Business and Franchise Tips

Over the past month, our office has gathered some basic information that relates to businesses and franchising, and more specifically to franchises in the restaurant industry. The basic information below is meant to help franchisors plan for the year and future growth and expenses. While some of the information has been taken from various publications and resources, some of the information is our opinion. The below is not legal advice or our promotion of any products or services and should not be construed as such.

1.    Bernstein Research in New York expects a 4% growth in restaurant sales in 2013—assuming the economy remains about where it is now.

   2.  OBAMACARE –the below are some statistics that are meant to help you understand the possible impact of the health care mandate.

a.    The Hudson Institute (for IFA) estimates the health care mandate will cost the franchise industry $6.4 billion dollars.

b.    McDonald’s estimates that it will cost $10,000 to $30,000 per store.

c.    Jack in the Box estimates the cost to be $10,000 per employee, but that the cost can be covered by a 1% increase in menu prices.

d.    Most sources and experts are recommending a price increase over cutting working hours, but that is in flux. Each franchise system needs to balance the fear of backlash relating to cutting working hours versus the fear of backlash relating to increased menu prices and/or loss of menu items.

e.    GE Capital believes the restaurant sector will ultimately weather this and will be able to cover the increase in costs through price increases alone. However, the amount of price increases and the public perception of an increase as the economy remains slow was not specifically addressed.

3  3.  CONSCIOUS CAPITALISM BY JOHN MACKEY

This book may be a helpful read to franchisors and business owners in all sectors. We have not read the book but several articles have referenced both John Mackey and his book in recent publications. John Mackey is the founder of Whole Foods. His basic theory is that the owners of a corporation should view the business as an opportunity to create value for the owners, employees and the communities where they do business. Value is defined in many different ways. In the long run a company that creates value will do far better because doing so changes the way the managers and other employees view what they are doing. However, it is important that the value created needs to become a central part of the corporate culture if this Whole Foods model is to succeed.  The book questions the traditional “profits and all costs” model as being often counterproductive and one that can readily create enemies.

4  4.  RULE OF THUMB FOR EQUITY CAPITAL –For Investors in a restaurant system

As a typical rule of thumb for restaurant acquisitions, the equity capital investor is looking for:

a.         $750 per square foot in sales;

b.         $300 per foot cost to build;

c.         18-20 percent unit level cash flow;

d.         Cash-on-cash return on investment of at least 40%

The above points and tips hopefully will help you in your business whether it is in creating growth, in creating a new corporate culture or in preparing your business for acquisition by another individual, company or investment firm. 

Annual Franchise Renewals

If you are a franchisor, you are (or need to be) aware that it is, for most franchise systems, franchise renewal season. It is that time of the year when you are required to update your FDD with any material changes and to include a new audit for 2012. It is important to note that for most franchise systems, if you do not update your FDD you will be unable to offer or sell franchises after April 30, 2013, and as early as March 31, 2013 in some registration states.

This post is meant to give some helpful tips on preparing for this hectic time of the year.

·         Order your audit early –as in today. In reality, we recommend that your audit be ordered no later than January 31, 2013. This is because audits can take time and you will not have a completely updated FDD without an audit.

·         Between now and early February, sit down with your sales team and/or those overseeing the franchise system to discuss what material changes you would like or need to make to the FDD and franchise agreement. This can be anything from a change in royalties to how training is conducted. If you have found that you are continuously waiving a “requirement” with each new franchisee, you will want to talk to your franchise attorney about whether or not that should be a material change. A good place to start is with your Items 5, 6 and 7 and make sure that all the amounts stated are still true and accurate.

·         Take time to accurately fill out Item 20. This is often left to the last minute, but the 5 required tables are important and should accurately reflect the status of the franchise system.

·         Review any ancillary agreements you require your franchisees to sign. According to the FTC Amended Rule, “franchisors are required to attach a copy of all proposed agreements relating to the franchise offering that the franchisor provides or for which the franchisor makes arrangements.” This can include a required lease agreement form, ADA Certification, Personal Guarantees, Confidentiality Agreements, ACH Agreements, and many others. You will want to discuss with your franchise attorney all the agreements you require or provide for your franchisees to determine if they are required to be included in the FDD.

The renewal process can be long and arduous. But if you follow the above tips and take the time early on, the process can be smoother and you will be able to offer and sell without any delay.

Several registration states offer guides and tips in helping you through the annual renewal process.

The California Department of Corporations 
The State of Indiana
The State of Virginia (franchise forms)

Franchisor Control and Liability Issues

One area of a franchise system that must carefully be examined by franchisors is the amount of control exerted over both franchisees and the franchise system. Courts are increasingly finding ways to impose liability on the franchisor for the actions or omissions of the franchisee. As a rule of thumb, a franchisor is able to exercise the amount of control necessary to protect the brand, goodwill, trademark and quality control of services and products. Overstepping this can lead to devastating consequences.

When examining the possibility of imposing liability on a franchisor, the courts look at both the franchise agreement and the actions of the franchisor. The greater the level of control in the day-to-day operations or the details of the franchisee’s business, the greater the likelihood of imposing liability on the franchisor. For example, becoming involved in the hiring and firing of a franchisees employees can lead to imposition of liability, dictating the exact method of how floors should be cleaned, at what times and with which products can lead to liability, as can having security cameras on the franchisee’s premises that the franchisor continually monitors.

There are generally three types of liability imposed: vicarious liability, liability in a co-employer relationship, and liability in that the franchisor acts as the actual business instead of the franchisee. For the last type of liability, the courts looks at whether a franchisee can and will reasonably and justifiably believe the franchisor actually controls the operations of the business, and not the franchisee.

Avoiding the above-types of liability and other possible liabilities requires a franchisor to make careful considerations. Clearly maintaining a level of control is a necessity in a franchise system. However, the issue of control and the imposition of liability will continue to be a litigated issue. Franchisors should exercise caution when expanding controls, and should speak with a qualified franchise attorney to help them understand if the controls exerted stay within the acceptable levels of control or if they carry with them the possibility of liability. 

Helpful Resources:

Franchisor Liability for Franchisee Actions

Forgotten Essentials: Estate Planning for Business Owners

Business owners understand better than anyone that there are not enough hours in the day. With all the time, effort, and duties surrounding owning a business, a business owner can get overwhelmed with the number of items on their to-do list. Often a business owner will overlook one legal area that may ultimately be most important: estate planning.

 

Business owners work hard to build their businesses. This is usually done with the goal of providing for their family. However, without some estate planning, if the business owner passes away, all the hard work will not have been worth it because the family will not be protected.

 

The first estate planning tool for a business owner to consider is a buy sell agreement. This is an agreement that governs what happens if an owner dies or chooses to leave the business. This protects the interests of all owners. By agreeing beforehand how to handle these situations, the owners reduce the risk of lawsuits or other issues which could harm or ultimately ruin the business.

 

Next the business owner must consider estate planning documents that apply if the owner is incapacitated. This includes powers of attorney and advanced directives. A power of attorney is an authorization for someone to act on behalf of another regarding that person’s financial or legal needs. If an owner is incapacitated, then someone needs to have the power to make decisions and keep the business operating until the owner is able to do so himself or herself. Advanced directives are a set of written instructions for taking care of the health care decision of someone who is incapacitated. This helps ensure that the wishes of the owner regarding the medical they would receive if incapacitated are followed.

 

Finally, the business owner should make a will and consider using a trust, family limited partnership or LLC for certain property. This ensures that the business owner’s assets are divided between his or her heirs in the way that the business owner believes is best. The estate planning tools used by the business owner may have significant tax consequences.

 

In making any of these estate planning decisions, a business owner should consult an attorney to decide what would be best for his or her circumstances.

 

 

Success in Franchising

When I tell someone that my business law practice focuses on franchising, I will at times get a blank stare. This is where I explain that franchising is a concept where a person licenses out their brand and business system to another person in order for that person to operate a similar business under the same name. If I am still getting a deer-in-the-headlights look, I will say, you know, like McDonald’s. Once the golden arches are mentioned everyone understands.

 

However, I was recently reading an online article from Entrepreneur Magazine about the top franchises[1]. The surprise I took away from this article was the fact that Subway outranked McDonalds on the list of America’s top 10 franchises and the top 10 international franchises.

 

I don’t know the exact ingredients that Subway has combined in order to make their franchise even more successful than the most well known franchise in the world. If I were to guess, I would not bank it on the popularity of Jared as a spokesperson, $5 footlongs, or the innovative and newest sandwich. Instead, I would guess that, in some way, Subway’s franchisees are making more money than McDonald’s franchisees.

 

Whenever I meet with a new startup franchisor, the number one thing I like to emphasize is that a successful franchise brand is one in which the franchisees are successful. There are other issues to consider for success, but a franchise system in which the franchisees have the ability to make money will grow. Successful franchisees will tell others about the franchise and franchise sellers and brokers will feel comfortable pushing the franchise brand over other brands.

 

Some other factors that go into the success of a franchise business include: having a teachable system in place; providing the proper amount of support to the franchisees; excellent training; creative branding; and good marketing. All of these things will help the franchise system grow. But when you really focus on these additional items, they all boil down to the same goal: helping the franchisee turn a profit.

 

So the next time you want to brainstorm about expanding your franchise business, first look to your system and see how you can help your franchisees increase their profits. This will help you increase the number of franchises in your system. Maybe one day your system will be even more recognizable than the golden arches.

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[1] http://www.entrepreneur.com/slideshow/222422

Franchisor Duties: Protect the Brand

Recently the Quebec Superior Court ruled that Dunkin’ Donuts’ master franchisee had failed to protect and enhance the Dunkin’ Donuts brand in Quebec in violation of its contractual obligations under the franchise agreement with its Quebec franchisees. The Superior Court noted that this was one of the franchisor’s few duties under the agreement and its failure to do so led to 200 store closures.


This is a chilling reminder to all franchisors of their duty to protect the brand. In the Dunkin’ Donuts’ case, the franchisor claimed that it was competition from another brand that hurt their system. But the court showed that the franchisees had alerted Dunkin’ Donuts of the competition back in 1996 and asked for some sort of plan to respond to the effect the new competitor was having on their sales. Unfortunately, Dunkin’ Donuts did nothing to try to counter the negative effect this new competition was having on its franchisees.


This is just one example of how a franchisor can fail to protect the brand. The franchisor needs to be constantly aware of its brand and protecting that brand in the market. Some of the areas the franchisor needs to monitor to protect its brand are as follows:

• Make sure that franchisees are using the brand only as directed by the franchise agreement and operations manual. Franchisees that do not follow the system and operate under the brand name can effectively hurt other franchisees.

• Monitor the use of the trademark to ensure that others are not using the marks or marks that are significantly similar to the franchisor’s mark. This can dilute the marks, cause confusion in the market and ultimately hurt the value of the brand.

• Monitor competition with the brand and come up with ways to counteract the effects of competition on the brand. (This is the Dunkin’ Donuts example.)

• Review the brand to ensure that the brand is current for the marketplace. This may mean updating the brand so that it appears fresh and continues to draw old and new customers.

Vicarious Liability and Franchisors

A rising concern for franchisors is being found vicariously liable for the acts of its franchisees. Previously, when a franchisor was sued, the franchisors could cite the fact that the franchisee’s business was “independently owned and operated” from the franchisor’s business to be removed from the lawsuit during summary judgment and escape being dragged into trial to determine liability. However, in the last 20 years courts have looked to the controls of the franchisor over the franchisee’s business to deny summary judgment and allow a jury to find the franchisor vicariously liable.

This leads the franchisor with the unclear position of trying to determine how best to keep its system uniform and protect its trademarks through controls and yet not cross over this hazy line to be found vicariously liable.

The nature of the franchise business is a long term relationship that needs uniformity and flexibility. To meet these objectives, most franchisors exercise controls through an operations manual. The courts not only look at the franchise agreement to determine liability, but they also look to the operations manual. This is a very broad test of control. The concern about such a broad control test is that almost every franchisor has very significant controls through their operations manual in order to maintain uniformity and protect their marks.

Recently, some courts have been more specific about the controls they look at to determine vicarious liability. The controls must be related to the matter that was the cause of the injury. Just because the franchisor gives guidance and controls over a majority of the franchisee’s business, that is not enough, unless the franchisor had the right to control the particular activity giving rise to the claim. Even if the franchisor gives direction and guidance regarding the direct activity that caused the injury, there may be some additional hope for the franchisor. In Ketterling v. Burger King Corporation the fact that Burger King’s operations manual specifically stated that the franchisor did not have control over the day to day operations of the franchisee made the court find that the franchisor could not be vicariously liable and allowed summary judgment.

When drafting an operations manual, the franchisor should consider the following:

1)         Does the control lead to an obvious potential vicarious liability claims? If so, consider the following question.

2)         Are the controls necessary for protecting the franchise system and trademarks? If not, the franchisor may not want to include such controls. If so, the franchisor should consider the following question.

3)         Does the operations manual clearly and concisely state that the franchisor does not control the day to day operations of the franchise business? If not, the franchisor should include this in the operations manual and in the franchise agreement.

Tips On Being Ready To Franchise Your Business

Franchising your business is a great way to expand your business without the requirements of upfront capital that company expansion would require. Franchising may appear to be the “golden ticket” to financial security, but if you and your business are not ready to enter into the business of franchising, then the seeming golden ticket may end up being a mirage. This post is meant to give an overview of things you want to think about before taking the giant step into the world of franchising. Remember, if your business is not ready for franchising, pushing it there might result in ultimate failure.

What is your Golden Egg? The reason the golden egg was worth such sacrifice and effort to obtain in the fairy tale of Jack and the Bean stock, was because it was unique. Everyone can obtain a regular egg, but the golden egg? that was unique and difficult to procure on one’s own. If you are considering taking your business to a franchise business, you need to have that “golden egg.” You need to know what would draw a potential franchisee to not only consider your franchise concept, but pay you to be a part of it. This does not mean that your concept has to be a one of a kind or extraordinary concept or service, but the way it is done, or the manner it is procured needs to be something that would compel someone to buy. Closely examine your business to find out what unique element, idea or service you can offer your franchisees.

Is your business a proven concept? Another way to ask this question is whether your business has worked out most of the kinks and if your business is “turnkey” ready. A startup concept is typically not ready for franchising because the concept has not been worked out and tested in the market. Even if you have just a couple of stores or units open and operating, if they are successful and the public is accepting of the business, then your business model may be ready for franchising. There is no hard and fast rule as to how many stores or units need to be in operation before you are ready to franchise, but

Is your business easy to learn? A successful franchise concept is going to be easy to learn. Some franchising guides will ask if your business is easily replicated. You may be worried that if your concept is easy then others will steal the idea and leave you behind. This is a risk with any business; but remind yourself of the first point above. A unique business does not have to be difficult to explain or replicate –it just has to be unique in some way. You want your franchisees to be able to understand the concept immediately and to feel comfortable that they can be successful. A business model that can be easily taught and duplicated for your franchisees is a key element in being ready to franchise.

What is being sold –you or your business? Take a step back and determine whether your business is successful because of your stellar salesmanship, or the location, or another extraneous factor, or is it successful because of the concept meaning it can be successful if run in most locations and by most people. Of course this is generalizing things, but the point is, the concept itself needs to be saleable. If you take the super star location away or the super star salesperson away, will your concept still work. If the answer is yes, then you are on the path to being ready to franchise.

Do you have the time to sell and teach your business? Franchising is a new business. You may have a successful business model for a store that you have been running, but franchising will take you away from that business and require you to focus on the new business of franchising. Some of the most successful franchises are those where the franchisor is committed to helping franchisees succeed and take the time to train. Most successful franchisors are dedicated to producing a symbiotic relationship with their franchisees.

Do you have sufficient capital? While franchising requires less capital than self expansion would require, franchising is a business in and of itself, which requires capital. Here are just a few of the areas you will need to spend a substantial amount of money on: 1) Attorney fees. There are many regulations and rules at the federal and state level that are imposed on franchisors. In addition, there are regulated documents that must be provided to each potential franchisee and the requirements for those documents are strictly enforced. 2) Accountant fees. Every start-up franchise will need to provide an opening balance sheet and in some states, an audited balance sheet is required. You will also want to work with an accountant to set up your accounting system for franchisees, including how royalties will be collected, and what line items should be included in the reporting by franchisees. 3) Staff. Franchising is a new business and requires staff with a different set of skills than you have probably hired for your own business concept. You will need sufficient support staff. 4) Advertising. Every franchisor needs to understand the value of advertising and marketing. You will need to promote your franchise in order to sell your franchise.

The above are just pointers and there are exceptions to most rules. However, by going through the list you can feel more confident in your decision to hold off on franchising or to move forward with franchising.

Franchisor Guide to Common Mistakes in Selling Franchises

Last week we blogged about the top franchisee missteps and mistakes when purchasing a franchise; this week, we thought we would focus on franchisor missteps and mistakes when selling franchises. Generally these arise in two categories: 1) misrepresentations in the disclosure documents provided to prospective franchisees; and 2) failure to know and follow the procedural requirements during the sales process.

1. Misrepresentations. All franchisors must give a prospective franchisee a franchise disclosure document (FDD) prior to entering into a franchise sale. The FDD has 23 sections and hundreds of specific issues that must be disclosed to the prospective franchisee prior to entering into a franchise agreement. Just providing an FDD is not enough – it must be materially correct and not misleading. The consequences for inaccurate information can be severe.  Some of the areas that are regularly inaccurately disclosed include the following:

        a. Supplier rebates. Supplier rebates not only pertains to actual rebates that the franchisor may receive from suppliers due to franchisee purchases, but also applies to any other benefit that the franchisor receives from the supplier due to the franchisee purchases.

        b. Territorial rights and restrictions. Often the FDD will not accurately define the territorial rights of the franchisee and will fail to correctly disclose the franchisor’s reservations. If this is not clear and a dispute arises in the future, the franchisor may be more vulnerable to a lawsuit by the franchisee.

         c. Start up costs. The franchisor is required to provide the prospective franchisee with an accurate estimation of the startup costs for opening a franchise. Often this information is inaccurately reported in order to show a lower cost investment to help entice franchisees to purchase the franchise. However, this can be very dangerous for the franchisor. This is one of the easiest ways for a franchisee to show inaccuracy in the FDD provided by the franchisor.

2. Procedural Requirements. Under the FTC Franchise Rule, there are very specific rules related to providing disclosures, waiting periods and restrictions on what franchisors can tell a franchise prior to completing a franchise sale. If your franchise sellers do not follow the rules for franchise sales, the franchise sale may be illegal and lead to serious consequences, such as rescission of the franchise agreement by the franchisee. Some of the common mistakes include:

            a. Receipt page. Failing to collect a signed receipt page after sending the disclosure document to a prospective franchisee. Under the FTC Franchise Rule, the franchisor must keep a copy of all receipts for 3 years, whether or not the prospective franchisee purchases the franchise or not. This is the best defense to show that the FDD was provided and show that the waiting period was met. Too often the franchisor does not have this document when a problem arises with a franchisee.

            b. Waiting period. Not waiting the full 14 day period before collecting money or signing a binding agreement. Under the rule, the franchisor must send the FDD and give the prospective franchisee a full 14 days to review the documents.

            c. Earnings claims. Providing financial performance representations also known as earnings claims, either verbal or written, outside the FDD. Under the rule, the franchisor may provide numbers on historic or projected earnings ONLY within Item 19 of the FDD. There are certain disclosures and cautions that the franchisor must also provide with this information. Often sales staff will give out numbers that can be construed as financial performance representations. Even if these are accurate numbers, the rule only allows this information to be provided if it is in the FDD with the required cautions and warnings.

            d. State registrations. Some states require that the franchisor register its FDD with the state prior to selling (or even offering to sell) franchises in the state. Too often sales staff will offer a franchise or sell a franchise to a person who is in a registration state or plans to open the franchise in a registration state, without knowing if the franchisor’s FDD has been registered. This sort of action can create a rescission action for any contract entered into and it can also trigger fines and fees from the registration state. If the action is in blatant violation of the law, it may cause the state to disallow any further franchise sales in the state by the franchisor.

All of these issues can be avoided by ensuring that you provide accurate information to the attorney preparing your disclosure documents, regularly update your FDD for any material changes to the franchise system, and train your franchise sellers to understand the rules required to sell franchises.

More on Royalty Taxation

We have had a few requests to provide more information on the taxation of royalties received by franchisors. Ultimately, the KFC case (see KFC Corp. v. Iowa Department of Revenue, 792 N.W.2d 308 (Iowa 2010) held that having a trademark in a state is the equivalent of physical presence, thus satisfying the physical nexus required under the Supreme Court ruling in

Quill Corp. v. North Dakota, 504 U.S. 298 (1992). This is a topic that should be carefully watched and discussed with your legal counsel.

Below are links to several articles that provide more information on this topic. We are also preparing a more in-depth article which should be available in the coming months.

A great article summarizing these topics from the American Bar Association: http://www.americanbar.org/newsletter/publications/franchise_lawyer/5_state_taxation.html

Link to the IFA's summary of this issue: http://www.franchise.org/Franchise-Industry-News-Detail.aspx?id=51948

Link to the Iowa Supreme Court's ruling: http://www.iowacourtsonline.org/Supreme_Court/Recent_Opinions/20101230/09-1032.pdf?search=KFC+COrporation

Franchisor Royalties and Income Tax

In recent years we have noticed more states starting to impose a state income tax on franchisor royalties, even where the franchisor has no physical presence in that state. In 2011, the Supreme Court of Iowa, in KFC Corporation vs. Iowa Department of Revenue, held that Iowa was allowed to assess an income tax on the franchisor, on those royalties paid to the franchisor by KFC franchisees in Iowa. This decision was made despite the fact that KFC Corporation had no physical presence in the State of Iowa. The U.S. Supreme Court has declined to review the ruling.

This ruling, along with other recent court rulings in various states indicates that most states will likely begin, or continue, to aggressively pursue the collection of income taxes off of royalty income from franchisors, regardless of their physical presence in a state. Franchisors need to prepare for the possibility of having to pay income tax in various states. We suggest each franchisor with franchisees in multiple states begin working with an accountant to analyze taxable income with respect to these types of tax liabilities.