Franchising

Introduction

What makes a Business “Franchisable?”

Most businesses are capable of being franchised. If it makes business sense for a business owner to consider opening additional outlets as company-owned units, it usually makes business sense to open outlets as franchises.

Ideally, before a business is franchised it should have been operating long enough to have proven its commercial attractiveness, worked out most of its kinks, be somewhat unique in the view of the consuming public, be capable of being duplicated, not be dependent on the personality or unique skills of its founders, be capable of being taught to others and be subject to systemization. The prospective franchisor should have the necessary finances and personnel to develop, market and sell the franchising program and to train and supervise its franchisees. The business must provide the franchisee with the opportunity to make a reasonable return on his or her investment and adequate compensation for the time and effort devoted to the business. Franchising is a regulated method of distribution. There are laws and regulations governing the offer and sale franchises in 14 states, including California. Most of these laws require the filing or registration of the franchise, including all of the franchising contracts that are part of the transaction, and approval by the concerned state prior to the offer of the franchise to residents of that state or if the franchise will be operated in that state. In addition, the state

must approve the financial condition of the franchisor, as further discussed below.

In addition to the state laws, the Federal Trade Commission (“FTC”) has adopted a rule that imposes franchise disclosure requirements on franchisors throughout the United States although there is no separate filing with the FTC. Under the FTC rule, and in most of the states with laws governing the offer and sale of franchises, a franchisor (the seller of the franchise) must present a Franchise Disclosure Document to each prospective franchisee (the buyer of the franchise) at least 14 days before any binding contract is signed or any money or other consideration changes hands. The Franchise Disclosure Document is a disclosure document, akin to a public stock offering prospectus, which describes the franchisor, its principals, the key terms of the contracts that the franchisee may be required to sign, and other details about the business being franchised. Also described in the Franchise Disclosure Document are the trademark and service mark rights of the franchisor as well as its financial condition.

It is essential that a federal trademark or service mark registration, or at least an application for registration, be on file with the United States Patent and Trademark Office when the franchise is offered since the identifying marks and names are an important attribute of a franchise. A current audited financial statement, and in some cases an unaudited interim financial statement, must be included as part of the Franchise Disclosure Document.

If the franchisor will offer or sell franchises to residents of California, or if the franchised business will be located in California, the Franchise Disclosure Document and its exhibits must be submitted to the California Department of Corporations for review and approval prior to the offer of the franchise in California. Similar disclosures, but not necessarily prior registration and approval, must be made in all other states, either under the Federal Trade

Commission rule or under franchise registration laws similar to those in California. Filing fees are required to be paid to each state where filing is undertaken. No filing is made, nor fee paid, to the Federal Trade Commission. State initial filing fees run from $250.00 to $750.00. In California, the fee for the initial franchise registration application is $675.00. The Franchise Disclosure Document must contain copies of all agreements the franchisee may be required to sign.

The basic contract is usually called a Franchise Agreement. This agreement sets forth the rights and obligations of the parties in connection with the franchise. Depending on the complexity of the business involved, a Franchise Agreement may run to over 50 pages. Additional agreements may be appropriate, such as an area development agreement, an area representation agreement, a deposit agreement, leases, subleases, confidentiality agreements, releases, conditional lease assignments, security agreements and so forth.

Legal expenses will be incurred by the franchisor for the preparation of the Franchise Disclosure Document, the Franchise Agreement and the other contracts that the franchisor and its attorneys decide are advisable, for searching a trademark or service mark, filing an application for trademark or service mark registration with the U. S. Patent and Trademark Office, preparing franchise registration applications and dealing with the appropriate state agencies in connection with the franchise registration process. In addition, if audited financial statements have not been prepared by the franchisor in the past, accountants will have to be employed to audit the franchisor’s financial statements. In many cases added to those expenses are costs for the formation of a new entity to serve as the franchisor, any required license agreements allowing the franchisor to use the necessary names and marks, the preparation of marketing materials for use in connection with the solicitation of franchisees, preparing operating and other manuals, designing of training programs and any incremental costs required in connection with the franchising business, such as hiring staff, advertising for franchisees and working capital. It is likely that the total start up costs for initiating a new franchising program will be $50,000.00 or higher.