Unlike a couple on their first date, a franchisor and franchisee should start discussing the trajectory of their relationship from the very beginning. Franchisors want to create a network of loyal, profitable franchisees. Franchisees want to enjoy and safeguard the fruits of their labor. This article offers suggestions about how franchisors and franchisees can work together to plan a future that is rewarding for each of them.
Succession planning is one way for a franchisor to demonstrate its commitment to its franchisees, even in the early stages of their relationship. Franchisors can discuss with franchisees important considerations in transitioning their business when they are ready to exit the system or retire, as well as financial planning techniques that will help them preserve their financial gains.
Franchisor-Created Succession Programs
Typically, franchisees are responsible for finding a buyer when they want to sell their franchises. The franchisor in these circumstances may have limited time and opportunity to evaluate and approve the buyer. But when a franchisor short-changes this vetting process, it is taking a gamble with its future revenue stream. By contrast, if a franchisor works with its existing franchisees on succession planning, rather than merely reacting to a pending resale, many of the problems that typically arise with changes in ownership can be avoided.
Succession planning may involve a franchisee identifying a successor (in some cases, a family member or key employee), a franchisor evaluating and approving the successor, and both franchisor and franchisee working jointly to educate and train the successor in operating a successful franchise. Training provided by a franchisee that understands the customer base and market area can be far more beneficial than training provided by a franchisor alone.
A franchisor-created succession program can be an effective tool for recruiting new franchisees as well. An essential part of a prospective franchisee’s due diligence is learning how the franchisor relates with its franchisees. When a franchisor is known for working with franchisees to their mutual benefit on initiatives such as succession planning, this can positively reinforce the franchisor’s brand.
Joint Ventures with Key Employees
With a franchisor’s approval, franchisees may eventually transfer their business to one or more key employees through a joint venture arrangement. In this arrangement, a franchisee would identify one or more key employees who are interested in acquiring the franchise in the future. The franchisee would grant the employees some form of “sweat equity” and the right eventually to purchase the franchise based on a prearranged price or formula.
At the end of the joint venture arrangement, all parties benefit. The franchisor has a new franchisee. The franchisee has an exit strategy that will allow for a seamless transfer of the business. And the key employees take over a business that they have experience operating. During the sweat equity period, this also provides for loyal, motivated key employees who will continue in a franchisee’s employ so that they can obtain the promised equity.
Wealth Transfer Planning
Another way for a franchisor to demonstrate its commitment to its franchisees’ success is to discuss with them wealth transfer planning techniques that can help them protect their financial gains.
Irrevocable Life Insurance Trusts
The death of a business owner can threaten the survival of virtually any business. If the owner dies without adequately planning for the payment of estate taxes and the inclusion of the decedent’s ownership interest in his or her estate generates an estate tax, then that ownership interest may have to be liquidated just to pay the estate taxes owed.
An Irrevocable Life Insurance Trust (“ILIT”) is designed to provide the liquidity to pay the estate tax, as well as to provide funds for the franchisee’s family. For those owning a large life insurance policy, the face value of the policy will be included in the franchisee’s estate (along with the franchise and any other assets the franchisee may own), increasing the size of the estate and the possibility of owing estate taxes. Not all estates are likely to owe federal estate taxes because under the current federal exemption, only estates with assets greater than $5.25 million are subject to federal estate taxes. But some states, such as Connecticut, Delaware, Massachusetts, New Jersey, New York and Pennsylvania, to name a few, levy estate or inheritance taxes (or both) on lower exemption amounts – some as low as $675,000.
Franchisees with substantial life insurance policies may consider structuring their policies into an ILIT to avoid federal and state inheritance tax implications. This technique may be used without a franchisor’s approval. To create an ILIT, an irrevocable trust is created, with someone other than the insured named as trustee. The policy is transferred to the trust, and the trust becomes the owner and beneficiary of the policy. Because the policy is owned by the trust, the franchisee will no longer have any control over the policy. Through the terms of the trust, however, the franchisee can determine who will have control, how premiums will be paid, who will benefit from the trust, and how payments should be made to beneficiaries. If an existing policy is transferred from the franchisee to the trust, the franchisee must live for at least three years from the date of the transfer for the policy to be excluded from his or her estate. If the trust is established and the trust purchases a new life insurance policy, then the three-year rule can be avoided.
Grantor Retained Annuity Trust
A Grantor Retained Annuity Trust (“GRAT”) is a wealth transfer technique created under section 2702 of the Internal Revenue Code. GRATs are irrevocable trusts that are structured to allow the creator of the trust (the “grantor”) to transfer assets to family members with minimal gift tax implications. This works by having the grantor transfer assets to a GRAT and retain an interest in the GRAT for a number of years. The retained interest is structured as the right to receive certain predetermined payments (“annuity payments”) from the trust over a specified time (typically, three to 10 years). This “retained interest” is typically a significant portion of the value of the asset transferred to the GRAT.
The remaining balance of the value transferred to the GRAT – the “remainder interest” – is typically only a fraction of the value transferred. This remainder interest is considered “transferred” for gift and estate tax purposes at a value that is not subject to gift taxes. Once the annuity payments have been made to the grantor from the GRAT, the remainder passes to the grantor’s family without an additional gift or estate tax. The value of the asset transferred to the GRAT, including the appreciation, is also excluded from the grantor’s net worth for estate tax purposes. This can be an ideal plan for someone who is contemplating retirement at the end of the selected term of the GRAT. For this technique to work, the franchisee must survive the GRAT term.
With the approval of a franchisor, a GRAT can be a good mechanism for wealth transfer. A franchisee would create a family limited partnership or corporation (if one does not already exist), to hold the franchisee’s shares of the business and transfer some or all of the franchisee’s shares to the GRAT for a specified term. This allows a franchisee to pass on the appreciation of his or her interest in the franchised business with minimal gift and estate tax implications. The franchisee can retain control over the business throughout the GRAT term without causing inclusion of the value of the business in his or her estate. A GRAT may also be advantageous for a franchisee holding property that is appreciating because a transfer to a GRAT effectively “freezes” the value of the property at the date of the transfer and insulates the appreciation from gift and estate taxes.
Communication and Planning
When franchisors and franchisees communicate and plan for business succession and financial protection, the results can be mutually beneficial. For franchisors, this can foster goodwill among franchisees and lead to fewer surprises and smoother transitions when franchisees leave the system. For franchisees, this can mean more predictability and greater opportunity to enjoy the financial rewards of their hard work and resulting success.