THE FRANCHISING FRONTIER: OPPORTUNITIES AND PITFALLS FOR THE 1990's
By Andrew J. Sherman, Esq.

The diversity of products and services offered by franchised businesses have enabled the contractual method of marketing and distribution known as franchising to become a powerful force in the United States economy. It would be difficult to imagine a day going by in either our personal or business lives without interacting with a franchised business.

On a personal level, we can buy our home, cars, food and our clothing from franchised stores and offices. We drop off our vehicles in the morning from franchised automobile service centers and our clothing for laundering from franchised dry cleaners. We plan our vacations with franchised travel agencies and enjoy our vacations and enjoy our recreation at franchised entertainment facilities and health clubs. We can have our children tutored and our pets groomed at franchised offices nationwide.

At the business level, we can contract for temporary help, cleaning services, printing, accounting, computers, automobile rental, corporate travel, video production, interior design, coffee and tea, catering, courier services and even rented mail boxes from franchised companies across the country. We can buy our business forms, business supplies and even have our businesses sold by franchisors and franchisees.

But what does all of this mean to you as prospective franchisees and entrepreneurs? It means that a fundamental understanding of the business and legal issues affecting the franchise relationship is crucial to prospering in today's competitive marketplace. It means that one way or another, you are going to interact with or become a member of the franchising community.

Franchising in the U.S. economy continues to boom. In a study recently compiled by the International Franchise Association, franchised sales of goods and services at well over 600,000 locations across the country have reached over $800 billion by the year 2000. Franchised businesses now account for well over seven million jobs in nearly one hundred different industries. From a global perspective, nearly 400 franchisors have sold franchises abroad, accounting for over 30,000 locations, in markets as diverse as Africa, Japan, Israel, France, and the Caribbean.

What has made franchising so popular in the United States? From the perspective of the franchisor, franchising represents an efficient method of rapid market penetration and product distribution without the capital costs of internal expansion. From the perspective of the franchisee, franchising offers a method of owning a business, but with a mitigated chance of failure due to the initial and ongoing training and support services offered by the franchisor. From the perspective of the consumer, franchised outlets offer a wide range of products and services at a consistent level of quality at affordable prices.

From both a personal and business perspective, franchising truly affects every aspect of our lives and offers tremendous economic opportunities for individuals looking to expand or start a small business, invest in a risk-mitigated situation or acquire area or master franchising rights.

Evaluating Franchise Opportunities

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.

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 is not too dependent on the presence or expertise of the founders of the system;
• 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;
• Sufficient capitalization to launch the franchising program and provide ongoing support and assistance to franchisees;
• A recognized protected and distin ctive trade identity which includes federal and state registered trademarks as well as a uniform trade appearance and overall image;
• Proprietary and proven methods of operation and management which can be reduced in writing in a clearly written operations manual;
• A comprehensive training program for franchisees - initially at the company's headquarters and on-site at the franchisee's proposed location;
• A field support staff who are available to visit and periodically assist franchisees and monitor quality control standards;
• A set of comprehensive legal documents that reflect the company's business history, strategies and policies. Offering documents must be in accordance with applicable federal and state disclosure laws and franchise agreements should strike a delicate balance between the rights and obligations of franchisor and franchisee;
• A demonstrated market demand for the products and services developed by the franchisor that will be distributed through the franchisees; and
• A set of carefully developed site selection criteria that are based on market studies and demographic reports that require sites which can be secured 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, Virginia and Wisconsin. These states generally follow a more detailed disclosure format, known as the "Uniform Franchise Offering Circular" or "UFOC."

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 :

• Unregistered and unprotected trademarks and copyrights
• Extensive litigation against franchisees for no apparent reason
• Weak balance sheet of a troubled or start-up franchisor
• Overly excessive control by the franchisor over the franchisee in unnecessary areas
• 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
• 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 on bank financing
• Franchisors who assume the control of the franchisee's location by serving as the sublessor
• Extensive and burdensome covenants against competition during and after the term of the franchise agreement
• Overly stringent conditions to the renewal of the franchise upon expiration of the term, such as excessive renewal fees, a mandatory 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 securities, approval of a proposed transferee or allocation of national advertising funds
• Extremely broad grounds for termination of the franchise agreement for virtually any breach by the franchisee
• Provisions which provide little to no assurance of geographic exclusivity being granted to the franchisee (which could result in market situations)
• Contractual clauses which provide for termination upon the death of the franchisee without the right to transfer the franchise to an heir or surviving spouse
• An unclear or ambiguous statement of the exact duties and support services which will be provided by the franchisor to the franchisee
• An inexperienced management team who knows little about franchising or an overly strong dependence on a particular person
• A very short training program (which may imply a shallow foundation for the system) or a very long training program (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 "implied covenants of good faith and fair dealing" into certain franchise agreements which must also be interpreted in accordance with "traditional 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.