How to Buy a Franchise
by
James A. Meaney,
Attorney at Law
Third Edition
Copyright © 2011 by James A.
Meaney
SBN-13: 978-0-615-58160-6
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Cover Art/Design © 2011 by Benjamin J. Meaney
First Edition: 1986
Second
Edition: 2004 (Second Printing, April 2005)
Third Edition: 2011
Table of Contents
The Franchise Disclosure Document
Franchise Salespeople and Brokers
The Background of the Franchisor
Investigating Existing Franchisees
Financial Performance Representations
Understanding and Negotiating the Franchise Agreement
Franchisee Input and Franchisee Associations
Opening Remarks
The first incarnation of this book dates back to 1986 and was intended to serve as a simple guide for first-time franchise buyers. Much has changed since that time—in franchising and the business world—but the basic premise of this book has not: an educated franchise buyer who engages in thorough and analytical due diligence is more likely to make the right franchise decision and succeed in their business.
The idea for this book arose from my experience in a state attorney generals’ office where I was in charge of enforcing franchise and business opportunity law violations and stopping outright scams. It struck me that innocent folks who were being taken advantage of knew little about business and less about buying a business. In addition, most franchise and business opportunity purchasers were short on time and eager to begin a new business. With this, it was clear that a franchise-buying guide would have to be short, concise and simple. In updating this guide, I have endeavored to stay true to this original principle.
But, as noted, much has changed and the time has come to revise and update the information you need to make the right franchise choice.
In 2007, the Federal Trade Commission (FTC) amended its rule that served as the national minimum for franchise disclosures and prohibitions. Now known as the “Amended FTC Franchise Rule” (16 CFR Part 436), the Amended Rule has modernized and further standardized the disclosures required in a franchise sale. While we will avoid becoming overly-legalistic, it is important to understand the basic regimen of federal and state laws designed to protect you. More will be discussed on the laws and regulations in coming chapters.
There is little question that franchising has taken the world by storm. New franchises come into existence every day. From Topeka to Timbuktu, the names of well-known franchise companies have become household words.
Many people consider franchising the epitome of the American dream—an opportunity for financial success unparalleled in U.S. business history. A vintage report issued by the U.S. House of Representative's Committee on Small Business (Franchising in the U.S. Economy: Prospects and Promises) when the first national franchise regulations were implemented, reflected these sentiments:
"Franchising has been called the most dynamic business arrangement since the emergence of the corporation a century ago. It is heralded as a 'dominating force' in the distribution of goods and services and the wave of the future for the U.S. marketplace."
This was true more than 30 years ago and remains so today. Franchising has lived up to these high expectations and remains a “dominating force” today:
• There are currently over 760,000 franchised business outlets
• Total annual economic output of $2.3 trillion
• Franchised businesses provide 21 million American jobs (15.3% of all U.S. jobs)
• Economic activity from franchising accounts for 11% of the private sector economy.
• Franchises now cover the world and some of the largest franchise systems are developing more units in foreign countries than they have in the U.S.
(Source: Economic Impact of Franchised Businesses: Volume 2 (2008) (International Franchise Association Study, conducted by PricewaterhouseCoopers) (“IFA Report”))
A truly remarkable record by any standard – and that’s why so many people are interested in purchasing a franchise. But just because franchising has enjoyed a rosy reputation does not mean that every franchise system is successful and that every franchise buyer has succeeded. They have not.
For instance, during the years since franchising became the rage, there have been many times when honest, hard-working people have simply been duped by scam artists. An early example illustrates the point.
Example:
A middle-aged couple was interested in starting a side business while keeping their regular jobs. They were intrigued by an ad in their local newspaper reading:
Earn Big Money While Keeping Your Regular Job-Invest In Your Own Vending Machine Franchise Business.
The ad went on to promise that, by establishing a vending machine business, you would be on the road to independent wealth in no time.
When they followed up on the ad, the seller of the opportunity assured them that by making a $20,000 investment in the machines and start-up inventory, they could build the business step-by-step into a successful empire. In addition, by joining the "We've Got Your Franchise System," they would share in the proven format and techniques that were the keys to success. He showed them pictures of his luxurious warehouses in a neighboring state filled with rows of brand new machines just waiting for a home. He presented them with lists of potential locations in their area where his demographic studies showed people would just kill for vending products. And finally, he used the big hook: "Oh, and by the way folks, this is a no-lose proposition. If you don't succeed, I'll return your investment. No questions asked." They were sold.
The eager buyers wrote the check and sat back to wait, excited by the prospect of beginning their new venture. In a few weeks, as promised, the seller delivered the vending machines-but there was a small problem. The machines appeared to be second-hand, not nearly as glamorous as the bright, shiny ones shown in the sales pictures. When the buyers called the seller to complain, he quickly apologized. He told them he meant to call them ahead of time as there was a temporary shortage of new machines, but they could get started with these and as soon as the new ones arrived he would replace them. He also told them that he had included their "Initial Route Slip" in with the paperwork for the machines and they should begin securing their locations immediately.
Temporarily satisfied with this explanation, and still pumped at the thought of having their own business, the buyers rose at the crack of dawn to establish their locations. To their dismay, the first turned out to be an old, closed gas station. At the next, a small country grocery store, they were told by the owner that he charged $20.00 a month rent and they had to purchase all the products to stock the machines from his store. And on they went throughout the course of the day, decidedly discouraged by their lack of success. They did manage to place two machines at the small grocery store and were able to get the owner to go for a 2-for-1 rent deal.
As they pulled into the driveway that evening, the phone was ringing. It was the seller, who wasted no time reassuring them. He was certain they had had a tough day. He said sympathetically, "the first days are always the toughest." Buoyed by his interest and astute knowledge, the buyers were able to place their other eight machines during the course of the next two weeks. Over the next month their machines generated revenues of $100.00. After paying the rent to the grocer and figuring their inventory costs, they calculated their profit for the month to be $13.13.
Knowing this was a bad omen, they decided to get their money back and look for something else. When they called the seller, an electronic operator informed them that "this is no longer a working number." When they complained to state officials whose jobs were to help bilked investors, they learned that they were not alone. Twenty-five others had fallen for the same routine and were out $20,000 in exchange for a few worthless vending machines.
The message is clear. Even though franchising has gained a reputation as the preferred method of doing business in America—if not the world—all franchise opportunities are not created equal. Success is not around every franchise corner. The same Committee report referred to earlier noted that many of the abuses and failures seen in franchising come from an "informational imbalance" that exists between franchisors and franchise buyers.
Do not fall prey to scam artists. Exercise caution in your business affairs-especially if it is your first time. Learn how to investigate a business opportunity so you go into it with your eyes wide open. Guard against emotional decisions by relying on the well-proven ways of Sherlock Holmes-investigate, investigate, and investigate. The process starts here.
This book begins with some basic franchise history and principles, and the distinctions between a franchise, business opportunity, dealership, and distributorship. Next, we explore how to determine which franchise opportunity best suits you. Then, since it is imperative that buyers know how to research the franchise company as well as the opportunity itself, there is a description of the facts you need to obtain and the method you can use to:
• analyze financial and sales information
• review financial performance statements made by the franchisor.
Finally, we discuss how to negotiate the franchise agreement and the factors involved in the ongoing relationship with the franchisor.
To form a successful, ongoing relationship with your new franchise partner, one that has the potential to give you the profit and fulfillment you want, you must be extremely careful that you are making the right decision and handling the transaction properly. This book puts you on the right path.
To maximize the value of this book and your franchise learning experience, three appendices are included:
• Appendix A contains a sample Disclosure Document (from which some non-pertinent information has been deleted).
• Appendix B contains a sample Franchise Agreement.
• Appendix C contains contact information for state agencies that oversee franchise and business opportunity disclosure laws and regulations.
To enhance your franchise education, the appendices are referred to throughout this book.
Abbreviated Glossary
Before we delve into the particulars of buying a franchise, reviewing some of the basic definitions used in this book may also be of value:
• Amended FTC Franchise Rule - in 2007, the Federal Trade Commission amended its rule that served as the national minimum for franchise disclosures and prohibitions that was first adopted in 1979. Now known as the “Amended FTC Franchise Rule” (16 CFR Part 436), the Amended Franchise Rule has modernized and further standardized the disclosures required in a franchise sale; it has replaced the Uniform Franchise Offering Circular disclosure format (defined below) as the preferred disclosure format in the U.S.
• Business Opportunity or Business Opportunity Plan - generally speaking, a business opportunity plan is a hybrid of a franchise and a distributorship or dealership arrangement, though some definitions of business opportunity plans do encompass franchises. The most notable differences are that business opportunity plans often do not contain a trademark requirement and the laws governing them focus more on specific types of distributorship businesses, such as rack distributors, vending machine routes, and video machine sales and placement. The vending machine business discussed earlier is a good example of a business opportunity.
• Disclosure Document, Franchise Disclosure Document or FDD - a large, multi-page document required by state and federal law that contains 23 categories of information concerning the franchise offered for sale, including all agreements and financial statements. Before the 2007 FTC Amended Rule came into effect, most franchisors followed the Uniform Franchise Offering Circular or UFOC disclosure format which was adopted by the North American Securities Administrators Association and preferred by many states that regulate franchise sales.
• Financial Performance Representation or FPR - any representation, including any oral, written, or visual representation, to a prospective franchisee, including a representation in the general media, that states, expressly or by implication, a specific level or range of actual or potential sales, income, gross profits, or net profits. The term includes a chart, table, or mathematical calculation that shows possible results based on a combination of variables.
• Federal Trade Commission or FTC – a federal agency that regulates trade and commerce in the U.S. and which adopted the first national franchise and business opportunity regulation. The FTC has enforcement powers to prosecute violations of the franchise and business opportunity regulations.
• Franchise – although defined differently in many states, the FTC defines a franchise as: any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that: (1) The franchisee will obtain the right to operate a business that is identified or associated with the franchisor's trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor's trademark; (2) The franchisor will exert or has authority to exert a significant degree of control over the franchisee's method of operation, or provide significant assistance in the franchisee's method of operation; and (3) As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.
• Franchisee – a person or entity who purchases a franchise
• Franchisor – a person or entity that sells a franchise.
• Plain English – an attempt by franchise regulators to require Disclosure Documents be written in simple, non-legalistic language so they are understandable by people who are unfamiliar with franchising.
• North American Securities Administrator Association or NASAA – state securities administrators were the first franchise regulators and most are members of NASAA which, according to its website, was organized in 1919, and is the oldest international organization devoted to investor protection. NASAA is a voluntary association whose membership consists of 67 state, provincial, and territorial securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada, and Mexico. NASAA adopted the Uniform Franchise Offering Circular disclosure format (defined below) before the FTC entered the picture.
• Uniform Franchise Offering Circular or UFOC – first conceived and adopted by NASAA in the mid-1970’s, the UFOC was the preferred disclosure document format until the 2007 amendment of the FTC Rule. The UFOC format and guidelines set the foundation of today’s Amended FTC Franchise Rule disclosure format.
Chapter One
Why Buy a Franchise?
Most people buy a franchise because they feel it is less risky than starting a business from scratch. They recognize that their work experience has not prepared them with the knowledge or skills needed to begin and run a business of their own. In addition, many are unwilling to spend time, effort, and money reinventing what is already available.
Franchising is also attractive because, to some extent, a franchise is a cooperative-a community of common interests-from centralized national advertising to common products, operating procedures, and quality control standards. Because of the protective nature of franchising-with its intensive training programs, written standards and procedures, and national name recognition-people who otherwise would not have risked entering the business world have taken the leap and opened their own businesses and done well.
Government statistics bear this out. Although it has been the subject of debate, the chance of surviving in a small business is greatly enhanced by membership in a franchising system. The failure rate is reported to be far lower than that of small businesses unsupported by a franchising parent.
Originally, franchises that repackaged existing products and services were some of the most successful franchise systems. (Think of how many hamburger places existed before McDonald's helped make fast food a way of life.) Tomorrow's success stories will probably come from capitalizing on new ideas and new technologies.
There seems to be no limit to where and how the franchising concept is applied. Real estate, clothing, sports equipment, computer goods and services, packaging services, business services, and lodging are only some of the hundreds of businesses that use franchising to distribute their goods and services.
International franchising is the next wave. As franchise systems saturate the United States, they look for new opportunities in new markets. Using modern communication and computer technology, franchisors are able to cast a wider net without boundaries.
The following sections describe some of the elements usually responsible for a franchising system's success and some of the reasons why buying a franchise can be a sound investment. These are the primary building blocks for a successful franchise system and potential franchise buyers should place them at the top of their list of elements to investigate.
DEFINED AND PROVEN BUSINESS FORMAT
What most franchisors are selling is a defined and proven business format or method of operation. Although some offer a unique product or service, many franchisors have simply come up with a new way to slice bread. The founder of Dunkin' Donuts was quoted as saying:
"Howard Johnson's didn't invent the ice cream cone.
Colonel Sanders didn't invent fried chicken. I didn't invent coffee and doughnuts. We just did it better, we had a passion for building a concept."
It has been said that the simpler the idea, the better the franchise. What each of the business leaders mentioned by Dunkin' Donuts founder did was develop a proven, recognizable format that was easily duplicated. They standardized the presentation of their products and the services that went along with them. This is the essence of a proven format in the world of franchising and at the top of the list of reasons for franchising's success. Many of the original franchises began with people who operated their own independent business, refined it, and demonstrated-to themselves and others-that it could be successful.
A defined format is what is passed on to franchisees and strictly enforced. It is what creates a positive public image and identification. It is the prime building block of a successful franchise.
Today, while many systems still have grass root beginnings, franchise-making has become big business. Major corporations buy and sell franchise systems like pieces on a huge chess board. But at the heart of every successful franchise system, you will still find a proven format.
SPECIALIZATION
Another reason franchising has found such a solid niche in our modern economy is that it caters to specialized needs. Many American consumers no longer want a muffler installed by a service station, a hamburger from a diner, a pizza from someone who will not deliver it within 30 minutes, or their hair cut by a local barber. Specialists, it seems, do it better and the franchise industry is only too willing to accommodate this belief.
While the early foundations of franchising were built upon standardization, the success of modern franchising depends on finding ways to meet the ever-changing needs of affluent consumers. New businesses not even thought of ten years ago are sprouting wings and taking to the sky. Franchising organizations capitalize on this era of specialization by expanding through sales to independent parties (who become franchisees) rather than by investing their own money. The capital saved is used by franchisors to develop new and better ways to serve consumers' specialized needs.
Specialization helps franchisees because it creates new marketing niches for franchises to pursue. Offering products and services to those niche customers works for the common good of all in the system. The ongoing trend towards specialization will lead to the creation of new franchises and keep franchising at the forefront of business distribution methods.
UNIFORM SYSTEM
As mentioned earlier, franchising will continue to succeed in the era of specialization by calling upon its traditional roots to see that consumers receive uniform quality—efficiently and cost-effectively—through uniform systems of operation. A uniform system brings with it the advantages of:
• mass purchasing power;
• brand identification;
• customer loyalty; and,
• a proven format.
A federal court described the importance of uniformity when dealing with a case involving Domino's Pizza.
The essence of a successful nationwide fast-food chain is product uniformity and consistency. Uniformity benefits franchisees because customers can purchase pizza from any Domino's store and be certain the pizza will taste exactly like the Domino's pizza with which they are familiar. This means that individual franchisees need not build up their own good will. Uniformity also benefits the franchisor. It ensures the brand name will continue to attract and hold customers, increasing franchise fees and royalties.
To serve our mobile society and continue to attract loyal, repeat customers anywhere in the country (or world), franchise systems must utilize uniform systems to provide uniform products and services.
ADVERTISING NETWORK
The term strength in numbers aptly describes franchise advertising. Because of collective advertising funds and cooperatives, franchisees-who normally could only afford to advertise locally, if at all-can take advantage of national and regional advertising (which is exorbitantly expensive). Franchisees also benefit from the creative talent that large corporations draw upon to effectively market their products and services. On the other hand, franchisors benefit because they can consolidate their advertising efforts and fund expensive advertising campaigns with the financial help of their franchisees.
Both the national and regional success of a franchise depends largely upon the franchisor's ability to develop name recognition and product or format acceptability. Local, regional, and national advertising instills in consumers the confidence that they can go across the country and find-in a franchise outlet-the same quality as they would in their own neighborhood. Advertising networks, therefore, are a vital part of every franchise system.
NAME IDENTIFICATION
Another benefit that potential franchisees can expect is to be identified with the franchisor's name. By delivering a quality service or product (a proven format) and with the help of advertising, franchisors achieve name recognition with the public.
This recognition is one of the intangibles that franchisors offer franchisees. As the franchise matures and name recognition increases, this intangible benefit becomes more valuable. Franchisors often charge new franchisees a higher fee for the privilege of operating under the established franchise name.
With a successful franchisor, product or service recognition confers an image of quality, integrity, and trust. Therefore, in addition to obtaining a product or service to sell the public that is presented in a proven format, franchisees also gain instant integrity and recognition. This is one of the reasons franchised businesses seem to enjoy a better track record of success than their non-franchised counterparts. Clearly, with the right franchise system, the new business owner is off to a much better start.
TRAINING
Because reproducing the franchisor's format is so important to the ultimate success of the entire network, many franchisors have strict training requirements. New franchisees are required to attend franchising universities. Some franchisors use a combination of classroom and on-site training to indoctrinate franchisees in the ways of their systems. This training instills the proven format or methodology in each of its franchisees and gives them some of the knowledge and experience they need. Sharing a proven format so it can be replicated lies at the heart of the franchise model. This is why “the simpler the idea—the better the franchise.”
The training that normally accompanies the sale of a franchise allows people, otherwise inexperienced in the operation of the franchisor's business, to successfully offer the same quality service or product in a uniform manner.
FRANCHISE NETWORK
For franchisees, especially new ones, the franchise network or family of franchisees is an invaluable resource for information and business experience. Because all are working toward a common goal, keen new franchisees can draw freely upon the available knowledge base offered within a franchise structure. Partnering with other franchisees can be a great help. Before joining a franchise system, consult with some of its franchisees for valuable inside information. (More about this in Chapter 10.)
Properly stimulated by the franchisor, the synergy of franchisee relationships can continually spark new methods of operation and product ideas. As new business issues arise, new solutions are reached collectively and every franchisee benefits.
Wise franchisors also draw upon this ready resource. Many improvements to franchise systems have resulted from accepting new ideas and suggestions from their family of franchisees.
The entire system benefits from the collective knowledge, experiences, and mistakes of existing franchisees. This is one of the most valuable and underrated benefits of joining a franchise system.
POWER BUYING AND COMPUTERIZATION
Although not always available, cooperative buying arrangements offered by the franchisor (or franchisee groups) are an important benefit of joining a franchise system. Because some systems use vast amounts of raw materials or ancillary services, volume discounts as well as customized service can be negotiated with vendors. In some industries these discounts or specialized services provide the competitive edge necessary for success. Many franchise systems are also able to help new franchisees with discounts on the initial fixtures and equipment needed to start the business.
A successful franchise system's power buying is an important attribute especially as computer equipment has infiltrated almost every aspect of business. Computerization is an expensive capital investment. By working from the franchise system's base of knowledge, franchisees can get help making the correct purchase and maximizing their efficiency. Many franchisors have developed customized software to operate every aspect of the system. Types of software include:
• computerized point-of-sale systems;
• reservation systems;
• inventory controls;
• sales report systems; and,
• data communication between franchisee and franchisor.
Modern franchise systems have developed electronic communication systems for their franchisees. In addition, many franchisors maintain websites on the Internet and encourage their franchisees to participate in online lists (bulletin boards) and/or forums or discussion groups (chat groups) where common issues and problems are discussed.
Indeed, computerization and purchasing cooperatives are necessities in modern retail and service industries. Few will survive if they do not tele-connect with their suppliers, vendors, and customers.
Chapter Two
What is a Franchise?
As obvious as this may seem, it is important to clearly understand what a franchise is if you are thinking of buying one. Unfortunately, the term franchise does not lend itself to an easy or precise definition. Simply put, it is a method of distributing goods or services-a unique selling concept that fits hand-in glove with our highly mobile, service-intensive society. A more precise legal definition can be found in the Abbreviated Glossary.
A franchise system benefits both individual franchisees and the franchise as a whole. As described in Chapter 1, these benefits usually include:
• proven business format;
• standardized method of operation;
• national advertising;
• franchise name recognition;
• franchisee training;
• franchisee network;
• standardized fixtures and equipment;
• professional site location assistance;
• centralized buying power; and,
• rules and quality control standards.
Franchisors create their systems to rapidly expand their businesses without investing as much capital or adding as much personnel as would be needed if they did it on their own. In fact, franchisors raise capital by charging franchise fees of their franchisees. In other words, by franchising their products and/or services, franchisors can build both their profits and their business, without spending significant amounts of money. Understanding the development of franchises can also help define a franchise.
A BRIEF HISTORY
The booming post-war economy of the 1950's propelled franchising into the modern economic era. The newly-formed interstate highway system provided the infrastructure for new restaurants, hotels, and service stations, all designed to meet the changing, growing needs of a new breed of mobile and adventurous Americans. Added to the mix was the power of television that provided the first truly national advertising medium. These dynamic forces, combined with newfound wealth, fueled the franchise fire.
Yet franchising can trace its roots back over one-hundred years, from when Isaac Singer first utilized the concept. He reportedly accepted a royalty or license fee from independent salesmen for territorial rights to sell his sewing machine. Then, the invention of the automobile thrust franchising into a higher gear, as it did with many other aspects of American life in the early 1900's. General Motors established dealerships to meet the rising demand for automobiles and oil companies offered service station franchises to the mechanics of the day to create an automobile service industry that thrives to this day.
The names Howard Johnson's and Kentucky Fried Chicken could not have been etched into our collective memories without the upsurge of the franchising method of doing business. McDonald's would not have taken on the proportions of an American icon. Much is owed to the early franchise pioneers who provided a novel business methodology that allowed rapid expansion, the pooling of capital, and a harnessing of the American entrepreneurial spirit.
As franchising evolved in the early 1960's, the need for a precise definition increased. However, it was not until 1971 that California adopted the first law regulating the sale of a franchise. And, it was not until the end of that decade that the FTC adopted a regulation on the federal level under the Federal Trade Commission Act. Unfortunately, the definitions adopted by the FTC and California were not identical and the enforcement structures were very different. Adding to the regulatory confusion in the mid-1970’s was NASAA’s (then under a different name) adoption of the Uniform Franchise Offering Circular format and guidelines (which effectively occupied the disclosure arena until 2007).These multiple starts established a regulatory morass that continues today.
To this day there is no single state or federal definition of the term “franchise.” There are now three basic approaches used to define a franchise: the California model, the FTC approach, and the Minnesota model (or community of interest approach). Each requires that the purchaser pay a fee and that the buyer receive, in some way, the right to use a trademark, service mark, or trade name of the franchisor. From there, the three approaches diverge.
DEFINING A FRANCHISE
The three main approaches give the average franchise purchaser a good overview of what are generally considered the essential elements of a franchise. Those elements include:
• payment of an initial franchise fee;
• the right to use a trademark, service mark, or trade name; and,
• an additional ingredient connecting franchisor and franchisee, called either a marketing plan, significant assistance, or community of interest. (Years of legal interpretation, case law, and advisory opinions further define the meaning of many of the esoteric terms and phrases used to define a franchise.)
From these three approaches a general definition can be formed:
A franchise is a legal business arrangement, governed and created by a contract, under which the franchisor (owner/supplier) sells to a franchisee (retailer/buyer) the right to sell certain goods and/or services of the supplier under specific, agreed-upon conditions, including the right to operate the business in association with the franchisor's trademark.
Consult the Abbreviated Glossary for a more precise legal definition under the FTC Rule.
California Model
The California model focuses on the franchisor's requirement that a franchisee follow a prescribed marketing plan. This approach is generally followed by Illinois, Indiana, Maryland, Michigan, North Dakota, Rhode Island, and Wisconsin and, with some variances, New York and Virginia.
Under the state laws adopting the California model, the term prescribed marketing plan is not specifically defined, but rather left for the courts to interpret and define. The various interpretations assigned by courts are well beyond the scope of this book, but suffice it to say that courts tend to "know it when they see it." In other words, any advertising or marketing plan or system outlined by a franchisor will do.
FTC Approach
The FTC approach requires a franchisor to exert, or have the authority to exert, a significant degree of control over the franchisee's method of operation or to provide significant assistance to the franchisee in their method of operation before the relationship is considered a franchise. The Amended FTC Rule makes it clear that a “franchise” can be found regardless of the label or nomenclature used (license, dealer, etc.) Again, the Abbreviated Glossary provides a more precise legal definition under the FTC Rule.
While neither “significant degree of control” nor “significant assistance” is defined directly in the Amended FTC Rule, the 2008 FTC Compliance Guide indicates that “significant” types of control include: site approval, site design, hours of operation, production techniques, accounting practices, personnel policies, promotional campaigns, restrictions on customers and territorial restrictions. “Significant assistance” may include: formal training, establishing accounting systems, management advice, selecting locations, computer networks and websites and providing a detailed operations manual.
While the FTC Compliance Guide further vaguely interprets “significant” as a function of a franchisee’s level of reliance on the franchisor and the franchisee’s relative inexperience, the FTC is clear that overall “control or assistance must relate to the franchisee’s overall method of operation—not a small part of the franchisee’s business.”
The FTC offers more detail but you get the picture.
Minnesota
Model
(Community of Interest Approach)
Minnesota, Hawaii, South Dakota, and Washington follow the community of interest approach. Central to this approach is the requirement that a close mutual marketing relationship exist between the franchisor and franchisee. Similar to the California model, the state laws following the Minnesota model do not define the phrase community of interest. The language simply provides:
... the franchisor and franchisee have a community of interest in the marketing of goods or services at wholesale, retail, by lease, agreement, or otherwise.
Once again, the Minnesota model leaves it for the courts to decide. Quite simply, however, if there is any ongoing connection between you and a franchisor in the marketing the product or service of the franchise (i.e., royalties paid to franchisor), it is likely a court will find the required community of interest.
BUSINESS OPPORTUNITY PLANS
As a close cousin to franchising, business opportunity plans provide the framework for certain dealerships and distributorships that can be easily confused with typical franchises. Generally speaking, a business opportunity plan is a hybrid of a franchise and a distributorship arrangement, though some definitions of business opportunity plan do encompass franchises. The most notable differences are that business opportunity plans often do not contain the trademark requirement and the laws governing them focus more on specific types of distributorship businesses, such as rack distributors, vending machine routes, and video machine sales and placement. Approximately 25 states have laws covering the sale of business opportunities (a list of states that require pre-sale registration of business opportunity plans appears in future chapters).
The FTC also regulates the sale of business opportunity plans and effective March 2012 a new FTC Rule applying to business opportunities takes effect. Go to http://www.ftc.gov/opa/2011/11/busopp.shtm for more information about the new FTC Rule for business opportunities.
TAKE-AWAY
As we noted earlier, there is no single state or federal definition of the term “franchise.” The legal definitions can be tricky and subject to many interpretations. The same can be said for “business opportunity plans.”
However, from this review you should recognize that almost any “start your own business,” franchise offering, and dealership or distributorship opportunity may be considered a regulated “franchise” or “business opportunity.” This means you should receive the advantages and protections of the various franchise and business opportunity laws and regulations. More on these topics in future chapters.
Chapter Three
Finding the Right Franchise
The starting point for finding the right franchise is not in any book, and no secret formula exists. It is so obvious that many would-be franchisees overlook it entirely. It is you.
Just as with other aspects of your life, finding the right franchise starts with your interests, background, education, and experience. For example, many franchise systems require direct owner involvement in the operation of the business. What kind of business appeals to you? Would you want to manage a restaurant? Do you have the experience or ability to run a computer training facility? Is cleaning carpets going to be a fulfilling enough work experience? Is dealing with folks whose cars are broken-down, really your cup of tea?
Before you consider buying a franchise, let alone a specific type of franchise, you should ask yourself some very fundamental questions.
• Am I a team-player?
• Can I accept direction from others and play the role of follower to get my business rolling?
• How do I feel about sharing my profits with someone who has not made a direct cash investment in my business?
• Do I know what it takes to run my own business even under the protection of a franchise system?
• How many hours am I willing to devote to the business and am I willing to pay the price?
Example:
One client, who faced lay-offs after twenty-five years from a major commercial shipping concern (she was the chief shipping clerk, a position of considerable responsibility), was desperate to start her own business. Being inexperienced in new business affairs, she thought franchising could make up any deficit. Although most of her experience involved keeping track of vast amounts of shipments and working on her own with numbers, reports, and accounts, she was determined to do something new and began looking at temporary employee/personnel placement franchises. She thought working with people would be fun.
Without any professional assistance, she selected a franchise system with a solid background and good track record. Within a year, however, her business was a shambles. When she visited a law office to lay blame on the franchisor, it became apparent that she, not the franchisor, was at fault. She was absolutely, positively not a people-person. She hated dealing with people, had the personality of a snail, and just could not believe that people needed so much hand-holding after she placed them in a position.
The message is clear—before you consider buying a franchise or starting any other business, you should conduct a thorough self-analysis of your goals, aspirations, abilities (including weak points), and personality traits, good and bad. Be candid with yourself about your level of ability and own up to those traits that are undesirable in a franchisee or any other type of small business owner. The value of this self-analysis cannot be overstated. First, know thyself.
The next step is to consider your interests and knowledge in different business areas. Business advisers the world over routinely advise newcomers to focus on areas where they have an interest. The chances for success are much greater if you choose something you enjoy doing. Few successful people have a strong dislike for their business enterprise.
SHOP AROUND
Once you have done a thorough self-analysis, you can start the search for a specific franchise in earnest. There are many franchises to choose from in any location or industry. You might already have one in mind or simply be exploring franchising in general with the intention of choosing a franchise you believe is right for you. Or, you may be considering starting your own business and are simply giving franchising a sideward glance along the way. Whatever your approach, you will have better results if you do a little comparison shopping before buying a franchise.
The first rule is patience. Some people intend to be patient, but their juices start flowing at the very thought of starting their own business. The sooner we get going the better-they think. In reality, a no hurry attitude will serve you best through the entire purchasing process. People who are in a hurry tend to make mistakes and let emotion rule reason. It is important to control your emotions and tell yourself that you have the upper hand. Like the vending machine buyers at the beginning of this book, the majority of people who later regret their franchise purchase decision simply did not take the time to properly shop their purchase at the outset.
LET THE BUYER BEWARE
The success and resulting growth of franchising are undeniable. It is the preferred choice when compared to business starts that are unsupported by franchising systems. But, while the advantages are obvious and enticing, franchisors and franchisees do fail. Some franchisees, of course, fail of their own accord. Others fail because of a poor franchising system or franchisor malfeasance. Because the franchising concept is being applied to an ever-growing number of businesses-some unproven-prospective buyers must proceed cautiously.
No one in the franchising and distribution community likes to talk about the numerous low-investment, ill-managed franchises and business opportunities that sweep the nation each year. Although this happens less frequently today, over-eager entrepreneurs are still taken advantage of by fly-by-night operators. Most victims were driven by emotion rather than prudence, logic, and a careful, systematized franchise search.
STARTING YOUR SEARCH
Before you begin your search, it is important to be franchise-educated. Knowing what to look for will clearly improve your selection ability. Use your education wisely to eliminate as many risks as possible.
There are a number of resources available to help in your search for the right franchise. To become an astute franchise buyer, you should take advantage of as many of these resources as possible. There is plenty of information available through networking and on the Internet.
International Franchise Association
An excellent starting point is the International Franchise Association (IFA), the oldest and largest of the franchise trade associations. While primarily an association of franchise companies, the IFA has welcomed a large number of franchisees into its ranks. The IFA has fashioned a more balanced approach to their role in the franchising world than in years past and is forging a reputation as a moderating voice in the sometimes contentious relationship between franchisors and franchisees. The IFA has a list of publications to assist you with your purchasing decision. The IFA can be contacted at:
International Franchise Association
1501 K Street, N.W., Suite
350
Washington, D.C. 20005
Phone: (202) 628-8000
Fax: (202)
628-0812
www.franchise.org
The IFA's website includes the IFA's Franchise Opportunities Online Guide. It contains numerous franchise offerings listed alphabetically, by category, and by total cash investment requirements. The IFA website offers an array of information that literally opens a window to the world of franchising by providing links to other sites and internal informational features.
Other Franchise Associations
Two other associations offer information to the franchise purchaser. Both provide information to potential franchisees and serve existing franchisee members by seeking to influence state and federal franchise legislation, developing meaningful dialogue with franchisors concerning the content of franchise agreements, and attempting to bring greater fairness to the franchise relationship. Both are dedicated to the plight of franchisees and also maintain a list of publications for the franchise buyer. The two associations are:
The American Association of Franchisees and Dealers (AAFD)
P.O.
Box 81887
San Diego, California
92138-1887
800-773-9858
www.aafd.org
American Franchisee Association (AFA)
53 West Jackson Blvd., Suite
205
Chicago, Illinois 60604
800-334-4AFA
www.franchisee.org
According to their website, “the AAFD is a national non-profit trade association representing the rights and interests of franchisees and independent dealers throughout the United States. The AAFD was formed by Declaration of Trust in May of 1992 with the original mission of "Bringing Fairness to Franchising." As the AAFD has expanded and evolved, and as many fine franchising companies have stepped forward to contractually embrace the promise of Win-Win Franchising, the AAFD's mission has expanded, but can be succinctly stated as follows: To define, identify and to use marketplace solutions to promote Total Quality Franchising.”
The AFA’s website indicates that “The American Franchisee Association (AFA) is a national trade association of franchisees and dealers founded in February 1993. The AFA works to improve the industry of franchising while protecting its members’ economic investments in their businesses. AFA advocates for and provides testimony in favor of changing the rules and laws that govern franchising on both the state and federal level. In 1995 the AFA organized its franchisee and dealer membership nationwide, attaining the election of 137 delegates from 27 different chains to attend the White House Conference on Small Business in Washington, DC where franchisee legal issues were among the final 60 recommendations presented to the President and Congress for immediate action.”
Both websites offer a wealth of franchise buying and franchise relationship information and guidance.
Popular Press and Online Resources
Other offerings on franchising through the popular press and online resources include:
Entrepreneur Magazine
Franchise 500 Survey
(Published in
January Edition)
714-261-2325
www.entrepreneur.com
Franchise Update Media Group
6489 Camden Ave., Ste. 108
San
Jose, CA 95120
PH. (408) 997-7795
www.franchise-update.com
Blue MauMau
www.bluemaumau.org/
Contacts:
www.bluemaumau.org/contact_us
FranchiseHelp.com offers:
Step-by-step guides for selecting the
right franchise
A list of franchise opportunities
Franchise
disclosure documents and research reports (for a
fee)
www.franchisehelp.com/
James A. Meaney, Attorney at Law
My website devotes an entire page
to many franchise resources
www.fddlawyer.com/resources.php
These resources offer a broad range of information and leads to other resources.
Frandata
Frandata, a fee-based information resource, gathers information marketed primarily to franchisors and their service providers and maintains comprehensive information on franchise companies. Frandata has overviews of franchisors within specific industries as well as a multitude of franchisor's disclosure documents (although you can generally obtain the disclosure documents free of charge directly from the franchise company). Frandata can be contacted at:
Frandata
4300 Wilson Boulevard Suite 480
Arlington, VA
22203
703-740-4700
www.frandata.com
FTC
As discussed in greater detail later in the book, the Federal Trade Commission is the only federal agency regulating the franchise industry. Its regulation of the franchise industry, however, is very loose. The FTC maintains information on franchising in general and may disclose public enforcement actions taken against franchisors. You can view a tremendous volume of information about franchising (including the full text of the FTC Rule concerning franchising) at www.ftc.gov. In addition, under the "About FTC" link, you can obtain the department telephone numbers and complaint forms for the agency but here is the main contact information:
Federal Trade Commission
600 Pennsylvania Avenue, NW
Washington,
DC 20580
(202) 326-2222
www.ftc.gov
SBA
The Small Business Administration (SBA) has had a growing interest in franchising, offering assistance with loans and general information on franchising. Contact your local SBA office to obtain the information they have available on franchising and the loans they make available to purchase franchises. To find the SBA office near you and for other valuable information, go to www.sba.gov and just click on the map. Like the FTC Web page, a virtual treasure trove of information can be found on the SBA Web page.
In addition the SBA has authorized and participates in The Franchise Registry, a web-oriented partnership between the SBA and FRANdata that offers franchisees expedited loan processing through the SBA. The essence of the Franchise Registry program is streamlined loan processing. This is accomplished through a centralized review of franchisor-worksheets and franchise agreements; eliminating the need for independent review at one or more of the 69 local SBA offices.
In explaining the SBA-FRANdata partnership, it is noted on the website that “FranchiseRegistry.com is a site that allows franchisees to see which systems are participating in the program, SBA lenders to see details of the SBA approval, and franchisors to submit applications.” The Franchise Registry is not a pre-approval for SBA financing on particular deals or for a specific system’s franchisees. It may simply expedite the processing of a qualifying loan.
Visit www.franchiseregistry.com/ for more information.
State Offices
In some states, the State Securities Administrator or the Attorney General may have a list of franchise companies registered with the state. Although it is difficult to extract any meaningful information from state and federal officials on specific franchise offerings, they are permitted to disclose publicly-filed actions taken against franchisors. Make the effort to contact these officials to inquire about any actions taken against a franchise company that interests you. Easy access to the state offices can be found on my website www.fddlawyer.com/resources.php
Other Franchisees
A primary source for information about franchisors may be right around the corner. Assuming that most people would like to own a business in their own community, talking with local franchisees would be the logical place to start when seeking a realistic appraisal. Discussing the system with someone already familiar with it should provide invaluable information.
Trade Shows
Other ways you can start your search are to look in the business opportunity section of your local newspaper or attend a franchise trade show. If you do, be very careful and selective. Some franchisors enhance their ads with exaggerated claims, while trade shows can be over-hyped, emotionally-charged atmospheres. Many of these “you can't lose opportunities” prove to be exactly the opposite.
The FTC has taken enforcement action directly against trade show promoters for failing to properly screen and supervise franchise and business opportunity participants. Newspapers and trade show promoters do not ensure that the ads or information being distributed are factual. So, especially if this is your initial exposure to franchising, you need to backup all information with hard facts before making any purchasing decision.
PATIENCE
Conducting a proper search does not end with choosing the type of franchise you would like to buy-it is only the beginning. While it is important to select an area in which you will be happy, and hopefully successful, remember that patience is the watchword and analysis is imperative. You want to make an intelligent, deliberate decision about how you are going to plot your successful future.
During the late 1960's and early 1970's, a wave of bogus start your own business opportunities swept through the United States. Numerous complaints rolled into government agencies, prompting state legislatures and the FTC to take action to stop the rash of fraudulent schemes.
It was found that many of the victims were first-time investors who knew little or nothing about purchasing a business. Many lost their life savings or retirement income to fast-talking salespeople who made false claims. The FTC, after reviewing voluminous complaints against these early, fraudulent franchisors, realized that these deceptive and unfair practices occurred largely due to an informational imbalance between franchisors and franchise buyers. In light of this, regulators concluded that franchise purchasers should be able to get more complete information about the business system they were going to buy. This gave rise to the disclosure laws in effect today.
To correct the imbalance, the FTC and a number of state governments borrowed the concept of pre-sale disclosure from the securities industry. More precisely, the disclosure and registration policy came about because, under existing securities laws, attempts to prosecute unlawful franchise sellers failed. As a result, it is now standard practice for the proposed buyer to receive disclosure documents in advance of every franchise and business opportunity sale.
The FTC and approximately twenty-five states have adopted laws protecting prospective franchise and business opportunity buyers. In states where no specific state law is on the books, the Amended FTC Rule fills the void. The basic framework of the state laws and the Amended FTC Rule is to provide a disclosure document prepared by a franchise company for prospective purchasers.
DISCLOSURE DOCUMENTS
The basic disclosure document sets forth 23 categories of information about the franchise company. This information is vital to your purchasing decision. Although the length of the disclosure document may be somewhat intimidating, it is essential that you take the time to properly review it. (The next chapter explores what to look for in disclosure documents)
Although the FTC does not require franchisors to register (file) disclosure documents, some states—the so-called registration states—do require franchisors to register disclosure documents with the state Securities Administrator or the Attorney General. This allows state agencies to regulate franchisors who sell in their states more closely and makes it easy to determine whether a franchisor is complying with the state's law. (See Appendix C for contact information for state agencies that oversee franchise and business opportunity disclosure laws and regulations.)
If you are buying a franchise in a registration state (or are resident of a registration state), your search should begin with a call to the government agency in charge of registering franchises to make sure the franchise company is registered. If it is not, you have reason to be concerned. State registration is a basic requirement of a legitimate franchise sales program and any system that has not registered is suspect. Remember though not all states require registration.
The following states presently require registration of franchises.
• California
• Hawaii
• Illinois
• Indiana
• Maryland
• Michigan
• Minnesota
• New York
• North Dakota
• Rhode Island
• South Dakota
• Virginia
• Washington
• Wisconsin
The following states require registration of business opportunity plans.
• California
• Connecticut
• Florida
• Georgia
• Indiana
• Iowa
• Maine
• Maryland
• Michigan
• Minnesota
• New Hampshire
• North Carolina
• Oklahoma
• South Carolina
• South Dakota
• Texas
• Utah
• Washington
Contact information for the state regulatory agencies can be found at the end of this Chapter, in Appendix C and at www.fddlawyer.com/resources.php.
While the Amended FTC Rule and various state laws protect prospective franchise buyers, the major drawback to these provisions is their lack of uniformity. As discussed earlier, each state law is slightly different and they all differ from the Amended FTC Rule. Some states require more disclosure information than the Amended FTC Rule; others require less. The Amended FTC Rule states that disclosure in all states must be at least as strict as the Rule. However, if a state chooses to have a tougher regulation than the FTC, that is permitted. If it sounds confusing, it is. Because of this confusion, it is a good idea to work with an attorney and at least get a basic disclosure document from the franchisor.
INITIAL CONSIDERATION
The important thing to do as you seek disclosure information is to find out if the business you intend to buy is a franchise or a business opportunity covered by a protective law. This means the essence of the offering must be analyzed to determine if the proposed relationship will be considered a franchise or a business opportunity under any applicable law. In some locations it may be a franchise, in others a business opportunity plan, and still, in others, both or nothing at all. As we discussed in the last chapter, it depends upon the applicable definition. This is not something you can generally determine on your own. Professional assistance is recommended to determine if the business falls under the protections offered by the Amended FTC Rule or state law. (Information about obtaining professional assistance can be found in Chapter 7.)
Returning to our vending machine buyers who we met earlier, one of the pitfalls they fell into was believing that the opportunity they were interested in was not regulated—that is, they did not realize at the time of their purchase that protective laws (in that instance a business opportunity law) required that they receive a disclosure document. Had they understood this, and used it to their advantage, the scam would have been easy to discover.
If the seller indicates that the company you are considering is not a franchise or a business opportunity under a particular law, and you are still interested in entering into a business arrangement, seek the services of an attorney. Surprisingly, sellers can sometimes be totally ignorant of the laws protecting purchasers of franchises, licenses, dealerships, distributorships and business opportunities. Many times this results from an over-eager entrepreneur who believes he can just sell licenses; other times, it can be someone who knows the law but chooses to ignore it. Either way, it is a sign of inexperience, so be on your guard. (Information about getting professional assistance is in Chapter 7.) As a general rule, if you are thinking of starting your own business as a franchisee, don't sign an agreement, pay any money or enter into a transaction until you know that the seller is complying with the various franchise disclosure laws.
COOLING-OFF PERIOD
In some states, in addition to disclosure documents and registration requirements, prospective purchasers are given cooling-off periods during which they can cancel a franchise or business opportunity contract after signing it. Cooling-off periods are more typically found in business opportunity laws than in franchise laws. It is not a good practice, however, to rely on a cooling-off period in lieu of solid investigation.
RELATIONSHIP LAWS
In addition to laws regulating the franchise sales, a number of states have laws governing a franchisor's termination of or refusal to renew a franchise. Known as relationship laws, they prohibit franchisors from terminating or refusing to renew a franchise without good cause and advance notice. Franchisees in certain industries, such as service station dealers and automobile dealerships, also have special state and federal laws guarding against unfair terminations. Without these laws, franchisees would have far less protection and fewer rights.
The following states have franchise relationship laws that may be of assistance at the end of your relationship.
• Arkansas
• California
• Connecticut
• Delaware
• Hawaii
• Illinois
• Indiana
• Iowa
• Michigan
• Minnesota
• Mississippi
• Missouri
• New Jersey
• South Dakota
• Virginia
• Washington
• Wisconsin
Government regulation of franchising and its hybrid, business opportunity plans, can be a confusing maze. Despite the confusion in applying these protection laws, you, the prospective franchise purchaser, should take full advantage of all aspects of the law.
STATE AGENCIES
For more specific information concerning the laws that may apply in your situation, contact the following agencies.
Alaska
Attorney
General’s Office
Commercial and Fair Business Section
1031 W.
4th Avenue, Suite 200
Anchorage, Alaska 99501
(907) 269-5200
California
Commissioner
of Corporations
Department of Corporations
1515 K
Street
Sacramento, CA 95814
(916) 445-7205
Connecticut
Securities
and Business Investment Division
Connecticut Department of
Banking
260 Constitution Plaza
Hartford, CT 06103
860-240-8299
Florida
Consumer
Services Consultant
Department of Agriculture and Consumer
Services
Division of Consumer Services
407 S. Calhoun
St.
Finance & Accounting Section
Tallahassee, FL
32301
(850) 488-2221
(800) 342-2176 (FL only)
Georgia
Office
of Consumer Affairs
No. 2 - Martin Luther King Dr.
Plaza Level,
East Tower
Atlanta, GA 30334
(404) 656-3790
(no filing
required)
Hawaii
Securities
Examiner
1010 Richards Street
Honolulu, HI 96813
808-586-2727
Illinois
Franchise
Division
Office of Attorney General
500 South Second
Street
Springfield, IL 62706
217-782-4465