When you think of franchises, or franchises, you are likely thinking of national—and even global—fast-food chains and restaurants such as Taco Bell or Applebee’s. Since the 1920s, when A&W Root beer and Howard Johnson launched the first franchise operations in 1925, franchises have remained an attractive business model for entrepreneurs looking to go into business on their own.
Although franchises can vary in complexity, franchises generally provide a ready-made, tested business model that does not involve the risk of starting your own business from scratch. However, this does not mean that franchising a business is easy. There are many key components and processes that must be understood and completed before a business can be franchised.
This article will attempt to provide a foundational understanding of what a franchise is, the laws and regulations that govern franchising, the types of franchises available, the components involved in creating a franchise, and advantages and disadvantages in franchising a business.
FRANCHISE DEFINED
A franchise can be explained as a licensing agreement in which one party (the “franchisor”) authorizes another (the “franchisee”) to use its business model, goods, services, and/or trademark. In general, in exchange for the franchisor agreeing to the initial franchise, the franchisee will provide the franchisor with an initial fee, in addition to ongoing fees, known as “royalty fees,” throughout the life of the franchise.
TYPES OF FRANCHISES
In general, there are two kinds of franchises: (1) a “business format” franchise; and (2) a “product” franchise.
In a “business format” franchise, the franchisor will license the franchisee to use a particular business model or operation which is associated with the franchisor’s trademark. In a business format franchise, the franchisor will generally provide substantial assistance in understanding and using the franchisor’s particular business model. Among other things, this assistance could include use of the franchisor’s operating manual and other materials, hands-on, on-site training on the franchisor’s advertising procedures, distribution practices, and accounting protocols, and much more. Business format franchises are generally the preferred franchise type for first-time franchisees due to the franchisor’s level of involvement. Most franchises in the U.S. come within the business format type. Examples of business format franchises include McDonald’s, Subway, Motel 6, Cinemark, and more.
A “product” franchise, also known as a “trade name” franchise, gives the franchisee the right to distribute the franchisor’s products. While the franchisee may carry and distribute one franchisor’s products, they can also carry and distribute other brand’s products. The product franchise is much less common than the business format franchise. Examples of product franchises include, Coca-Cola, Ford Motor Company, Kellogg’s, and more
GOVERNING LAW
Franchises are predominantly governed under state law. However, franchising is also regulated by federal law—namely, federal rules and regulations promulgated and enforced by the Federal Trade Commission. There are 24 states which have their own regulations regarding the franchise relationship and required disclosures, which will be discussed more below. Accordingly, federal law essentially sets the minimum standards for franchising a business.
FRANCHISE COMPONENTS
There are several key elements that are required to create a franchise, most of which include specific legal documents and programs. However, the key elements to create a franchise discussed herein should not be read to be the key elements of creating a successful franchise. The key elements in creating a successful franchise cannot necessarily be defined, and can be dependent on various external factors, such as brand power, innovation, the target market, the economy, wealth, entrepreneurial motivation and skill, and more.
The components discussed below—the franchise application, the FDD, and the operating manual—are not the only components that make up a franchise. These components, however, are universal to the franchise process and play an essential role in forming a franchised business. It is always advisable to consult with an experienced franchise attorney prior to beginning the franchise process.
THE FRANCHISE APPLICATION
A franchise application is the beginning step in becoming a franchisee and is much like an employment application. The franchise application is a mechanism by which a franchisor can get to know potential franchisees on a business level. However, unlike an employment application, franchise applications require much more information, including detailed personal information. Prior to filling out the application, the franchisor might begin with an initial inquiry form. You can see McDonald’s Franchising Initial Inquiry Form, as an example.
On a franchise application form, an applicant could expect to see requests regarding the applicant’s business interests and business background, their preferred franchise location, and particularly the potential franchisee’s financial status. Unequivocally, the most important section of a franchise application is the section covering the franchisee’s current financial situation, including the potential franchisee’s current asset and liabilities—and potentially even their spouse’s current assets and liabilities.
Many times, potential franchisee applicants do not have the capital or the finances to fully fund the initial franchise investment. However, many franchise brands have established partnerships with lenders who can assist franchisees in assessing and evaluating the cost of getting a franchised business up and running. If you are considering opening a franchise, you might consider Small Business Association-backed (“SBA”-backed) loans to finance your franchise. The SBA Franchise Directory provides a list of franchise brands approved for SBA-backed financing. A sample franchise agreement template can be viewed in the SEC website for Baskin Robbins.
THE FRANCHISE DISCLOSURE DOCUMENT (FDD)
A Franchise Disclosure Document (“FDD”), also known as the “Franchise Rule” (16 CFR, 436 and 437) is a document which provides legal disclosures to individuals interested in purchasing a franchise. A “disclosure” is a statement regarding all important details that could or would impact an individual’s decision-making process. The FDD is a required step in the due diligence pre-sale process, as prescribed by the FTC, and is the starting point of formally franchising a business.
There are 23 sections in an FDD, which include details regarding: (1) The franchisor; (2) business experience; (3) litigation; (4) bankruptcy; (5) initial fees; (6) other fees; (7) the estimated initial investment; (8) restriction on sourcing products and services; (9) the franchisee’s obligations; (10) financing; (11) the franchisor’s assistance, advertising, systems, and training; (12) territory; (13) trademarks; (14) patents, copyrights, and proprietary information; (15) the franchisee’s obligation to participate in the actual operation of the franchise; (16) restrictions on what the franchisee can sell; (17) renewal, termination, and transfer of the franchise, including dispute resolution; (18) public figures; (19) estimated financial performance representations; (20) outlets and franchise information; (21) financial statements; (22) contracts; and (23) receipts.
It should be noted that, to engage in a proper and valid licensing agreement for a franchise, the franchisor is required to provide the franchisee with the FDD at least two weeks prior to any agreement being signed, or any money being exchanged between the franchisor and the franchisee.
As you can see, the FDD is a lengthy, complex legal document. To add to this complexity, many states have additional FDD requirements. These states are generally known as “registration states” and require that the FDD comply with certain state regulations prior to being approved. These “registration states” include: (1) California; (2) Hawaii; (3) Illinois; (4) Indiana; (5) Maryland; (6) Michigan; (7) Minnesota; (8) New York; (9) North Dakota; (10) Rhode Island; (11) South Dakota; (12) Virginia; (13) Washington; and (14) Wisconsin.
Once the FDD complies with FTC regulations, and state law, where applicable, the FDD is submitted to the FTC. An FDD must be updated each year. However, the FTC does not require that the FDD be re-reviewed and re-approved. Once approved, state regulators in the registration states rather than the FTC will be charged with monitoring the FDD each year. A sample FDD can be viewed on the SEC website.
THE FRANCHISE AGREEMENT
Much like FDD, a franchise agreement is a lengthy, detailed, and sometimes complex document. Although the FDD and the franchise agreement share many commonalities, the franchise agreement will provide more particular information and details about the specific franchise, along with the roles, responsibilities, and obligations of the franchisor and franchisee. Indeed, the franchise agreement must be included as an exhibit in the FDD. Ultimately, the franchise agreement is the governing legal document which establishes and defines the franchisor-franchisee relationship.
Some of the substantive legal rights and obligations contained in a franchise agreement include: (1) the grant of franchises rights and the designate term of the franchise; (2) the franchisee’s development obligations; (3) training; (4) territorial rights; (5) operating procedures; (6) initial fees; (7) ongoing fees; (8) marketing fees and obligations; (9) restrictive covenants and non-compete agreements/clauses; and (10) legal rights and jurisdiction.
It is important to note that, although franchise agreements are negotiable, the terms of a franchise agreement cannot be negotiated to be less favorable to the franchisee. Accordingly, while franchise agreements are modified, the modifications that can be made are very limited in scope.
THE OPERATIONS MANUAL
The operations manual is a blueprint that sets out how the franchised business should run and operate. The operations manual will provide detailed information regarding every aspect of establishing and running the franchise, including operating procedures, marketing strategies, accounting protocols, approved suppliers, and more. It is important to note that operation manuals are generally confidential and are not disclosed to the public. Many times, operation manuals contain trade secrets
Operation manuals are not stagnant and will evolve over time. As the franchise grows and develops, the operations manual will also grow and develop. Although the operations manual serves as a how-to document, it also serves as a legal document that communicates the mandatory and/or minimum operating standards of the franchisor.
In general, there are approximately 6-7 sections in the average operations manual. These sections include: (1) confidentiality and legal notices; (2) brand introduction; (3) development of the franchised business; (4) training; (5) operating systems and requirements; and (6) marketing and business development.
ADVANTAGES AND DISADVANTAGES OF FRANCHISING
When determining whether franchising a brand is the right business model, both the advantages and disadvantages to franchising must be considered. Like all other business forms, there are serious advantages and serious disadvantages. Like the success of a franchise, whether or not to choose to franchise a business from the beginning is dependent on a plethora of factors—many external, and many out of a franchisee’s control.
ADVANTAGES
Here, there are some very simple advantages to franchising a business, such as brand recognition, an established business model, and limited to no decisions to be made about what products to sell. In addition, there is generally a lower risk of failure with franchising because there is an established network, proven to attract a broad customer base.
Likely the most significant advantage of franchising is the opportunity for rapid growth. For a franchisor, establishing a second location could be cumbersome and costly. Because a streamlined process for franchising a brand has been developed, and because the franchisee is using their own capital and financing to fund their franchise location, the franchisor business can grow at a much faster rate than if the franchisor bore the sole burden in establishing multiple locations.
DISADVANTAGES
With advantages also come disadvantages, and there are at least a few disadvantages when it comes to franchising. Even though franchising an already successful business is less of a financial gamble than the franchisor took in developing the original business model, that does not mean that franchising a business isn’t expensive or can become financially unsound. The start-up costs required to franchise, in addition to royalty costs, can be hefty. The franchisee will be responsible for ongoing fees owed to the franchisor, which can range anywhere from 4.6% to 12.5%, depending on the franchise brand. In addition, there is a risk that the franchisor may not provide the franchisee with accurate information regarding the franchise’s actual value. Accordingly, franchisees can be intentionally duped into franchising a failing business.
Another aspect to consider is the inflexibility in operating your business as you see fit. The franchisor—not the franchisee—establishes the nitpicky details, such as operating hours, the décor, pricing, and products. Franchising may not be the most conducive business model for someone who wants complete control or wants to be their own boss. However, for the franchisor, this is an advantage. The franchisor creates all the rules without having to manage the day-to-day of its franchisee’s location.
CONCLUSION
This article is not a complete examination of franchise law in the United States. Franchise law can be broad and quite complicated for both franchisors and franchisees to understand. As established above, when considering franchising a business, there are legal, financial, and business considerations that must be examined. An experienced franchise attorney can provide insight and guidance as you examine these considerations. For this reason, it is prudent to have an experienced business attorney advise you on establishing a franchise.
