What is a Franchise Business

What is a franchise business?

Simply, a franchise business is a method a company uses to distribute its products or services through retail outlets owned by independent, third party operators. The independent operator does business using the marketing methods, trademarked goods and services and the "goodwill" and name recognition developed by the company. In exchange, the independent operator pays an initial fee and royalties to the owner of the franchise.

The company that grants the independent operator the right to distribute its trademarks, products, or techniques is known as the franchiser. The independent, third party business person distributing the franchiser's products or services through retail or service outlets is called the franchisee.

I am looking to buy an existing franchise. What do I do?
Although the FTC-required disclosure documents are mandatory for first-time purchasers of a franchise, there are no required government disclosure documents that must be furnished to the buyer of an existing franchise business. The seller of the franchise is not required to provide the would-be buyer with the franchiser's disclosure document.

You will want to very carefully study the terms of the existing franchise contract between the existing franchise and the franchiser. How long is its remaining term? Is the price reasonable? Will the operator compete with you afterwards? How does it compare with new franchises the franchiser sells to others? Will you be acceptable to the franchiser? Franchisers invariably have right to approve the transfer or sale of a franchise, or even to negotiate the right to buy back the franchise, and you don't want to be a seller's stalking horse.

An investment in a franchise is a substantial commitment of your money, your time, and your reputation. Our advice is to retain a lawyer to assist you in the process. It usually pays for itself many times over.

What do most franchise businesses have in common?
Generally speaking, a franchise business has three common factors:

the franchiser is in the business of selling franchises to independent third party local operators to market a product or services under a method created by the franchiser;

the business is based upon a common method or approach, that relies on a combination of techniques or products plus the franchiser's special trademark, service mark, trade name, logotype, advertising, or other symbol that designates the franchiser; and

the franchisee is required to pay fees and conduct its local business in a manner meeting the franchiser's requirements.

Franchise offerings must comply with federal regulations, and, in some cases, with even tougher state regulatory laws. Some states do not require registration based upon the net worth of the franchiser or if the franchiser has a federally registered trademark. Foreign countries also set their own terms and conditions regulating franchising activities.

I have a great business idea. Can I franchise it?
If you are contemplating a franchising system you should first subject your concept to a careful feasibility study to see if the business you have in mind makes sense economically, and as a franchise concept. And, of course, the operation must be running and successful-- no one is going to pay a franchise fee for an untested concept.

Then, if you are convinced it does make sense, you should arrange an attorney for the Intellectual Property protections you'll need, in terms of trademarks, patents, trade secrets, etc., and also consider how you will comply with the FTC laws and the franchising laws of the key states in which the franchise would be offered or BEFORE you start to sell the franchises.

The franchise is supposed to be a "goldmine." How can I tell?
If the franchiser is making claims you should ask for an earnings claim statement. It is an optional section of the FTC-disclosure document. There may be a statement providing for the inclusion of the actual, average, projected or forecasted income of the business owner.

While the franchiser is not obligated to give you this information, its failure or refusal to do so should raise a red-flag. If they are included, both the financial statement and the earnings claims statement provide crucial information necessary to evaluate the financial health of the company, selling you the franchise and projections of what you might expect from operating one of its franchises, before the purchase is made.

All earnings claims statements must be prepared according to an FTC-prescribed format and supply information with government-required disclaimers.

Can a buyer of a franchise select the business location?
The franchise territory is defined in the franchising agreement, but be aware the franchiser generally has the "bigger say" and can limit the territory and location of the franchising business so long as it has a business reason to justify the restricted area. For example, say you plan on opening the first Burger King in downtown Boston, and you want to be the only Burger King in downtown Boston. Burger King is likely to insist on the right to open another restaurant a few blocks away, so you would set out on a map the very limited few blocks for your "exclusive". However, Burger King may be willing to allow you to have the right of first refusal for a new Burger King franchise in an adjoining "neighborhood" as part of your deal with them.

Issues regarding territory may later arise, for example, (a) due to a change in the owner of the trademarked property, a competing business in the same industry and having the right to use the same trade name or trade mark opens in the "neighborhood", (b) trademarked property being distributed to other retail or company-owned outlets, or (c) the protected area is lost for failure to meet sales quotas.

Can the franchisor be taken to court in the franchisee's home state?
That all depends on your state's law and, if consistent with state law, the franchise agreement. Many franchise agreements provide that all disputes must be settled out of court in arbitration, precluding any lawsuits, unless your state's law does not permit that type of provision.

If lawsuits are possible, be aware that most franchisers want to have any lawsuits heard in their home state, and structure their franchise agreements accordingly. However, several states have laws which require that franchisers be amenable to suit in the state in which the franchise is located.

What disclosure am I entitled to when I consider buying a franchise?
If you are looking to buy a franchise from a franchiser, the franchiser must give you two crucial documents mandated by the Federal Trade Commission (the "FTC"): (1) a written disclosure statement (or "offering circular") that sets forth certain information about the business to be franchised, and (2) proposed franchise agreement or contract. A third attachment, an "earnings-claim" statement of the franchiser, may or may not be furnished, at the election of the franchiser. All the above documentation, including the earnings-claim statement, is contained in a single form (as opposed to separate documents), commonly referred to as the "Uniform Franchise Offering Circular" (UFOC). (Most franchisers prefer the UFOC document since the document, with some modifications, is acceptable in all states.)

The disclosure is supposed to be written in plain English, clearly, concisely, and in narrative form. Even so, it sometimes requires a lawyer to interpret what is really being said -- and what is not being said -- which you should be cautious about.

You are entitled to the disclosure material either at the first face-to-face meeting with the franchiser or 10 days in advance of the signing of the actual contract or paying money, whichever happens first.

The fact that the disclosure is government mandated does not mean that the offering has the approval or recommendation of the government, or that the information is complete or accurate, or the franchiser is reputable. Or that the government checks for truth, or how good a franchise is or risk (this is despite a "risk factors" section in the document). Any confirmation, verification, and assessment of the contents are the responsibility of the buyer of the franchise. While misrepresentations, fraud, or omissions in the disclosure statement may result in civil and criminal liability to the franchiser, as a prospective franchise buyer you should be more interested in making sure you get what you bargain for, than having to sue someone down the road.

What's in the disclosure statement (or circular offering)
The circular offering (UFOC) requires data and information from the franchiser in over 20 categories. Cover pages of the offering circular must spell out any risk factors in bold type, such as what happens in the event of disputes (lawsuits or arbitration, and where the dispute may be resolved); costs; the effective date of the offering; and the state law controlling the agreement. They must be updated at least annually, or when there is a material change to the information contained in the document, quarterly.

The key items of the disclosure statement include:

Background information on the franchiser and any predecessor;

The identity and business background of key personnel affiliated with the franchiser or franchise brokers;

Any prior litigation actions;

Any bankruptcy history;

Franchisee's initial franchise fee or other initial payment to begin the operation;

Other fees, such as service fees, training fees, advertising fees, royalties;

Any commitment of a franchisee to purchase or lease from designated sources;

Franchisee's principal obligations;

Obligations of the franchiser; supervision; assistance; services;

Exclusive area or territory;

Trademarks, service marks, trade names, logos, and commercial symbols;

Patents and copyrights;

Any commitment of the franchisee to personally participate in the actual operation of the franchise business;

Renewal, termination, transfer and dispute resolution;

Statistical information and listing of other existing franchisees; and

Audited financial statements.

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Information About Franchise Agreement

The franchise agreement is the cornerstone document of the franchisee--franchiser relationship. It is this document that is legally binding on both parties, laying out the rights and obligations of each. A sample agreement may either be attached to the disclosure statement or presented separately. Either way, you are entitled to receive it as a prospective franchisee five business days before signature. You should have it reviewed by a lawyer familiar with franchise matters--especially since most agreements are extremely one-sided in favor of the franchiser. No one should enter into a franchise and expect to have an evenly drawn contract.

What's in a Franchise Agreement?

The agreement will contain provisions covering, in considerable detail, the obligations of the franchiser (the company) and franchisee (you) regarding operating the business; the training and operational support the franchiser will provide (and at what cost); your territory and any exclusivity; the initial duration of the franchise and any renewal rights; how much you must invest; how you must deal with things such as trademarks, patents and signs; what royalties and service fees you will pay; tax issues; what happens if you should want to sell or transfer the franchise; advertising policies; franchisee termination issues; settlement of disputes; by the company, operating practices, cancellation, and attorney fees.

There is no standard form of franchise agreement because the terms, conditions, and the methods of operations of various franchises vary widely depending on the type of business involved. For example, franchises for printing, employment agencies, and automotive products will differ from the franchises for fast food service, convenience stores, or clothing.

Can I negotiate the franchise agreement, or is it "take it or leave it?"
In almost every franchise agreement there are terms that can be negotiated – perhaps price, timing of payments, duration of the franchise, the number of people they will train, and territorial exclusivity -- and some that probably cannot be negotiated, such as trademark issues. However, much depends on the relative bargaining position of the franchiser and you as a prospective franchisee, and how astute your lawyer is. Also, you should note that many registration states do not permit a contract to be signed other than the one on file. (However, New York is an exception, in that the state allows a franchiser to give a franchisee a better contract than one that is on file.)

As a first step, make sure the statements in the franchising agreement are consistent with the representations made in the disclosure material. Careful examination of the agreement to verify that what the offering circular promises is contained in the agreement is the first step in the process.

What can I negotiate?
That varies all over the lot. If you want to buy a McDonald's franchise, don't expect McDonald's to modify the agreement's provisions regarding how you can use its Golden Arches trademark, nor should you expect them to allow you to sell Sushi. However, the company may permit you to send more people to its training sessions, or allow you to adjust the size of the signs to meet local zoning ordinances. On the other hand if you will be buying the second "Tony Martin Pizza Factory" franchise, you'll probably have much more negotiating room.

If you review the proposed legal contract with a lawyer you will learn that even certain of the provisions which appear to be "boiler-plate" can be changed, if it is important to you, and not significant to the franchiser. A lawyer can also help you anticipate problems that may arise (e.g. location, equipment, pricing, competition, new products) during the life of a contract, and perhaps solve some now, saving you time, money and headache later. Agreed modifications should be in written, not oral, form.

Can the franchise agreement be terminated or not renewed?
This generally will depend on what the franchise agreement you signed says, whether or not you have complied with it, and whether the franchiser did all that it had promised to do in the agreement.

At the outset, franchisers generally have the right to choose the parties they wish to do business with and may use their own judgment in entering into a new franchise relationship. After the period covered in the franchise agreement, and subject to your rights to renew, you will be in a negotiating session with the franchiser over extending the franchise.

If you have failed to comply with the agreement, you can expect that the franchiser will not be pleased about the prospect of having you continue with the arrangement. In fact, even before the original term is over, the franchiser may seek to terminate your franchise – as a McDonald's franchisee who starts selling Sushi would soon find out.

Depending upon the appropriate state law, a franchiser may have the right to terminate a franchise or to refuse to renew a franchise for "good cause" – such as failure to meet sales quotas or lack of quality standards. Many contracts are drafted in such a manner that it is probable that a franchisee would breach it at sometime allowing the franchiser to cancel the contract or not renew it. Some state statutes require specific conditions, such as failure to meet monetary obligations, correct defects, or quality standards, for termination or for non-renewal. Other states also require special notices within certain time periods be provided to the franchisee before termination or non-renewal.

What if the information given to a prospective franchisee in the disclosure agreement is misleading or fraudulent or incomplete?

The law prohibits the sale of a franchise by way of any communication that contains an untrue statement of a material fact or fails to state a material fact that should be stated. Generally, a "material fact" is one that a reasonable person would believe to be important in making a decision on whether to buy a franchise or not the transaction. Such a fact might be that X% of the company's franchisees have gone bankrupt, as a reasonable person would find this information important in making a decision to purchase a franchise. If a material fact is omitted by a franchiser, a franchisee may bring legal action to recover damages.

Do state laws and rules for franchises differ?
Yes, which is why it is so important to deal with an attorney familiar with franchising generally and your state's laws in particular. Some states have rather strict franchise regulations others do not. For example California, Hawaii, Illinois, New York, Rhode Island have enacted "franchise registration" statutes governing sales practices. Other states, including Florida, Georgia, Iowa, Kentucky and North Carolina regulate franchising through "business opportunity" acts. A few states, such as Connecticut, Michigan, Minnesota and South Dakota have both. Maryland, Arkansas, California, Illinois, Iowa, and Minnesota are among the states with laws regulating termination and non-renewals of agreements. And proposed ads must be pre-approved in California Illinois, Indiana, and Maryland prior to publication.

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