22 Feb Legal Concerns in Franchising
As a small business advisor, I often get asked if buying a franchise is a wise idea. Buying a franchise is one way in which a person who wants to own a small business can launch, operate, and make money in a business. Franchising has a different set of challenges and criteria that any potential franchise owner needs to look at.
There are franchises for almost anything that you could imagine — from restaurants like McDonalds, Burger King, Chick-fil-A, and Taco Bell. You can find franchises for personal services like massage therapists or nail salons, or home improvement services like handymen or blind companies. You can find franchises for educational services such as tutoring. There are many industries out there.
First, let’s talk about the benefits of a franchise. When you buy a franchise, you buy the right from a company to use their trademarks, operational systems, and business goodwill (or the reputation of the brand). So rather than having to start a business, make mistakes about business processes, and to build a brand, a franchise side-steps all those difficutlies—for a price.
Each franchise must have a franchise disclosure document (FDD). The FDD is a standardized document, meaning that it will always have the same sections, and it is regulated by federal and state laws. This consistent format allows any potential franchisee to compare FDD’s from various industries. It will always include the same kinds of information. This gives a certain level of protection for small business owners. The franchise disclosure agreement must be given to the potential franchisee must be given at least 14 days to review before signing the franchise contract.
Another important document is the franchise agreement, which is usually based heavily on the FDD. There will be some additions and exhibits, such as a description of the geographic area that the franchise will operate in. There may also be some amendment items to be given to a landlord if you will be leasing space. Still, it should be very similar to the franchise disclosure agreement.
At the very least, you should have an attorney review the franchise. To be blunt, there is usually not a lot of negotiation, if any, that happens in a franchise agreement. At best, you may be able to tinker with additions and exhibits, but the core franchise agreement pretty much never changes.
A franchise has a number of additional expenses that are not usually present in a small business.
First, there is a royalty payment. A franchise is buying the use of a brand name and goodwill of a business. That brand name might be as famous as McDonald’s, or maybe a smaller brand. This includes the right to use the trademarks and business processes. Essentially you are purchasing a license to use these business elements. With that license comes a royalty fee. Typically, that fee is based upon a percentage of your gross sales. Gross sales might be defined as your gross sales minus state income tax, but usually it is the straight up gross sales. Typically, that royalty payment will be between 5-10% of your gross sales. That is 5-10% of the money coming off the top going directly to the franchise owner. Often times, it is taken on a weekly basis straight out of your bank account. You’d likely be using the owner’s software, so they will know what your sales are and calculate accordingly.
Often there is a marketing fee. The franchisor builds the brand, vision, and reputation, and the franchisee benefits from the corporate entity’s marketing. If McDonald’s makes a tv commercial, that benefits all McDonald’s franchisees. IN many franchises, the franchisee will be required to pay between 1-3% of gross sales to the marketing fund. This fund is used to market the franchisor and the national corporate brand.
There are often other fees associated with operating a franchise. You might have a technology fee in which you are required to use a specific software system for use on a computer you have to purchase. There could be a purchase of equipment in fixtures that you will be using, but there would also be the requirement to buy an inventory. That is additional money that is coming out of your pocket.
A franchisee may also be required to purchase supplies from a designated supplier. There is a function there that limits the franchisee to make decisions to maximize profit by finding a cheaper alternative. Usually, that won’t be the case, particularly if you are going to purchase printed materials, whether that be packaging or something like cups. There has to be permission to use the logo and trademarks. The corporate entity often negotiates that deal with a manufacturer and then all franchisees are required to buy from that specific manufacturer. Be mindful of those restrictions.
Finally, there are often training costs and requirements. The franchisee, their designee, or managers will have to attend multi-day training at the expense of the franchisee.
Starting a franchise is often expensive. There are often a lot of specific (and large, sometimes measured in six figures) fees that you must pay up front in order to get started with a franchise.
The good news is that banks are usually more willing to lend to a franchisee, particularly if the franchisee is getting the franchise from a well-known brand. Because there has been some success behind the brand, it is less of a risk when it comes to lending money to a franchisee, as opposed to someone who is starting a business from scratch.
To sum up, I’m a big fan of franchises. I think they are a wonderful tool for building a small business, but I do suggest that if you are working with a franchisor, please sit with an attorney and walk through both the franchise disclosure document and the franchise agreement before you sign any documents. Often times, that franchise fee does not get refunded if you choose not to go forward.
If you are considering buying a franchise, please reach out and give us a call so we can schedule a time to chat and help you with some thoughtful guidance.