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Cronin’s Corner – Franchising

By Michael T. Cronin | Categories: Business & Tax Law | Share May 2013

A Quick Word and Checklist about Franchising
Mike Cronin

Michael T. Cronin

The purchase of a franchise business has many advantages.  Operating systems, training, advertising and brand name recognition are just a few of the reasons why many of us are attracted to franchises.  However, you need to do your due diligence and homework before making such a significant decision.  This article will focus, in a summary fashion, on some of the pitfalls and lessons learned in representing franchisees over the last 25 years.  These are all from real world examples.  The names have been changed to protect the innocent.

•    Lease Issues.  Make sure the term of your lease coincides with the term of your franchise agreement.  Most franchise agreements have a term of 10 years.  Many retail leases have a term of 5 years with 5 year renewal options.  For example, you acquire an existing franchise in a strip mall.  The franchise has an excellent financial track record and location.  However, 2 years into your franchise operations it becomes time to renew your lease at a substantially higher lease rate.  Even worse, the landlord is not willing to renegotiate the lease, and you are required to relocate.

•    Noncompetition/Restrictive Covenants.  Every franchise agreement will require the franchisee and its principals to enter into a covenant not to compete within a geographic region, which is generally a radius expressed in miles from any existing or future location of the franchisor or its affiliates.  However, many franchise agreements do not prevent the affiliates of the franchisor from opening other locations within your protected region.

•    Unexpected Working Capital Requirements.  Item 7 of the FDD provides very detailed analysis of your estimated additional investment.  At the end of this item is typically a line item for additional funds for the first 3 months.  Read the assumptions that underlie this amount.  Many times franchisees under estimate the working capital and additional out-of-pocket costs associated with generating positive cash flow from a new franchise.  There are always unexpected costs.  Be conservative and make sure you have an adequate cash cushion.

•    Use of 401(k)/Retirement Funds to Purchase a Franchise.  This is a growing source of financing for may franchises because of the credit crunch experienced by the melt down the U.S. financial markets.  While our financial markets certainly have better legs, it is at best a difficult situation to obtain a loan or financing for the start up of a franchise, absent your personal guaranty to a financial institution, which is backed by adequate collateral.  Thus, many individuals turn to their retirement funds.  Many traditional retirement fund administrators will view this as an impermissible use of retirement funds under ERISA or plan fiduciary obligations.  It can take several months and additional fees and expenses in order to transfer your retirement funds to an administrator, which will allow you to invest in an entity that you control to purchase your franchise.

•    Advertising/Co-Op Fees.  Pay attention to the additional amounts that you may be required to deposit into local and national advertising funds.  Determine what flexibility you have in your local advertising efforts.  There have been many disputes between franchisors and franchisees over the use of local and national advertising funds.  Advertising is an essential component of any effective franchise program.

•    Automatic Debits to your Operating Account.  In recent years, it has become standard practice in all franchise agreements to allow the franchisor to automatically debit your operating account for the monthly franchisor royalty fee, advertising fees and other amounts.  This can be problematic in months where you are operating in a working capital deficit or in seasonal slow months.  The NSF fees and other costs can become significant if you do not adequately manage your cash.  It is an event of default under almost every franchise agreement for you not to deposit all of your revenues into the operating account.

•    New v. Existing Franchise.  As a general rule, the purchase of an existing franchise, if it is profitable and well-run, will cost more than a new franchise.  However, you have the benefit of an up and running business with an established customer base and market presence.  Unfortunately, there are many unsuccessful initial franchises, which the franchisor takes control or acquires.  You should carefully review the tables in Item 20 of the FDD.  If you see a significant number of units being reacquired by the franchisor, that may be a warning signal.

•    Disputes with Partners.  Franchise businesses are no different than any other business.  Partners enter into an agreement with the best of intentions, and many end up in disputes.  The most difficult factual situation is a 50/50 ownership interest with 2 couples.  Deadlocks are difficult to resolve.  The business deteriorates while the owners fight.  Pay attention to the old cliché, it is as important to know the people you do business with as the business you are in.

Conclusion

If you do your homework and due diligence, the purchase of a franchise is one of the best small business opportunities that are available today.  Don’t be afraid to ask questions.  Surround yourself with competent legal and accounting professionals to help in this important decision.  As a side note, I am seeing more deals marketed that they are not a franchise due to recent negative publicity.  Well, I guess if it walks like a duck and flies like a duck it’s really not a duck.  I have also included a franchise agreement checklist, which is useful in negotiating key points.

Franchise Agreement Checklist

Negotiating and drafting a franchise agreement raises certain key issues for both the franchisor and franchisee.  This Checklist compares the position of the franchisor and the franchisee on these issues.  This Checklist provides general information and is not industry or state specific.  Applicable industry regulations and state franchising laws may raise additional considerations.

Issue Franchisor Position Franchise Position
Grant of Rights and
Exclusivity
• Limit the right granted to the franchisee to maximize franchise opportunities.
• Consider reserving the franchisor’s right to participate in the franchised business by including carve-outs based on:

  • territory;
  • methods of distribution; or
  • channels of commerce.

• To minimize competition, seek broad rights and exclusivity, even against the franchisor, based on:

  • territory;
  • methods of distribution; or
  • channels of commerce.
Territory • For optimal brand penetration in the broader market area, limit the franchisee’s rights to a specific location or a small geographic area.
• Allow expansion within a defined geographic boundary only on satisfaction of specific conditions or milestones.
• Seek rights within a large geographic area to maximize individual store profits.
• Reserve rights to expand to additional locations within a defined geographic boundary.
Operating Obligations
And Procedures
• Require strict compliance with the franchisor’s operating manual and specifications (such as adherence to uniform hours of operation, layout or design requirements and procedures).
• Impose minimum franchisee working capital and inventory requirements.
• Seek maximum flexibility and minimal franchisor involvement in management of the franchised business.
• Resist or minimize any working capital and inventory-level requirements.

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