method of marketing and distributing goods and services. The parties to this commercial relationship are the franchisor, which has developed an established business format for delivering the goods and services, and the franchisee, who wishes to obtain a license to operate a site in conformity with the franchisor's prescribed system.

The offer and sale of a franchise is regulated at both the federal and state level. At the federal level, the Federal Trade Commission's trade regulation Rule 436 specifies the minimum amount of disclosure that must be made to a prospective franchisee in any of the fifty states. In addition to the federal rules, fifteen states have adopted their own rules and regulations for offering and selling franchises within their borders. Known as the "registration states," they include most of the nation's largest commercial marketplaces, such as California, New York, Illinois, Maryland, and Virginia. These states generally follow a more detailed disclosure format, known as the AUniform Franchise Offering Circular or AUFOC.

Area Development Agreements and Subfranchising

Most franchises are sold to individual owner/operators who will be responsible for managing a single site in accordance with the franchisor's business format and quality control standards. And it has been the context of the single-unit franchisee that this presentation has addressed thus far. A recent trend in franchising, however, has been the sale of "multiple-unit franchises" to more aggressive entrepreneurs who will be responsible for the development of an entire geographic region.

The two primary types of multiple-unit franchises are: (a) subfranchisors, who act as independent selling organizations that are responsible for the recruitment and ongoing support of franchisees within their given region; and (b) area developers, who have no resale rights but rather are themselves responsible for meeting a mandatory development schedule for their given region. There are a wide variety of variations on these two principal types of multiple-unit franchises. For example, some franchise relationships which are at the inception single-units, wind up as multiple-unit owners through the use of option agreements or rights of first refusal. Other franchisors have experimented with co-development rights among adjacent franchisees of a nearby territory, franchises coupled with management agreements (under those circumstances where the franchisee deserves to be more passive), equity participation by franchisors in franchisees (and vice-versa), employee ownership of franchisor-operated units and co-development rights between the franchisor and franchisee.

As a general rule, the inclusion of multiple-unit franchises in a franchisor's development strategy allows for even more rapid market penetration and less administrative burdens. Often times the franchisee demands the right to develop and operate multiple units. However, there are a wide range of legal and strategic issues which must be addressed when multiple-unit franchises are included in the overall franchising program.

Structuring Area Development Agreements

The key issues in structuring an area development agreement usually revolve around the size of the territory, fees, the mandatory timetable for development and ownership of the units. The franchisor will usually want to reserve certain rights and remedies in the event that the franchisee defaults on its development obligations. The area developer must usually pay an umbrella development fee for the region, over and above the individual initial fee that is to be due and payable as each unit becomes operational within the territory. The amount of the fee will vary, depending on factors such as the strength of the franchisor's trademarks and market share, the size of the territory and the term (and renewal) of the agreement. This development fee is essentially a payment to the franchisor that prevents the franchisor from offering any other franchises within that region (unless there is a default).

Structuring Subfranchising Agreements

Subfranchise agreements present a myriad of issues that are not raised in the sale of a single-unit franchise or an area development agreement. This is primarily because the rewards and responsibilities of the subfranchisor is much different than the area developer or single-unit operator. In most subfranchising relationships, the franchisor will share a portion of the initial franchise fee and ongoing royalty with the subfranchisor, in exchange for the subfranchisor assuming responsibilities within the given region. The proportions in which fees are shared usually has a direct relationship to the exact responsibilities of the subfranchisor. In addition, the subfranchisor will receive a comprehensive regional operations manual which covers sales and promotions, training and field support over and above the information contained in the operations manuals provided to individual franchisees.

Some "Red Flags" to Look Out for in the Offering Documents

When reviewing the franchise offering circular and franchise agreement with your lawyer and accountant, there are several "red flags" which should be of special concern to the prospective franchisee. Naturally, the specific "red flags" will vary from franchisor to franchisor, but commonly include the following :

• Claims by third parties alleging infringement by the franchisor involving the intellectual property (patents, recipes, etc.) which are critical components of the franchisor's system

• Class action litigation against the franchisor by the franchisees alleging fundamental flaws in the franchisor's systems

• Financial statements of the franchisor which reflect a negative net worth or consistent operating losses

• Overly excessive control by the franchisor over the operations of the franchisee in areas which are not critical to the integrity of the overall system

• Contractual provisions which require the franchisee to purchase all or virtually all of its inventory or supplies from the franchisor or an affiliate of the franchisor, particularly for items which are not an integral part of the franchisor's system

   

• An excessive number of "hidden fees" which are charged by the franchisor, such as lease review fees, consulting fees, additional training fees, transfer fees and commissions on leases or bank financing -- these fees will be disclosed in Items 5 and 6 of the UFOC and are typically in addition to the initial franchise fee

   

• Extensive and burdensome covenants against competition during and after the term of the franchise agreement -- the enforceability of these covenants will vary from jurisdiction to jurisdiction and from industry to industry but generally should not be more than is reasonable to protect the franchisor's legitimate business interests and intellectual property

   

• Overly stringent conditions to the renewal of the franchise upon expiration of the term, such as excessive renewal fees, (e.g. essentially requiring you to "repurchase" the franchise) a mandatory unilateral legal release form or an ability of the franchisor to deny renewal for even one notice of breach during the term

   

• Absolute discretion being vested in the franchisor in certain key areas such as approval of suppliers, approval of issuance of your company's securities on a private or public basis, approval of a proposed transferee or allocation of national advertising funds

• Extremely broad grounds for termination of the franchise agreement for virtually any breach of the franchise agreement by the franchisee, though in some cases there may be protection under state anti-termination statutes or under implied covenants of good faith and fair dealing

   

• Provisions which provide little to no assurance of geographic exclusivity being granted to the franchisee (which could result in market saturation) -- the need for some type of territorial protection will vary depending on the nature of the business and the level of competition in the local market

   

• Contractual clauses which provide for termination of the franchise agreement upon the death of the franchisee without the right to transfer the franchise to an heir or surviving spouse

   

• A very short training program (such as only a few days, which may imply a shallow foundation for the system) or a very long training program (such as more than three months, which may imply a high degree of difficulty in teaching the underlying concepts)

Ongoing Relations with the Franchisor

Franchising is designed to be a long-term and mutually beneficial relationship. Franchisors need franchisees as a source of revenue and as the principal contact with the marketplace to preserve and enhance the goodwill of the business format and trade identity. Franchisees need franchisors for ongoing support and assistance, research and development of new products and services, cooperative advertising, negotiations for volume discounts from key suppliers and the continuing license for the proprietary systems and trademarks. Failure to recognize that the relationship must be built on a balanced and harmonious basis, guided by fairness, honesty and continued fulfillment of contractual obligations will surely lead to disgruntled franchises who choose to breakaway from the system and the eventual demise of the franchisor. Even the courts have begun to recognize the need for achieving and maintaining a delicate balance of power between the franchisor and franchisee by reading Aimplied covenants of good faith and fair dealing "into certain franchise agreements which must also be interpreted in accordance with Atraditional notions of fair play and substantial justice."

What does this mean for the typical franchisee? First, it means that a material failure by the franchisor to fulfill its primary obligations under the franchise agreement should not be tolerated by the franchisee. In such cases, notice of the problem should be provided by the franchisee to the franchisor. If the default is not satisfactorily cured within a reasonable period of time, then a formal arbitration or civil suit should be commenced for breach of contract. Second, it means that if statements and promises were made prior to executing the franchise agreement solely to induce you to sign the contract which upon subsequent investigation prove to be false, then arbitration or litigation should be instituted for fraud or misrepresentation.

If the franchisor is interpreting rights and responsibilities under the franchise agreement in an unnecessarily unfair or arbitrary manner (either with respect to its obligations or yours), then the laws governing implied covenants in contracts within your jurisdiction should be carefully reviewed to determine what remedies may be available. Finally, attempts by the franchisor to unfairly or arbitrarily terminate the relationship should be checked against applicable state termination statutes and applicable common law. Note that litigation and arbitration are alternatives of the last resort, and should not be selected as the kneejerk reaction of any disgruntled franchisee. This does not mean, however, that a franchisee should ever accept a fate of spending the next twenty or more years of its life in a relationship that is unfair, overburdensome or unprofitable.

The relationship between franchisor and franchisee is often compared to that between parent and child. At birth, the franchisee looks to the franchisor for all of its guidance, wisdom and support. Failure by the franchisor to nurture the relationship at its early stages will usually lead to the franchisee's financial distress or business failure. As the franchisee grows older, suddenly everything the franchisor says is wrong and rebellion sets in. Conflicts arise and a sense of independence sets in similar to the relationship between a teenager and a parent. Finally, as the franchisee grows to be an adult, they realize that the franchisor really is not so bad and that a peaceful and harmonious co-existence is possible.

Conclusion

In completing your analysis of franchise package, one of the key themes should be: "What can this company do for me that I can't do for myself?" In other words, there should be a series of good reasons why you are willing to pay some initial and possibly ongoing fees to the offeror for the right to be in this business. If the Franchisor has a weak background, lacks financial strength, offers inferior products or services, provides little or no territorial protection, or enjoys a poor reputation in its industry or among its current distributors, then you are better off going into business for yourself without them. If, on the other hand, you are truly convinced that the tangible list of benefits and services directly outweigh the costs and risks, then it's time to get on with the tasks of understanding your legal rights, preparing a business plan, raising necessary capital and opening up for business.

For more information, feel free to contact the author, Andrew J. Sherman, Chairman of the Franchising, Licensing and Distribution Department at Katten Muchin & Zavis and author of seven books on business growth and franchising at asherman@kmz.com (email), (202) 625-3790 (phone), or (202) 298-7570 (fax).