Franchising

In response to my previous article, a good friend of mine and an exceptional real estate agent, Erica Frey, contacted me and expressed interest in opening a restaurant franchise, and asked for some insight regarding the process and legal issues involved.  In light of her concerns, I decided to devote this blog article to the concept of franchising.  Accordingly, the article below will briefly address the advantages, disadvantages, process and legal issues involved in opening and operating a franchise. 

I. A BRIEF INTRODUCTION TO FRANCHISING

What is a “Franchise”?

Voltaire once said, “If you wish to converse with me, define your terms.”  In light of that maxim, the first step in starting a discussion about franchising is to define what is meant by the term, “franchise.”  According to Corporations Code section 31005(a), a “franchise” is a contract between two or more people regarding the sale and purchase of a business having the following three characteristics: 

1. Global Marketing Plan.  A franchisee is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor; and
2. Global Trademark.  The operation of the franchisee's business pursuant to such plan or system is substantially associated with the franchisor's trademark, service mark, trade name, logotype, advertising or other commercial symbol designating the franchisor or its affiliate; and
3. Franchise Fee.  The franchisee is required to pay, directly or indirectly, a franchise fee.

Franchises are regulated on both a State and Federal level.  On the State level, franchises are regulated by and must be registered with the California Department of Corporations (DOC).  On the federal level, franchises are required to maintain a “franchise disclosure document” (FDD), the contents of which are regulated on a national level by the Federal Trade Commission (FTC).

An obvious example of a textbook franchise is McDonald’s:  The marketing plan of every McDonald’s location is dictated by McDonald’s Corporate (which is why every McDonald’s restaurant looks identical, and is also why you can never get a McMuffin after 10:30 am, anywhere!).  Each McDonald’s franchise makes use of McDonald’s trademarks (such as the infamous “Golden Arches”).  Lastly, each McDonald’s franchise pays a franchise fee to McDonald’s Corporate for the benefit of operating the franchise. 

Advantages and Disadvantages

While many people think buying a franchise is a shortcut to success, the ultimate success of any franchise depends on many factors.  If you are interested in starting a franchise, you should consider some of the advantages and disadvantages discussed below. 

Advantages

• Lower Failure Rate.  When you buy a franchise, you are buying an established concept that has already proved to be successful, rather than “reinventing the wheel” on your own venture.  Therefore, it’s not surprising that franchisees stand a much better chance of success than people who start independent businesses.  According to the U.S. Small Business Administration (SBA), independently-owned restaurants have the highest failure rate of any new business, and only about 20% survive the first two years.  In contrast, franchisees have an 80% survival rate. 

• Startup Assistance.  In contrast to independently-owned businesses, franchises are essentially “turnkey” operations, and the franchisor will provide you with a lot of help in starting up and running your business.  Often, the franchisor will provide you with all the equipment, supplies, and instruction needed to start the business.  Additionally, franchisors will usually also provide ongoing training, and help with management and marketing. 

• Economies of Scale.  Franchises have the huge benefit of “economies of scale” – as the franchisor, supplying uniform products and inventory to all of its franchisees, can buy in bulk and pass the cost savings on to the franchisees.  Accordingly, inventory and supplies will usually cost much less to franchisees than to those running an independent business. 

• Brand Recognition.  Probably the most significant advantage of owning a franchise is access to a well-known (often nationally-recognized) brand-name.  Essentially, buying a franchise can be like buying a business with built-in customers.

       Disadvantages

• Large Initial Investment.  Buying into well-known franchises is very expensive, and often requires extremely deep pockets or the ability to arrange the necessary financing.  As discussed below, some franchise agreements may even require a “personal guaranty” by the franchisee for the franchise’s obligations.

• Surrender of Independence (Their Way or the Highway).  The main disadvantage of buying a franchise is the loss of independence – the franchisee must [rigidly] comply with the franchisor’s system, sometimes right down to the way the napkin holders are filled.  True entrepreneurs, or those who highly value their autonomy, will probably find it difficult (or impossible) to successfully operate a franchise, as some franchisors exert a degree of control that can be excruciating.  As a franchisee, you are running the show…but running it their way. 

• Ongoing Costs.  In addition to the initial franchise fee, franchisees must also pay monthly royalties – a percentage of the franchise’s business revenue (often calculated as a percentage of “gross sales”).  The franchisor may also charge additional fees for certain services provided (e.g. the cost of advertising, or share in national marketing campaign). 

Assuming you have evaluated all the pros and cons and determined you still want to start a franchise, you will probably want to know how you can go about accomplishing that goal.  The next section will answer this question by describing the general process of starting a franchise, from beginning to end. 

II. PROCESS OF STARTING A FRANCHISE

From a legal standpoint, the process of starting a franchise can be summarized into four general steps:  completing the franchise application, verifying the legal standing of the franchise, reviewing the Franchise Disclosure Document (FDD), and reviewing the Franchise Agreement. 

        Step 1 – Complete Franchise Application

The first step in buying a franchise is similar to applying for a job, and begins by contacting the franchisor and completing their franchise application.  The franchise application is comparable to your franchise “resume,” and the franchisor will use the application in a similar way – a first level review to screen applicants and determine which applicants it should consider as potential franchisees. 

The franchise application will usually include detailed questions about your finances, your personal assets, your spouse’s financial situation, your experience, background, aspirations and goals, etc.  The franchisor not only wants to determine whether you are financially capable of operating the franchise (especially in the event the franchise runs into financial difficulties and requires the franchisee to tap into personal finances to keep the operation afloat), but also wants to determine whether you are the right type of person to operate their franchise (i.e. somebody who is not a “Maverick”, but somebody who can successfully operate within the franchisor’s pre-made system).  For better or worse, franchises depend on the uniform application of the franchisor’s system, so the franchisors usually don’t want people they view as too independent. 

If your franchise application is accepted by the franchisor, the next step will usually involve a meeting with the franchisor – similar to a job interview.  During this time, the franchisor will continue to explore your interest, commitment and suitability, and you will try to find out as much as possible about the franchise.  At this point, you should retain an attorney to assist you in evaluating the franchise and negotiating the deal. 

        Step 2 – Verify Legal Standing of Franchise

As a preliminary matter, your attorney should conduct several searches of the franchise, in various State and regulatory databases, to verify it is registered in California, in good legal standing, and not subject to any desist-and-refrain orders or other administrative proceedings. 

        Step 3 – Review Franchise Disclosure Document (FDD)

Next, you and your attorney need to review the franchise disclosure document provided to you by the franchisor to verify it is complete and up-to-date.  As stated above, the FDD is a document regulated by the FTC concerning disclosures required to be delivered to prospective buyers of franchises.  As required by the FTC, the FDD must contain 23 specific “items” of information, including the business background of the franchisor, litigation history, franchise fees, territorial rights, intellectual property, financial performance and statistical information, and the franchisor’s financial statements.  The FDD should be reviewed carefully, as it contains vital information about the specific details and “economics” of the franchise opportunity, such as the financial analysis of all fees, the calculation of royalties, and the performance of all franchisees (including existing franchises and those who left). 

As part of this analysis, you should also contact other franchisees and interview them with respect to their experience – i.e. their success, their relationship with the franchisor, their satisfaction with the franchise, etc.  These interviews should provide real-life, practical information about the franchise opportunity that would otherwise be unavailable.  Even if the economics look good on paper, if all the franchisees interviewed are unsatisfied with the franchise, you may decide to pursue a different opportunity. 

        Step 4 – Review Franchise Agreement

The last step in completing the franchise is the drafting of the franchise agreement.  Usually, the franchise agreement is a long (usually 30-200 pages!) standard-form agreement prepared by the franchisor.  Like any contract, the franchise agreement is technically negotiable.  However, since the franchise’s success depends on the uniform application of the franchisor’s system, the franchisor will most likely be unwilling to change many of the agreement’s provisions.  Regardless, you and your attorney should carefully review the franchise agreement so that you are fully informed of all the franchise details. 

As a note of caution, you should be concerned with any provisions requiring a personal guaranty, indemnification provisions, provisions discussing renewal/transfer/terminations rights, arbitration clauses and non-compete covenants.  If possible, you should have the franchise agreement redrafted so these provisions are as favorable to you as possible. 

Assuming both parties agree to the terms of the agreement, the agreement simply needs to be signed for the process to be complete.  Once the agreement has been signed and all formalities completed, you will be the proud owner of a franchise and [hopefully] ready for business. 

III. CONCLUSION

As discussed above, the process of starting a franchise is complicated and time consuming, requiring extensive background research and due diligence, the careful review of multiple documents and lengthy agreements, as well as a genuine self-evaluation to determine whether you are the type of person who can (and actually desires to) own and operate a franchise.  While a franchise involves the loss of a certain amount of autonomy that could make some entrepreneurs cringe, those devoted to the operation can reap huge economic benefits.  If you are interested in starting a franchise or simply have questions, please do not hesitate to give us a call.