Successful business owners who have created and mastered a
profitable system often decide to expand upon their success through
selling franchises. A franchised business could be anything from a
restaurant concept to an auto dealership, a retail furniture outlet to
a hair salon, a janitorial business to a gas station.
Overview
The person selling the concept is the “franchisor”, and buyers are
the various “franchisees”. The franchisees are the individuals who
ultimately run the day-to-day operations of the restaurant, retail
shop, or professional services company. Those franchisees usually
pay a royalty to the franchisor in exchange for use of that franchisor’
s commonly-recognized business name, recipies, employee training
systems, bulk-buying power for supplies, and other trade secrets.
Disclosure Requirements
Franchising is regulated by the Federal Trade Commission, a
government agency which requires the franchisor to make
numerous disclosures to prospective franchisees. This is known as
the "FTC Rule," and it has nationwide application to the sale of
franchises. Some states also require additional disclosures and
registrations in addition to those mandated by the FTC – but Arizona
law does not require any extra disclosures nor registrations.
Therefore, Arizona franchisors need only comply with the federal-
level laws.
However, if an Arizona franchisor plans to sell to franchisees in other
states, then the franchisor becomes bound to follow all regulations
in those other states. For example, say you have built up a
successful chain Phoenix-area Arizona gift shops, and you wish to
sell franchises in Tucson, Flagstaff, Los Angels, Denver, San Diego,
and Chicago. In that scenario, although your potential franchisees
in Tucson and Flagstaff are not entitled to additional disclosures
beyond those mandated by the FTC – the out-of-state franchisees
might be entitled by operation of their states’ laws to receive extra
disclosures. Those other states might also require you to pay them
a registration fee. In that case, when you offer to sell to franchisees
in those states, you must follow the laws of their states – not your
own state.
In any state, a franchisor or its attorney must start by drafting a
“franchise offering circular”. Potential franchisors should also supply
audited financial statements, including a balance sheet and income
statement. Disclosures regarding individual key personnel are also
required. More specifically, the offering circular should include the
name and business experience of top persons affiliated with the
franchisor. This “bio” must also state whether these persons have
ever been involved with litigation or any bankruptcy proceeding. The
circular should also disclose all existing franchises, their addresses,
and the names of their owners. The circular should also disclose the
franchisor’s “earnings claims”, which is a good-faith, reasonable
estimate of how much successful franchisees can hope to earn if
they purchase a franchise. An earnings claim is a projection that
must be based on concrete data of past performance rather than on
mere speculation.
Operations Manual
It is fairly common in the industry for a franchisor to provide an
operations manual or book of instructions to the franchisees. The
manual is a source of information and uniformity throughout the
system. The operations manual serves as the best method for a
franchisor to dictate standards, procedures, and requirements.
The Franchise Agreement, Trademarks, and Geographic
Exclusivity
The franchise agreement is the primary contract between the
franchisor and franchisee. It grants, to the franchisee, an exclusive
right and license to operate a business for a certain number of
years (usually five years) in a specific geographic territory. This
grant allows the franchisee to use the franchisor’s name, proprietary
information, advertising, trade name, logos, slogans and other trade
secrets. Depending on the type of business, the exclusive
geographic territory belonging to each franchisee might be as small
as two city blocks or as large as the entire county. Some contracts
also grant the franchisee a right of first refusal to purchase
additional stores, or neighboring territories.
Costs of Purchasing a Franchise
New franchisees pay both an initial, lump-sum franchise fee as well
as several types of ongoing costs. A monthly royalty payment is
often calculated to equal a certain percentage (often five percent) of
monthly gross sales from the franchisee's business. Gross sales is
defined broadly to include all receipts, whether in cash or on credit,
from all activities of every type and description conducted by the
franchisee. Most franchisors charge a late fee if royalty payments
are not paid in a timely manner.
Franchisees must also pay an advertising fee in many cases. This is
referred to as an "ad-fund.” The amount due could be calculated as
a flat fee or as a small percentage (often one percent) of the
franchisee’s monthly gross sales. The franchisor controls the fund,
and is bound by its fiduciary duties to expend the ad-fund moneys
strictly for advertising of the franchisees’ businesses.
Of course, the financial outlay includes more than just the moneys
that directly go to the franchisor. It also encompasses furniture,
fixtures, equipment; inventory a liquor license, lease, leasehold
improvements, insurance accountant fees, attorney fees,
construction costs, painting, carpeting, decorating, and workman’s
compensation.
Relationship of the Parties
The nature of the relationship between Franchisee and Franchisor
is that of an independent contractor. It is not an employment
relationship nor a partnership or joint venture. For that reason,
neither party may represent the other, act as the agent of the other,
or become obligated for the debts of the other.
Employees of any franchisee are just that – employees of only the
local franchisee and not the corporate franchisor. This is true even
though those employees might receive training from the franchisor.
If a disgruntled former employee wishes to sue a business for
wrongful termination, that lawsuit can usually only hold against the
local franchisee and not the corporate franchisor.
The Franchisor’s Obligations
In exchange for receiving the above-mentioned fees and royalties, a
franchisor must assist its franchisees with a large number of
services. It is common for the corporate franchisor to operate a
week-long training program for new franchisees, as well as annual
“refresher courses” for veteran franchisees. During such sessions,
franchisees are advised regarding operational procedures,
marketing systems, and bookkeeping.
Due to the royalty-based fee system, franchisors are incentived to
provide promotional or merchandising methods. Franchisors should
also have an informal policy of providing ongoing consultation and
advice.
Marketing is the life-blood of most new franchise operations. Any
franchise contract should include provisions for the franchisor to
shall assist its franchisees with the identification and analysis of
targeted customers, demographic data regarding households in the
franchisee’s territory, and the purchase of mailing lists, commercial
air time, placement of print advertisements, and other components
necessary to market the business.
Franchisors also assist with supply-chain management, supplying a
franchisee's initial supply of raw materials.
The Franchisee’s Obligations
In addition to paying the various fees described above, the franchise
contract also requires franchisees to follow certain “ground rules”.
For examples, franchisees often must send a written monthly report
to the corporate office, describing on forms prescribed by
Franchisor, the general financial condition including expenses,
costs, income, profit, and so forth.
Franchisees must also comply with the franchisor's Policy and
Procedures Manual in order to ensure that customers associate the
national chain as providing a certain level of order, uniformity, and
service. This rule ensures that all franchisees maintain a high
reputation that will benefit their counterparts.
Franchisors often require that every franchisee purchase goods or
services from certain vendors. For example, an approved-vendor list
might include a certain architectural firm that designs all of the chain’
s outlets to ensure nation-wide uniformity in the look, feel, décor,
and space, of every franchise outlet. More commonly, franchisees
are required to purchase raw material such as food, plastic plates,
and other material, only from the franchisor or from the franchisor’s
approved vendor.
The contract often mandates that franchisees purchase from the
franchisor or its designated supplier promotional items including a
Grand Opening banner, Opening Soon banner, Now Hiring banner,
sign stand, employee uniforms, capital equipment, ovens, tables,
materials, and supplies. Alternatively, some franchisors do not
require a certain suppliers, but instead require detailed product
specifications that include standards as to quality, taste, texture,
composition, absorbency, strength, finish, and appearance of the
goods sold.
Purchasing a Franchise
Attorneys sometimes encourage their clients who are new
franchisees to engage in “comparison shopping” of several potential
franchisors in order to choose the franchisor offering the best price,
market power, stability, track record, and other items which will make
his or her business successful. In addition to reading the disclosure
documents, this law firm encourages potential new franchisees to
contact the existing franchisees of the subject franchisor by
telephone to discuss information which the franchisor is unwilling or
unable to provide. Because franchisees have been through the
process that the client now is going through, they are generally
willing to cooperate. A lawyer might also encourage the client to visit
an existing franchise operation to study whether it will be successful
and is the type of business the purchaser desires to operate.
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