Top 10 Mistakes Made by Small Businesses

To succeed in business you need to have a passion for what you do, failures cannot defeat you, and you must be  determined, optimistic and patient. Yet even with all these attributes some business owners still fail because they do not learn from the mistake of others. Below is a list of the top 10 mistakes made by business owners of small businesses and how to avoid them.

1)  Wrong Business Entity Choice. Which to choose? An LLC? A Corporation? An S-Corp? Choosing the right type of business entity can affect everything from management and ownership voting to taxes and personal liability.  Consult an experienced business attorney to determine which type of entity is best for your company.

2)  Under Capitalization. Most new businesses are underfunded because the business owners underestimate the cost of start-up and running the business and have unrealistic expectations of revenues from sales.  Most businesses take 1-2 years to turn a profit.  A business owner should expect to invest double what he originally anticipates. SBA loans are a great resource for start-ups and other small businesses.

3)  Lack of an Effective Business Plan.  Starting a business without a business plan is like starting a trip without a map. If you do not know where you are going, you will never get there. You can purchase inexpensive business planning software from most business supply stores. 

4)  Failure to Market Effectively.  Many small businesses waste money with ineffective marketing techniques. Be creative and utilize the internet and other forms of media. Make sure you have a good website that can be found. A marketing consultant may be beneficial as your business grows.     

5)  Lack of Necessary Agreements.  An operating agreement, bylaws, employment agreements and buy sell agreements are essential to your business. In addition, many business owners are victimized by having their brilliant ideas and business concepts stolen by employees, independent contractors and even business partners.  If you have employees, partners or consultants, these agreements are a must.

6)  Over-expansion. Do not confuse success with rapid expansion.  Focus on slow and steady growth.  Grow regionally first, build your brand identity and then expand out.

7)  Owners Lack Basic Accounting Skills.  Educate yourself on how to balance your books.  Well kept accounting is essential to any business. There are many self-help resources available and many competent accounts that can help. 

8)   Under Insured.  Businesses often fail because they lack the proper insurance. Insuring a business is less costly than most people think.  Obtaining proper insurance needs to be a priority.

9)  Businesses Try to Do It All by Themselves.  Most businesses do not take advantage of outsourcing.  Being a jack of all trades and master of none can keep your business from getting off the ground.  Know what you do well and seek help in the areas where you need it.

10) Wrong Choice of Professional Help.  Many small businesses think attorneys are an unnecessary expense.  However, many law firms offer special rates for small and start-up businesses.  In addition, an experienced business attorney can help a business owner avoid many of the problems that it has seen other businesses make. Investing in legal advice upfront starts a business off on the right foot and protects against costly legal trouble in the future.

FTC Business Opportunity Rule

There are three requirements to qualify as a business opportunity under the new FTC Business Opportunity Rule. (1) There must be a solicitation to enter into a new business (if it is in the same line of business as a purchaser, it is not a business opportunity); (2) the purchaser must make a required payment; and (3) the seller must represent it will provide any of the following: (a) location for purchaser’s display, kiosk, machine, equipment, etc.; (b) that the seller will buy back any goods or services acquired or purchased from the seller; or (c) the outlet, accounts or customers for the purchaser.

The Federal Trade Commission’s new Business Opportunity Rule went into effect on March 1, 2012. Among the changes that were made was the removal of the dollar amount requirement to qualify as a business opportunity, the expansion to include at-home business programs, and the reduction of required disclosures to be made from 20 to 5.

The new rule does not preempt the various state business opportunity laws; therefore, if you are offering in one of the 25 states with a specific business opportunity law, you must also comply with those state-specific disclosure requirements.

The Required Disclosures

There are now five required disclosures under the Business Opportunity Rule.

1.      Information on the Seller: this includes the name of the business, the name of the seller of the business opportunity, the business address and telephone number.

2.      Earnings Claim: this is a check the box disclosure. If you check ‘yes’ that there is an earnings claim, additional disclosures are required.

3.      Litigation History: similar to the FTC Franchise Disclosure Item 3 requirements, a business opportunity must disclose its litigation history for the past 10 years for itself, affiliates, parents and subsidiaries.

4.      Cancellation and Refund Policy: this is a check the box disclosure. If you provide for cancellation or refund of the business opportunity, there are additional required disclosures.

5.      List of Purchasers: you must provide a list of all purchasers of your business opportunity for the prior 3 years, or just the 10 purchasers residing closest to your prospective buyer.

Under the Rule, every seller of a business opportunity must retain several documents for at least 3 years after the disclosure is made to a prospective buyer. These are:

·         The disclosure receipt page;

·         Every version of the disclosure document;

·         All signed contracts with the buyer;

·         All verbal or written cancellation or refund requests by the buyer;

·         All earnings claim substantiation records.

Prohibitions

The new Business Opportunity Rule contains a long list of prohibited practices in making disclosures. Among these are the prohibition against making any representations (verbal or written) which contradict the disclosure document, providing extraneous information outside of the disclosure document; making false or unsubstantiated earnings claims; and requiring the buyer disclaim or waive reliance on any of the disclosures or representations.

The new Rule is comprehensive and you should become familiar with the requirements both on the federal and state levels.

U.S. Business Expansion in the Middle East

One of the hottest places to expand a franchise internationally is the Middle East. This is due to several factors, most among them is the fact that the area is very wealthy and is eager to expand its U.S. brand presence. Since the 1990’s several U.S. based franchises have expanded into Kuwait with further expansion in the UAE and Saudi Arabia in the last 5-10 years.

Many small businesses are seeking the international expansion route in the Middle East as a source of expanding their revenue stream. This week, Bloomberg Business Week provided a look at how small businesses are taking advantage of the opportunities in the Middle East (see http://www.businessweek.com/articles/2012-06-21/small-u-dot-s-dot-franchises-head-to-the-middle-east).

While there is a great opportunity for expansion in the Middle East, there are some precautions that a business owner should keep in mind. First, if your business is in the food industry, you will likely have to comply with Halal Certification which regulates the preparation of food and meats. Most countries in the Middle East do not have franchise specific laws and regulations, which opens the business owner up to compliance commercial agency laws and in many instances, Shari’a Law as well.

If you are seeking to expand your business into the Middle East, it is recommended that you have both U.S. based and Middle East based (country specific) legal counsel. Together, your legal team can help you prepare for the complexities of international expansion and to comply with the various laws and regulations that can affect your brand from trademark registration to Shari’a Law compliance.

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.

Top Franchisee Missteps and Mistakes

With renewed SBA funding by the current administration, now is the time to start thinking of buying a franchise. If you are looking at buying a franchise, there are common missteps and mistakes that you want to avoid. Most of these are simple and will not cost any additional money, but they are incredibly important to keep in mind as you negotiate yourself through the thick packet of documents know as the Franchise Disclosure Document and the Franchise Agreement. This is our top 10 list of common franchisee missteps and mistakes (in no particular order):

1. Not Reading Everything. To make an informed decision as to whether or not this is a good investment for you, you absolutely need to read every document provided to you. It seems like a daunting task, but it is worth it. This is a legal obligation you are considering and if you don’t know what your obligations are, you cannot make an informed decision and I promise, you will discover down the road that you agreed to something you had no idea about. Don’t be surprised or caught off guard.

2. Not Taking Enough Time. You may feel pressured to read through everything and sign on the dotted line quickly, but the truth is, you have time so take it. Remember, you have at least 14 days before you can sign anything or pay any money.

3. Having the Right Documents.  Make sure you have the most current Franchise Disclosure Document (FDD) and Franchise Agreement. If you are talking to a franchisor in June 2012 but you have a 2011 FDD, then there is something wrong. Remember, the franchisor is under federal and state requirements to have an annually updated FDD to provide to prospective franchisees. 

4. Failure to Understand the Product/Service. The franchise may appear to be a great idea, but do you really understand what you are selling or offering to the public? You need to be comfortable with your business and to know how to sell it. This due diligence step is often overlooked to the detriment of the franchisee.

5. Failure to Contact Current and Prior Franchisees. This takes time, but remember #2 above –take time. This includes calling up all the current and former franchisees in a small system and a lot in a mid-size to large-size system. You need to ask questions such as: a) how is their relationship with the franchisor; b) are there problems with the franchise system that are or are not being addressed; c) do they still feel like it was a good investment; d) what is their revenue; e) any advise in making the decision to purchase this franchise. This is just a short list and there are a lot of questions you can ask franchisees. They are an incredibly valuable resource that is often overlooked.

6. Failure to Have Adequate Initial Financing. While the FDD discloses the amounts estimated to start your franchise business, you need to plan for the unexpected. Not having sufficient working capital while in the initial phase of your franchise business could leave you without a business at all.

7. Failure to Have Sufficient Long-Term Capital. The franchise system you purchase is going to change. You will be expected to remodel, to upgrade software, hardware and equipment, and to possibly rebrand the business –all your own expense. Planning for the future by having planned for long-term capital needs will help sustain your franchise business.

8. Underestimating the Time Commitment. Buying a franchise is starting a business. You have a head-start in that you have a recognizable name, but you are still the owner of your own business and that takes a lot of your time. Make sure you are prepared to dedicate the time necessary to make your franchise business succeed.

9. Not Getting It In Writing. Whether you have an experienced franchise attorney helping negotiate for you or not, you need to make sure you get everything in writing. No matter how great the franchisor is today, if there is ever a dispute, you will wish you had that promise to lower royalties in 6 months in writing.

10. Not Marketing. There is a reason that most franchise agreements require a franchisee to spend money on marketing and advertising. Advertising and marketing works. Products and services don’t sell themselves. And remember, your competitor is spending time and money on marketing and advertising so don’t lose a sale to them.

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.