June 24, 2014

Opportunity and Risks: Counseling a New Franchisor

David J. Kaufmann, New York Law Journal
June 24, 2014

Counsel to franchisors are required to possess deep familiarity with the laws governing franchising: federal and state registration, disclosure and "relationship" laws; antitrust law; trademark law; the law of contracts; advertising law; labor law; tort law (especially with respect to "vicarious liability"); and, for financings and securitizations, securities and related laws. And, of course, all decisional law regarding these subjects.

However, very often counsel are asked fundamental questions posed by clients thinking of franchising their businesses, questions not related to law but to business: Should I franchise my business? What are the considerations for doing so? What legal and other documents will I need? As franchise counsel, we must be prepared to respond to these questions and amass the body of knowledge needed to do so. Let us try to review the basics in today's column and the column to follow.

Franchising Business Model
Your client may believe that its wildest dreams have already been realized—the business concept it imagined and developed on paper has come to life in the form of one or more company-owned units for which the public has expressed immeasurable enthusiasm. The client is an entrepreneur, her own boss and, perhaps most importantly, able to support her family by doing something she finds meaningful. Perhaps at this point the client will stop—satisfied that its business has hit its sweet spot and too nervous to push her luck by expanding further. Or perhaps, based on the business' success thus far and urging from the public, she is contemplating achieving success on a grander scale.

Enter franchising—a business model that accomplishes system expansion without the risks associated with funding, opening and operating additional company-owned units. In franchising, independent, third-party investors known as "franchisees" pay an initial franchise fee and ongoing royalty payments to the system's owner, known as the "franchisor," in exchange for the right to open and operate businesses under the franchisor's trademark and operating system.

Although franchising features its share of pros and cons when compared to more traditional methods of expansion, its ability to achieve swift expansion, put a system ahead of the competition, mitigate against the risks associated with fronting additional capital and opening additional company-owned units, and allow for expansion into geographic territories that would be too expensive and difficult for the franchisor to itself access, often favors exploiting this business expansion model.

Relevant Considerations
Before delving into the world of franchising, however, you must determine whether your client's particular business is right for franchising. Because franchising takes time, costs money, and exposes franchisors to various forms of liability, this determination should be made only after a serious analysis of relevant considerations. The following questions must be considered:

1. Does your client's business have a proven track record? Before incurring the cost and time associated with franchising, you must consider whether the client's company-owned unit or the units it is currently operating have a proven track record. After all, in order for a franchise system to flourish, the individual franchised units must be a success. If the company-owned units your client is currently operating are unstable or on the brink of failure, your client may need to focus on perfecting its system before offering it to others.

2. Does your client's business have staying power, or is it a flash in the pan? Certain business trends come and go, but successful and long-lasting franchise systems capitalize on those business segments with staying power. In order to ensure that interest in the franchise will not quickly fade away, it is crucial to consider whether the concept is just the latest trend that may slowly (or even swiftly) disappear or something that may stand the test of time while continuing to grow.

3. Does your client have a federally registered trademark that is well-recognized by the public? One of the most valuable assets to any franchise system is its intellectual property and associated goodwill. Before considering franchising, if your client has not already done so, it should register its trademark with the U.S. Patent and Trademark Office (USPTO). This not only helps ensure that the trademark does not infringe the rights of any other trademark holder, but also grants certain protections with regard to the trademark that is going to be the key identifier of its franchised brand. Prospective franchisees will also want to make sure that your client's trademark is protected. While it takes time for a trademark to become well-recognized by the public, the more recognition your client's trademark has, the better, as a powerful trademark provides for brand recognition and customer loyalty.

4. Is the business unique? While there can be multiple franchise systems within a certain business segment or industry, if your client wants to attract prospective franchisees and gain and keep customers, it is important that there is something special about its system that sets it apart from the competition. In order to survive and thrive, your client's system must bring something unique or improve on something that is already in the marketplace.

5. Would the client's business be well received by consumers in multiple geographic regions? While your client's business may be flourishing in its hometown, you have to consider whether the concept will be well-received in other locales. Some businesses may do well in a certain city or region, but not have the same appeal in other locales for any number of reasons. For this reason, if you are helping your client contemplate national or international expansion, it is important to consider whether there is demand for the concept in all regions or whether the business is best kept local.

6. Can the business be taught so that pertinent information may be imparted in one month or less? One of the key duties of a franchisor is to train its franchisees to operate the franchised business. Very often, prospective franchisees know little or nothing about running the type of business being franchised (or any business for that matter). Certain businesses may be too complex or require too much specialized knowledge to be taught to the average franchisee. A franchisor must be able to create a training program that allows it to train its franchisees thoroughly and within a reasonable amount of time.

7. Can the business be easily duplicated? Certain businesses are unique and cannot be replicated—such businesses are not typically appropriate for franchising. A franchise concept must be easily duplicated to ensure franchisees will be able to follow the model and ensure brand consistency.

8. Given the required initial investment, will the business yield an adequate return on investment to ensure financial health for the franchisee? Franchisees often expend a significant amount of capital to develop and open their franchised business. It is vital to ensure that the average unit yields a sufficient amount of revenue to make the initial investment worthwhile and to sustain the continued viability of the unit.

Planning Is Key
If you and your client have determined, after carefully analyzing the pros and cons of franchising as compared to more traditional methods of expansion, that franchising is right for your client's business, the tendency may be to jump right in and get started—eager to achieve swift expansion and put your client's system ahead of the competition. Crucial to understand, however, is that the most successful franchise systems emerge only after significant and careful planning. So what first steps are advisable in order to effectively franchise your business?

1. Obtain a Federal Registration for the Franchise System's Trademark. As noted earlier, even for businesses that ultimately decide not to expand through franchising, adopting a trademark and registering it with the USPTO is an important step in growing the business' brand identity. Indeed, a business' trademark is the symbol that will define the business and, eventually, engender valuable goodwill for the brand. The business' trademark will distinguish the business from competitors' businesses; become intertwined with the quality of the business' products and services; and, provide a uniform and common identity for the business.

The proper adoption and use of a trademark is even more vital in franchising, as the very essence of every franchise is the franchisor's licensing to its franchisees the right to operate under its name and trademark. After all, it is the franchisor's trademark and the public's recognition of that trademark that attracts franchisees to the franchisor's business to begin with. The exponentially higher value in opening a franchised McDonald's, for example, as opposed to a Billy Bob's Burger Joint, is due to the McDonald's name, trademark and reputation.

Accordingly, it is advisable that, before adopting a trademark, businesses seeking to franchise engage counsel to ensure that the trademark contemplated for the business is available for federal trademark registration and protection. The first step will be to conduct a "search" to confirm that no other individual or entity has already registered the proposed name such that the franchisor is precluded from enjoying principal rights in the mark. The second step will be to ensure that the proposed trademark contains elements that are, in fact, protectable and not subject to attack and copying. Finally, trademark legal counsel will assist in actually registering the final trademark with the USPTO, a process that can take upwards of one-and-a-half years. Once federally registered, the trademark will enjoy certain legal protections from competitors and other infringers.

2. Have Your Client Engage a Competent Franchise Consultant. Engaging a qualified franchise consultant is an investment that is sure to yield a valuable return, both in the short and long term. That is because the right franchise consultant has already "been there and done that," and is able to assist new franchisors as they embark into unchartered waters. Qualified franchise consultants often have backgrounds not only in franchising, but also in finance, business and economics. Furthermore, qualified franchise consultants have amassed significant experience in dealing with both start-up and mature franchise systems, and are able to prevent new franchisors from pursuing strategies and making decisions that have, in their experience, not worked for similar franchisors and franchise systems in the past.

In addition to assisting in determining whether your client's business is right for franchising to begin with, qualified franchise consultants serve a vital role in franchise program development, tactical planning, franchise relations, crisis management and strategic restructuring. Among the services provided by qualified franchise consultants are: actually evaluating, designing and developing a franchise strategy; ensuring that a franchise offering, franchise structure and franchise business' brand promise are all in alignment with that franchise strategy; developing franchise operations manuals; identifying the areas that need to be addressed in the development of a franchisor's business infrastructure while franchise legal documents are being developed; creating franchise sales programs; and, developing innovative and cost-effective franchise training programs.

However, new franchisors must beware, as not all franchise consultants are created equal. Before engaging a franchise consultant, it is important for a franchisor to conduct due diligence to ensure the consultant has a positive reputation in the industry, has significant and lengthy experience advising franchisors (especially larger, reputable franchisors) and has a record of assisting in the establishment of franchise networks that have "stuck" and proven successful.

3. Engage Competent Franchise Legal Counsel. Franchising in the United States is regulated at both the federal and state levels. Under both federal and certain state laws, franchisors are required to prepare what is known as the Franchise Disclosure Document (FDD), a document that sets forth in 23 distinct items specific, prescribed information about the franchisor and the franchise system. Although the FDD does not need to be filed or registered with the federal government, it does need to be filed and registered in certain "franchise registration/disclosure" states.

Other laws with which franchisors must be aware and familiar are referred to as "business opportunity laws" and "franchise relationship laws." Business opportunity laws indirectly regulate franchising and, like franchise registration/disclosure laws, may require a franchisor to complete a filing of some type. Franchise relationship laws, unlike franchise registration/disclosure laws which govern a franchisor's pre-sale activity, regulate the franchise relationship after the franchise sale has taken place.

New franchisors will also need legal guidance and representation as the franchise system matures, including assistance with negotiating franchise deals, preparing deal documents, updating the FDD when necessary, making renewal and amendment filings of the FDD with states featuring franchise registration/disclosure laws, assisting with merger, acquisition and securitization activity, and assisting with both franchisor and franchisee initiated litigation and other conflict resolution.

4. Form An Entity To Serve As Franchisor. Although not a requirement, it is advisable to form a new legal entity to serve as the "franchisor," the entity that actually grants the franchises. Forming a new entity will protect affiliated entities and other assets (such as company-owned units) from liability that may arise under the franchise system. It will also reduce the cost of having audited financial statements prepared, a requirement under federal and state franchise laws. The most popular entity choices for franchisors are limited liability companies and corporations.

5. Obtain Audited Financial Statements. As described above, federal and state franchise laws require franchisors to obtain audited financial statements, and to include those financial statements in the franchisor's FDD. Because the audited financial statements must be prepared by an independent certified public accountant, obtaining the audit can be an expensive undertaking. Because the fastest and least expensive type of audit is an "inception audit" performed for a company as of the date of formation, many franchisors are newly formed entities as opposed to entities with existing business operations.

David J. Kaufmann is senior partner of Kaufmann Gildin & Robbins; he wrote the New York Franchise Act while serving as special deputy attorney general of New York.

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