March 22, 2010

So Your Client Wants to Franchise Its Business? Practical Advice for Lawyers Embarking on Representing Franchisors

Franchising is viewed by many as a means to finding the pot of gold at the end of the rainbow. Clients hear about franchisor success stories and want to fall in line to achieve comparable success, or clients have been approached by third parties who want to duplicate their activities. In either case, the initial interest in franchising may stem from ignorance, rumor, misperceptions, or greed rather than a calculated, informed decision to franchise. The starting point on the road to franchising is education, and it is mutual. The client must learn what franchising is all about, including its strengths, risks, and limitations. At the same time, the lawyer must learn about his or her client, the client's capabilities and resources, the level of the client's knowledge, the client's business experience, the product or service the client has to offer, and the extent and success of the current business model, to identify some of the more critical areas. Once this information-gathering stage is complete, a two-prong strategy should be employed: one focused on business issues; the other on legal affairs. The challenge to the lawyer is whether he or she can provide either or both of these skills in guiding the client through the process of developing a franchise system.

A Word of Caution to the Lawyer
Franchising may not be as complex as other areas of the law, like securities law, on which the franchise sales regulatory scheme was modeled, but, like any area of the law, it has published authorities: statutes, regulations, and case law, and what we refer to as "folklore." Folklore includes the methods and information that are learned only through actual practice in this area. You may be tempted to say: "This doesn't look that difficult." However, unless a lawyer commits the resources to learning this field, that lawyer should be extremely wary of advising a client in developing the client's franchise system. In State of Nebraska ex rel. Counsel for Discipline v. Jeffrey L. Orr, 277 Neb. 102 (2009), one senior attorney in Nebraska recently learned this lesson the hard way. He failed to adequately advise his client in setting up a franchise system. The result: he was publicly reprimanded by that state's supreme court. Had the attorney not had an otherwise sterling track record and support from members of the community and bar, the penalty might have been more severe. In addition to malpractice claims from the client, lawyers can face claims by franchisees of the client in connection with the preparation of documents to set up a franchise system. In Courtney v. Waring, 191 Cal. App. 3d 1434, 237 Cal. Rptr. 233 (1987), the court held that the duty of competency in the preparation of the disclosure document extends to the prospective franchisee and the lawyer can be liable to the prospective franchisee. A similar claim is pending in Ian Inman v. Jungle Quest Franchising, LLC, Case No. C095584CW (N.D. Cal. filed Nov. 24, 2009). These cases are particularly troubling because they support the proposition that if a lawyer commits malpractice in connection with preparing documents for a franchisor, the lawyer could be committing malpractice to a host of others.

Legal knowledge is only half of the equation, however. The other half relates to business experience. A client new to franchising will need considerable advice. A lawyer must ask if he or she has the wherewithal to guide the client through the multitude of business decisions involved in developing the client's franchise system. There will be no right answer to some of the challenges the client will face. For example, consider questions like: What is the correct amount of an initial franchise fee for the franchise system? Should the client use a single unit franchise strategy or grant area development rights that will allow a franchisee to develop multiple units? If the lawyer cannot bring a knowledge base to approaching these issues, the lawyer should consider hiring, or recommend that the client hire, a competent franchise consultant.

Client Education
If the client lacks knowledge of what franchising entails, the first step is to educate him. There are numerous books on the subject that can give the client a quick, inexpensive overview of franchising. Two of our favorites are Franchising for Dummies and Franchising: Pathway to Wealth Creation. The International Franchise Association (www.franchise.org) is a source for information about franchising. A broader search on the Internet will provide a myriad of references on what franchising is all about and the challenges in developing a franchise system.

Lawyer Education
The lawyer who has little or no familiarity with franchising can find a plethora of information for guidance. A basic primer on the subject is the book Fundamentals of Franchising, issued by ABA Publishing. The ABA also maintains a listserv on which participants can ask questions and can receive responses from experienced franchise law practitioners, including the folklore of franchising. ABA Publishing's Franchise Desk Book can provide a jump-start education in this field. Samples of documents can be found by going to the California Corporations Commission's website, or by contacting commercial services such as Frandata or Franchise Help, which will charge a fee to provide samples used by various franchise systems. The novice lawyer who has no mentor within the office also should consider retaining another law firm with experience in franchise law: to review his or her work product, offer counsel on some of the business and legal issues that arise, and act as a mentor as he or she goes through the learning process. None of us likes to turn away profitable business but committing to learning a new area of the law can be a formidable challenge.

Information Gathering
Once the franchise development team has been established (and this must include an accountant who can audit and certify the franchisor's financial statements), the next step toward franchising is to understand the ingredients that comprise the current business, and what needs to be added to the mix in order to franchise. An understanding of the following issues is a must in order to identify what is necessary in order to franchise:

  • What is the product or service? How does it work?

  • How many company-owned units exist? Have they been economically successful?

  • How easy or difficult is it to replicate the business model?

  • Who is the competition? Is the product distinctive? What are the barriers to entry?

  • What is the franchisor's human capital to work on the franchise system buildup and maintenance? What skills do they have that will be helpful in developing the franchise system? Do they have any experience in working with franchise systems?

  • What are the financial resources of the franchisor?

  • What intellectual property, such as trademarks, patents, trade secrets, and know-how, does the franchisor own? Has it been adequately protected?

  • Will the franchisor be able to cultivate a pool of prospective franchisees?

Development of the Franchise Model
Once the lawyer, the client, and others who have been hired to develop the franchise understand available resources, the next step is the development of the franchise model. Often the current business will not resemble the franchise product:

  • The trade dress may need to be changed.

  • A new trademark may be necessary because others may be using a similar mark in desirable trade areas.

  • Aspects of the existing business may not be applicable to the envisioned franchise model. For example, the existing restaurant model does not provide drive-through opportunities.

  • The menu or product offering may need to be expanded or simplified.

In other words, what will the franchise look like when it goes to market? One issue that has been recently debated is whether the franchisor must have developed and tested a prototype prior to franchising. One thing is for sure: a franchisor that goes to market without a prototype will face additional challenges in operating and selling the franchise.

Resources to Implement the Strategy
A franchise relationship is a two-way street. The franchisee will have certain obligations it must perform in order to successfully develop and operate the franchise. The franchisor will have certain pre- and post-opening obligations to the franchisee. These obligations are described in the franchise agreement and the so-called franchise disclosure document (FDD). The critical question at this juncture is what resources the franchisor will need in order to move from its existing level of operations to where it will be able to sell, develop, and support franchisees managing their new businesses.

Franchise Sales Team. The franchisor will need to determine how it will attract prospective franchisees. Historically, trade shows, traditional forms of advertising, and franchise brokers were the main sources for leads. Sources for leads have been changing dramatically over the last several years. While trade shows are still a thriving business, more franchisors are looking to the Internet. Social networking has received considerable interest in the last couple of years as well, but the effectiveness of this method for driving franchise sales is still under scrutiny. A strong website has been viewed by many as the most effective means of leads. Broker networks also have become more sophisticated and larger, but recurring issues with brokers remain: Will they accurately present the franchisor's offering? Can they handle competing brands? To what extent will they be involved in the franchise sales process?

Development Team. The franchisor typically assumes certain duties in the start-up period when the franchisee is preparing to open the business and the initial period after the business opens. The franchisor will need to decide on the duties the franchisor will assume and have a team to perform the duties the franchisor commits to perform. These duties typically involve assistance in the following areas:

  • Construction and equipping assistance. If the franchise model involves real estate, depending on what the franchisor has committed to assist with, the franchisor will need the staff necessary to assist the franchisee in (1) approving a site, (2) locating and securing a site, and/or (3) managing the entire site acquisition process. The franchisor also will need to assist the franchisee in managing or monitoring the build-out for the facility. If the franchise is mobile-based, the franchisor will typically provide advice or sources for vehicle acquisition, and sometimes for a turnkey operation. In either case, the franchisor must create specifications for equipping the site or the vehicle, and may want to have specifications for any office that is used in operating the franchised business.

  • Initial training. Training the franchisee is a critical step in making a franchisee's operation a success. A curriculum for training franchisees will need to be developed by the franchisor. The franchisor also will need to decide who will provide initial training for the franchisee, what owners and employees of the franchisee will be required to attend initial training, and where initial training will take place. These are questions the franchisor must answer.

  • Sourcing of products. Where can the franchisee buy equipment and inventory? Will the franchisor restrict sources of these items? Will the franchisor arrange for preferred purchasing opportunities? The more the franchisor can assist in this part of the franchise operation, the better the quality control of the franchisees will be.

  • Opening assistance. Some franchisors make available opening assistance to the franchisee before and during the opening of the business. The franchisor will need to decide if opening assistance will be provided to franchisees and the extent of the opening assistance that the franchisor will provide. Once a decision has been made to provide opening assistance, the franchisor must determine what personnel the franchisor will provide and for what period.

  • Accounting software and point-of-sales equipment. Franchisors usually will recommend points of sale hardware and software. This hardware and software will be able to perform various accounting and financial reporting functions and give the franchisee, and possibly the franchisor, the tools to monitor the franchisee's activities and to evaluate its success.

Ongoing Services
After creating the franchise model, gathering the resources to bring the franchise to market, and selling the franchise opportunities, preparing the franchised business for continuing operation is the next challenge to make the franchise a success.

Elements to achieve this include

  • Continuing training. Learning is a never-ending process. Most franchisors will establish advanced training programs as well as training for new or modified products or services.

  • Field support. How well are the franchisee's operations doing? The franchisor will need staff to visit the sites, evaluate performance, and assist in counseling the franchisee on performance improvement opportunities.

  • Marketing and advertising. In addition to providing marketing assistance at the time of opening, the franchisor will typically need staff to provide ongoing marketing services, including market studies, public relations, point-of-sales and other advertising materials, and possibly placement of advertisements. Frequently, the franchisor will establish a brand fund to which the franchisees will contribute. The brand fund will be used to provide marketing and advertising services at a national or regional level, and in some cases will assist in local marketing efforts.

The Operations Manual
Virtually every franchisor has an operations manual. Standards and specifications, as well as details of delivering goods and services, are typically not spelled out in the franchise agreement. These items may change over time, and, in addition, the franchise agreement would become unwieldy if such details became part of the agreement. Thus, many of the rules and regulations that govern the rules of franchise operations are relegated to the manuals. Franchise manuals are not static. The content will frequently need to be modified to reflect changes in the franchise system, operations, and marketing. A good manual will provide information covering every step of operations, sources of supply, employment guidance, trademark usage, protection of confidential information, crisis management, and marketing.

Pricing the Franchise
A prospective franchisor may be tempted to simply look at what competitors are charging and then base his or her pricing terms on that information; but pricing is not that simple. The objective is to have fee levels that are not only competitive, but are commensurate with the products and services being offered. The fee structure should allow for both the franchisor and the franchisee to receive adequate returns on their investments.

The typical framework is for the franchisor to charge an up-front fee payable when the franchise is purchased, and ongoing royalties, which are most often a percentage of sales, although the royalties might have a monthly minimum, or be fixed in amount. Franchisors commonly charge a marketing fee to provide various marketing services, or develop and/or place advertising. There are often several other types of fees, which may be recurring, such as software maintenance fees, or nonrecurring, such as for consultations or additional training. It is critical for the franchisor to prepare pro formas to confirm that the anticipated revenue stream from the sale and operation of the franchise system can be profitable, based upon reasonable assumptions.

Trademark
By legal definition as well as for business reasons, every franchise will have a trademark. One of the franchisor's goals is to develop strong brand recognition to attract franchisees and, through them, customers. A strong mark enhances the price the franchisor receives if and when it is ready to sell the system, or go public, or obtain other forms of financing.

Usually, the primary mark will have been selected before the franchisor has its first meeting with a franchise lawyer. Unfortunately, the franchisor in selecting its mark may not have performed the steps necessary to protect the mark, grow the brand, and protect against infringement claims. Even if the mark has been federally registered with the U.S. Patent and Trademark Office, the franchisor may not have had a comprehensive trademark search performed. This search will inform the franchisor of other uses of the mark or a confusingly similar mark. For example, even if there may be no mark similar to the one selected by the franchisor, there may be a competitor operating in a particular geographical area who, by its usage of that mark, has earned senior trademark status in that particular market. If the market was Cheyenne, Wyoming, that might not be significant, but if the similar mark was well-known in Los Angeles or Chicago, that usage may prevent the franchisor from using its name in a very important market and thus make him decide to select a different mark. While having a registered trademark is not a necessity for a franchise, it provides a high level of comfort to prospective franchisees that they will be able to use that mark for the term of the franchise without fear of infringement claims.

A trademark typically takes around a year to register, so that the requisite trademark investigation and steps toward registration should be taken immediately after a decision to franchise has been made, if not sooner. (For a detailed discussion of trademark strategies for franchisors, see the related article in this issue by Marisa D. Faunce and Benjamin B. Reed.)

The Legal Documents
While the lawyer may be involved in the development of the franchise system from the beginning of the process, the lawyer's primary role—preparing the requisite legal documents—is likely not to come into play until the development process moves into its later stages. The documents typically consist of the franchise agreement and the FDD. Additional documents might include

  • An area development agreement (to be used when the franchisee will be granted the right to develop multiple units);

  • Personal guarantees;

  • Separate noncompetition agreements (although noncompetition provisions can be incorporated into the franchise agreement);

  • Lease addenda (to ensure that the franchisor will have control of real estate if the franchisee abandons the premises or is otherwise terminated, or the franchise expires); and

  • Form of lease, if the franchisor will be the landlord.

The terms of the franchise agreement will reflect the business model developed in the planning process, and will contain provisions that protect the rights of the franchisor, and, to a lesser extent, the rights of the franchisee, and spell out each party's rights and obligations with respect to future, foreseen and unforeseen, issues involving the franchise relationship.

Although the franchise agreement will contain its share of boilerplate, the document must be tailored to fit the peculiarities of the franchise system, as actually conceived, and reflect strategic decisions that the lawyer and client must make in the drafting. The original KFC and Dairy Queen agreements were each one page. Today, it is typical for the franchise agreement to run around 30 single-spaced typewritten pages, and we have seen agreements that are 70 pages and more, but rarely fewer than 20. It is possible to draft an agreement in the neighborhood of 10 pages, but this would require significantly less specificity with respect to the rights and obligations of the parties and deferral of many procedures and substantive terms to the operations manual. Proponents of lengthier documents argue that they eliminate ambiguities that might otherwise arise and give the parties a better understanding of the terms of their relationship. Proponents of short documents contend that they make the franchise easier to sell and that each time a sentence is added to the franchise agreement, it only gives the parties one or two more points to argue over if there is a dispute between them.

The second document of primary importance is the FDD. The FTC's Disclosure Rule outlines the basic disclosure requirements of this document, including

  • Information about the franchisor and its principals, and their and the company's litigation and bankruptcy records;

  • The basic financial terms of the franchise relationship;

  • Information relating to the operation of the franchise and intellectual property that the franchisee will be permitted to use;

  • A brief synopsis of the legal terms of the franchise relationship (all agreements that the franchisee will be asked to sign are included in the FDD);

  • Information regarding the status of company and franchised units (e.g., the number of units, how many have opened or closed in the last three years; the anticipated growth of the system); and

  • Audited financial statements of the franchisor or of an entity guaranteeing the franchisor's performance.

    A franchisor may, but is not required to, include historical or projected financial information about the franchise system (financial performance representations, or FPRs), but there are rules restricting the presentation and use of FPRs. Many franchisors decide not to use them for reasons including

  • They lack the information to prepare them;

  • The information they have received from their existing franchisees is not reliable or audited;

  • They would prefer that prospective franchisees undergo the due diligence themselves;

  • They fear that incorrect statements will lead to litigation; and

  • The information will not reflect favorably upon the franchise.

    Even though there are stringent rules relating to the presentation and use of FPRs, the basic dictate is simple: the franchisor must have a reasonable basis for making the FPR and must be willing to provide substantiating information to the prospective franchisee.

Franchise Sales Registration
Once the FDD has been completed, and assuming that the franchisor has established the infrastructure to assist the franchisees in developing and operating their businesses, the franchisor will be ready to begin franchise sales in approximately 36 states. In the other 14 jurisdictions, it will be necessary to register the franchise offering before franchises can be sold.

Conclusion
Starting up and maintaining a franchise system is no easy task. From the client's perspective, it requires careful thought, self-assessment, market and financial analysis, and detailed planning, none of which can be completed overnight.

From the lawyer's standpoint, it involves knowledge of the law of franchising. If the lawyer intends to give broader advice, the lawyer should give careful consideration to the limits of his or her experience and capabilities. If the client's business needs exceed these capabilities, then the lawyer must bring in other professionals to assist the client.

With effort, skill, and cooperation between client and lawyer, the final legal product will allow the franchisor to achieve his or her goal: harnessing the human capital and financial resources to expand the client's reach into the marketplace.

Additional Resources

Fundamentals of Franchising, Third Edition

Rupert M. Barkoff is a co-editor of Fundamentals of Franchising, Third Edition, issued by ABA Publishing.

The third edition of Fundamentals of Franchising is charged with useful definitions, practical tips, and expert advice from experienced practitioners. Written specifically to help lawyers and nonlawyers brush up on franchise law, this practical guide examines franchise law from a wide range of experiences and viewpoints. Each chapter is written to provide you with a well-rounded overview of franchise law and alerts you to issues that may require further research or expertise.

Developed from the ABA Forum on Franchising's popular "Fundamentals of Franchising" program, the book offers an instant education on the basics of every important aspect of franchise practice.

To see more information on this book or to order online, click here

Additional Resources

Avoiding the Accidental Franchise Malpractice Traps

Audio CD Package

Your client wants to expand their business by issuing licenses or distributorships to independent contractors who will invest their own money and hire their own employees to sell your client's goods or services. After discussing business objectives with your client, you draft the license or distribution agreement. A year later, the client receives a demand letter from an unhappy licensee or distributor alleging that the licensing or distribution program is really a franchise relationship which they now wish to unwind. The licensee or distributor has also complained to its local consumer protection agency, which has sent your client a demand letter inquiring into the specifics of the relationship. Your client wants you to explain why the licensing or distribution program is not a franchise and seeks advice on how to respond to the unhappy licensee or distributor as well as to the state regulator.

This audio package examines the meaning of the "accidental franchise" and the implications to you and your client for creating one.