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FRANCHISE REGISTRATION RENEWAL SEASON IS HERE!

FRANCHISE REGISTRATION RENEWAL SEASON IS HERE!

While many people are hunkering down for the winter or gearing up to go on spring break, at EntrePartner we are gearing up for one thing:  Franchise registration renewal season!  Most franchisors are required to update their Franchise Disclosure Documents (FDD) and complete renewal registrations in specific states in March/April of each year (with exact dates depending on specific circumstances as outlined below). This article is designed to provide you the tools to help you make the most of renewal season.

1.   Contact your Auditor ASAP

The renewal process requires that the franchisor entity’s updated audited financial statements be included in the renewal FDD, along with an auditor’s consent to use the financial statements in the document.  The audit can often be the most time-consuming process for franchisors. Due to new guidance released by the Financial Accounting Standards Board (FASB), franchisors may have significant changes to account for in their audits this year, making this process even more time consuming.  To make this a bit less painful, we recommend the following:

– Create a timeline with your auditor team, working backwards from the targeted issuance date of the renewal FDD. Include key dates for information gathering and on-site auditing activities if needed.

– Discuss affiliate entities up-front with your auditors to determine applicability of the rules to any other entities, corporate stores or other activities you may have. This will help avoid unexpected surprises.

– Request that auditors provide you with a list of documents and information that will be needed in the audit from the onset. This will allow your legal and financial teams to start gathering information ASAP.

– Ask your auditors if they will provide a discount for early completion. Many auditors are swamped during March and April, and will thus provide discounts to clients that complete their information early.

2.  Hold an Internal Strategy Meeting

Although FDD renewals can be a difficult and distracting process, franchisors can use the update as an opportunity to hold corresponding strategy meetings with their executive or management teams.  Big picture decisions will need to be incorporated into the FDD, so many franchisors like to use the first two months of the year to align on strategy for the coming year to avoid future FDD amendments.  Items for consideration include:

– Will the franchisor incorporate any fee increases in initial franchise fees, ongoing royalty payments, or ad fund contributions?

– Are there any new fees or costs that the franchisor should consider – such as incorporating specific software or technology fees to cover the franchisors costs in adding new systems?

– Do the costs outlined in Item 7 accurately reflect current start-up investments, and are they competitive with costs outlined by competitors or other franchise systems? Are there areas where costs can be reduced?

– Are there any new major taglines or slogans that trademark protection should be applied for and incorporated into the FDD?

– Does the franchisor need to make a change in the manner in which it assigns territories or develops certain markets, like including area development agreements or limiting population size of designated territories?

– Where does the franchisor plan to sell franchises next year, and how many units does it plan to sell?

– Are there any new loan programs or financing options that the franchisor has identified?

3.  Create an Internal Meeting Cadence and Assign Responsibilities

The decisions and process outlined above, and leading to an FDD renewal, are quite detailed and time-consuming.  This workload is piled on top of the normal day-to-day operations of the franchisor and its staff – and thus can easily get put off until a later date.  We recommend establishing a regular meeting cadence with key decision makers throughout the months of January through March to ensure that timelines kept on track.  Here is a suggested process:

– Early January – Kick-off meeting with individuals responsible for legal (including outside counsel), operations, finance, marketing, sales and development and executive/management team. At this meeting, high-level issues and necessary decisions are identified and tasks are assigned.

– Bi-weekly – Legal and finance meet to review and complete Item 19, audit activities, budgeting and corresponding fee changes, financing options, and other material items.Sales/development to join when needed.

– Every 3 weeks – Executive team/management meets with legal to review key decisions needed and incorporate into FDD.

4.  Prepare for Item 19

Statistics show that most franchisors include some type of Item 19 financial performance representation (FPR) in their FDD.  This often involves gathering detailed data regarding both corporate-store performance, as well as franchised location performance.  It is important that this information is accurate, complete, and comprehensive, so that the franchisor can safely rely on it to create its FPR.  We suggest that franchisors begin collecting applicable revenue and expense information as early as possible, so that it can review its options for Item 19 and ensure that it isn’t rushing to obtain data later in the year that may skew its presentation.

Starting now and staying on top of key tasks and decisions will help to make the process go smoothly.  It also helps all parties to minimize last minute fire drills, which can lead to mistakes and miscommunication among key parties.  EntrePartner is offering discounted rates to clients that schedule their kick-off meeting in January – contact us to learn more!

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WHAT ARE ‘OUTSIDE IN-HOUSE COUNSEL’ SERVICES FOR FRANCHISORS?

“How are you guys different from a typical law firm?”

We’ve answered this question several times recently in response to inquiries from franchisors about EntrePartner’s “Outside In-House Counsel” services. Thus, we’re including our response on our blog to help explain how we work with emerging, growing, and established franchised brands from a legal perspective.

Due to the nature of being in a regulated industry, every franchisor has ongoing and regular legal needs. This goes far beyond drafting an initial Franchise Disclosure Document and preparing annual updates. A growing franchisor is required to comply with ongoing regulatory requirements, as well as establish new systems for franchisee relationships and disputes, support its franchise sales program, comply with agreements, adopt new system standards and policies, and pursue additional growth avenues such as alternative growth structures and international growth.

Depending on certain factors, such as a franchisor’s size, industry, and growth trajectory, those legal needs can range from a standard set of projects, to a specified number of hours of legal support each month. For example, every franchisor will need a standard set of compliance documents to administer its franchise agreements, and ensure that the legal foundation to enforce those agreements against the appropriate people is in place. Additionally, a myriad of issues typically come up in day-to-day operations of a franchise program. Some specific requests that we have heard recently:

• What happens when a franchisee brings in a new partner?
• What do we do if a franchisee wants to sell or transfer its business?
• What if a franchisee wants to move its territory?
• What documentation do we need for a site approval process?
• What do we do if a franchisee misses its required opening date?
• What information can our sales team provide to a prospect?
• What terms should our vendors be required to adhere to?
• What disclaimers and terms should our ops manual and policies include?

Our team of former in-house lawyers provides the answers, and helps establish templates and systems to deal with these and other common recurring issues. Unlike most law firms, though, we provide these services through predictable flat fee arrangements or ongoing subscription agreements with discounted legal rates. Most of our clients that choose this model subscribe to a certain number of attorney hours per month at exclusive, reduced hourly rates. The more hours needed, the lower the hourly rate. While our clients appreciate the financial savings of this arrangement, equally important is the fact they get more in-depth representation. Our subscription clients may take advantage of unlimited emails and phone calls of 15 minutes or less, and a free, monthly client check-in lunch (or happy hour) meeting to discuss ongoing matters, business operations or other topics as necessary – which allows us to have deeper insight into our clients’ businesses.

We have found that this model can significantly delay the timeframe in which a franchisor needs to incur the payroll expense of a full-time general counsel. It also avoids the need to incur big firm legal rates for every question asked or document needed. Having represented many franchisors across various industries, our lawyers draw from a wide range of experience to solve both legal and business issues. Not only that – our lawyers have actually been franchisors AND franchisees, too! This allows us to offer insights beyond those provided from a purely legal advisor.

EntrePartner is founded on the belief that legal services can be provided in a different way. As entrepreneurs ourselves, we represent our clients the way we would want to be represented. First of all, we provide all services at a reasonable and predictable cost – whether that be subscription agreements, flat and capped fee arrangements, or proactive discussions with our clients about their legal budgets and corresponding value for services. In this manner, we focus on developing long term strategic alliances rather than maximizing legal fees.

Secondly, where we really excel is helping our clients translate legal advice into smart business decisions. We leverage our in-house and on-the-ground business experience to help clients avoid the common mistakes that many growing franchisors make, or reinventing the wheel with every issue. Whatever the issue, we’ve likely seen it or something like it (or are able to connect clients to the person who has), and have a first-hand awareness of where it should fall in your priorities list. We combine that actual business and operational experience with legal expertise to do what we do best: help you create, grow, and protect your franchise system.

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WHAT DO PROSPECTIVE FRANCHISEES LOOK FOR IN THE FRANCHISE DISCLOSURE DOCUMENT?

All franchisors face one common business growth challenge:  how do I sell my franchise to quality prospective franchisees?  If you’ve forayed into the franchise industry to any extent, you know that a franchisor’s Franchise Disclosure Document (FDD) is a cornerstone of any franchise sales program, and – for better or for worse – every prospective franchisee will eventually receive this document and information regarding their prospective franchisor.  Some industry professionals may brush off the document as being ‘too legal’ or not helpful in doing true due diligence about a franchise system – however, we advise our clients that there are nuggets of information that can really shed some light about a franchised brand.  Whether you’re a prospective franchisee going through the due diligence process, or a franchisor that needs to be prepared to answer questions regarding its disclosures, it is important to note these items in order to dig deeper into the presentation of a franchised network.

Item 19 – Obviously!

Most prospects will flip directly to the Item 19 financial performance representation section of the FDD, which franchisors can use to present a financial picture of units in its system.  Outside of limited exceptions, this is the only place that financial performance information should be presented.  We won’t spend too much time here on this item as analyzing this section is an article in and of itself, however, it goes without saying that prospects will want to understand whether and how a franchisor presents unit financial information. 

Skip Right to Franchisor Financials

After paging to Item 19, the next thing many prospects review are the franchisor financials, which are required to be included as an exhibit, and except in some specific circumstances, are required to be audited.  Here, prospects can glean some key information – such as, whether the franchisor has enough capital to be able to meet its ongoing obligations, and invest in infrastructure, support, and other investments needed to grow and evolve a brand.  Franchisees can also find other important information such as alternative revenue sources to the franchisor, like supplier or vendor rebates, conference or training revenue, and amounts for the purchase of equipment or other supplies directly from the franchisor.  The footnotes to the financials also often contain interesting nuggets of information – including whether third party financing or debt exists, which may include obligations that the franchisor has to third parties.

A Story of Openings and Closures

Item 20 of an FDD requires a franchisor to present state by state information on unit openings and closures over the most recent three fiscal years, plus a list of franchise agreements that have been signed, but for which the unit is not yet open, as of the end of the last fiscal year.  Reviewing this information in detail can be the most important way to understand the evolution of a franchised brand.  Openings or closure rates alone only tell one part of a story, and can be used to create a list of questions based on the information presented.  For example, a franchisor might display a year or multiple year period of significant openings, which can lead to questions as to how the franchisor has capitalized itself and what systems have been created to support such fast growth.  The same can be said about a significant number of franchise units which have yet to be opened.  As another example, closures can sometimes be limited to a time period or particular geographic region – which may indicate an obstacle that a franchisor faced or results of one particular troubled franchisee – from which the franchisor has strengthened its systems accordingly.

After reviewing Item 20 charts, we also advise reviewing the associated information about franchisees that have left the system or otherwise not communicated with the franchisor within 10 weeks of the issuance date of the disclosure document.  This list will display contact information for franchised locations that were bought, but never opened, which invites its own list of questions as to what led to these occurrences.

It’s All About the Ad Fund

The franchisor’s use and management of a system advertising fund can be one of the most contentious points in a franchise system on an ongoing basis.  How a franchisor collects and utilizes this money is often of significant importance to franchisees who contribute a percentage or portion of their revenues into the advertising fund, and hope for a return on this investment.

Item 11 of the FDD requires a franchisor to break down how it made expenditures from its ad fund in its last fiscal year. Smart prospective franchisees will review this information to determine whether the ad fund was spent on true marketing initiatives, how much was spent on administrative amounts (i.e., internal salaries and costs), and to determine if funds have been kept in reserves rather than being spent in a particular year.

Supplies and Rebate Revenues

Item 8 of the FDD is designed to present information regarding suppliers to the franchise system, which is often another hotly debated and relevant part of any network.  Franchisors commonly either sell items and/or services directly to franchisees, or designate mandatory or preferred suppliers to provide items and services to franchisees.  A close reading of this section should help to paint a picture as to under what circumstances a required supplier is used (i.e., a mandatory software vendor), and under what circumstances the franchisor itself is the direct vendor.  One key sentence in this section is often the starting point for many conversations:  the required disclosure that a franchisor must make regarding the amount of revenue it receives as a result of franchisee purchases in its last fiscal year, displayed also as a percentage of its total revenues.  Reading this disclosure carefully in conjunction with the franchisor financial statements can create an important picture in the minds of prospects.

Fee Negotiations

Obviously, up-front initial franchise and other fees (Item 5) and ongoing fees (Item 6) are going to be carefully reviewed by any prospect.  However, outside of the list of current fees, franchisors are also required to disclose information about initial fees that they charged in their last fiscal year.  This information can be scrutinized to determine if the franchisor offered any discounts or reductions to its standard fees, and can many times be a negotiating point for new prospects entering into the system.  This disclosure should be carefully reviewed and understood prior to negotiating any particular discounts, as it can have a real effect on ongoing disclosures and negotiations.

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As lawyers, we feel that the entire FDD is important and riveting information, but this list is a starting point on where we direct our franchisor clients to pay attention to their ongoing operational decision-making that may have an effect on these disclosures.  We also direct our franchisee clients to these sections to help them evaluate the franchise opportunity presented.  Most importantly, we encourage all prospects to truly read and understand the information presented in the disclosure document itself prior to making an investment, as many times purchasing a franchise can be a life changing decision for all parties involved.

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IS MY BUSINESS RIGHT FOR FRANCHISING?

One of the most common questions we get from business owners is whether their business is right for franchising.  On its face, franchising can seem like an excellent way to expand utilizing the capital and talents of qualified third parties.  And for those that do it right, it is!  That said, entering into franchise relationships takes a considerable investment in time, talent, and money, and we initially have many conversations with our clients about whether they are willing to invest accordingly.

Here are some of the questions we go over with our clients when we help them consider whether franchising is the right growth strategy for them:

1.  What is your stickiness factor? We believe this is one of the biggest threshold questions that needs to be answered.  Take a moment to consider a typical franchise relationship.  A franchisee is considering getting into business, but doesn’t necessarily have the know-how to do it on their own. The franchisor teaches the franchisee everything they know about the business up front, and the franchisee thereafter pays a royalty throughout the entire term of their relationship in exchange for operating as part of the franchise system.  As years go by, it is a common feeling for franchisees to feel that they are paying a royalty for things they already know, since it has been taught to them from the start.  The best franchise systems have a common proprietary element that operators cannot get somewhere else and continues to tie the network together past the initial “honeymoon” period – whether it be a literal secret sauce (or proprietary recipe), a technology platform that allows the business to operate and is not available elsewhere, a product or series of products that have been developed for the system, or some other proprietary element.  Consider whether, outside of the brand name, your business has this stickiness factor and if not, whether you can develop one before launching!

2.  Do you have a proven model? Brands often develop as they learn over time.  Many business owners launch their first location with a set of ideas and assumptions, that they later learn may or may not have been correct.  Most entrepreneurs that we work with tell us that if they knew when they started what they know now, they would have _______ (fill in the blank: leased a bigger space, leased a smaller space, added a different service element, simplified their menu, worked with different vendors, offered a different pricing model).

This experience is exactly what franchisees are paying for when they enter the system.  That said, a good franchisor will actually build-out and test what they consider to be the actual franchise “model” location.  The model is, in a vacuum, the ideal set of circumstances that a business under the brand should have to operate – size, location, services, pricing, etc.  Although companies aren’t required to have a model location actually established to begin franchising, it certainly helps franchisors provide relevant information to their franchisees, and also have a showcase location to show and train franchisees and prospective franchisees.

3.  Industry Trends and Competition.  Piggybacking off of the idea of having a proven model, good franchisors also have a brand that is differentiated in its market and poised for growth.  When considering whether to buy a franchise, franchisees will ask the franchisor why they should buy into their brand.  Whether it’s a new type of offering in the industry, or whether the franchisor has a new approach to go to market, franchisors should consider what makes them different and worth buying into.  And, since a big part of a franchisor’s success is the long-term success of a franchisee, the franchisor should also feel confident that their concept has the staying power to be successful in the marketplace, despite industry trends and changes in the competitive landscape, through the long-term franchise relationship.

4.  Are You Willing to Get Into the People Business? Franchising is about relationships. Although a contract ultimately governs the legal obligations of the parties, the majority of the relationship between a franchisor and franchisee is established by trust, communication, processes, and problem resolution.  Without these elements, franchisors are rarely successful in getting buy-in from their franchisees, and ultimately, selling new franchises.

Before franchising, the company is `first a business owner and expert in the industry in which they operate.  Their customers are the people who buy their product or service.  Many franchisors are required to shift their way of thinking to focus on their new customers – their franchisees – and concentrate time and effort on managing franchise relationships.

5.  Are You Up For Investing Into Your System? As we hopefully have hammered home in the above, launching and growing a franchise system does take an investment of capital, know-how, and talent.  In order to properly establish appropriate systems, technology, and support structures, most start-up franchisors are required to hire team members and bring on new technology and systems that come at a cost.  At a minimum, we recommend that franchisors, either internally or externally through vendors, have a plan for the following functionalities: executive leadership (overseeing and adapting the brand), franchise sales and development, marketing and advertising support, compliance, and business coaching and support.  Some of these roles may be played by the same individuals at first, but we do recommend that the franchisor establish a plan to cover these needs with individuals with the appropriate skill sets.

6.  How Is Your Endurance? Franchise agreements are typically longer-term agreements, as franchisees want to ensure they have time to obtain a return on their initial investment in establishing their business.  Common agreement terms are between 5 to 10 years, with rights to renew the agreement for ongoing additional 5 to 10 year periods.  Once a franchisor signs one of these agreements, they are contractually obligated for the long haul.  Although there are always exit strategies that franchisors can pursue, absent divesting, a franchisor will be tied to the system and the brand for the long-term.  We often counsel our clients to consider this and where they are at in their career, goals, and personal lives – and ensure that they have the stamina and energy to lead the system and perform their obligations as may be required.

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