But how do businesses become franchises? Franchises are governed by Federal and State law, and the mix of the two have created the following best practices:
Determine if franchising is best for your business
The two primary options for a business to expand out of its area are to franchise or open branches. A branch is wholly owned and controlled by the business itself, and all of its profits flow to the business. However, opening and operating a branch are entirely at the expense of the business. Due to the expenses involved, branches are more suited for slow, calculated growth.
On the other hand, franchising can allow a business to grow quickly, as the expenses to open and operate a franchise are paid by the franchisee, or the person buying the franchise. The business will condition the operation of the franchise upon numerous terms to maintain uniformity as much as possible, and will receive royalties for use of the brand (usually in the form of a percentage of the franchise's profits). However, franchising requires a strong brand identity that potential investors (the franchisees) want to buy into, liquidity (both for costs and regulatory requirements), and standardization of practices to be effective.
If your business has yet to do so, register your brand as a trademark. Brand identity is extremely important when franchising, whether you are building a brand or franchising an established one. Hence, it may be best to register your trademark(s) as soon as possible to begin building your brand identity. Strong brand identities can drive the price of franchises higher, so its in the business' best interest to strengthen the brand as early, and as much, as possible.
Additionally, registering a trademark gives the trademark holder a multitude of rights under Federal law.
Create a subsidiary for the business
A business should create a subsidiary entity to serve as the franchisor, or the company that sells franchises. This practice is used for several reasons. First, it helps limit the liability of the original company such that if any liabilities arise from franchising, like lawsuits, the parent company is likely protected. Secondly, the subsidiary is created for ease of accounting. The primary disclosure document, which must be created and disclosed prior to engaging potential franchisees and will be discussed shortly, requires a financial audit for several years prior. However, by establishing a subsidiary, the financial history can only reach back as far as the creation of the subsidiary and would not include the finances of the parent company.
Drafting the necessary documents
Prior to engaging in any talks with potential franchisees, several documents must be drafted. Firstly, Federal and State Law require the creation of a document compiling specified information regarding the company including its financial history, its company officers, any litigation, trademarks, and more. Depending on which accepted format of this document your business uses, this is either called the Federal Disclosure Document or the Uniform Franchise Offering Circular ("UFOC").
Additionally, all contracts that the franchisee would have to sign must be drafted. Primarily, this includes the franchise agreement. This contract sets out the many rules that franchisee's must abide by, including royalties, training, required sellers, signage, marketing, duration etc. This contract is comprehensive, but can be amended.
Importantly, these documents must continually be updated as material changes to the information it contains is available. This means that if any information changes which could impact a potential franchisee's decision to purchase a franchise, then the document must also be changed.
Such documents are highly technical as they incorporate Federal and State law, and require a financial audit. For this reason, attorneys and accountants are generally retained to prepare these documents.
Compliance with State regulations
Although Federal law regulates franchises, State laws impart additional requirements that must be met in order for businesses to offer, or continue to offer, a franchise in that State. Some of these additional requirements include:
- Registration with a state office (and fees)
- Increased disclosure regulations (what must be provided to potential franchisees and by when)
- Relationship laws that dictate the treatment of franchisees including grounds for termination, notice periods prior to termination, and grounds for not renewing a franchise.
Of course, the above are only a small sampling of the variances in State laws pertaining to franchises. Due to the complexity of the regulations pertaining to franchises, compliance should be managed by the business' attorneys so they may update and alter any documents as necessary and inform business personnel of any changes they must make in communications.
It is especially important that all people who are involved in the selling of franchises at the business are aware of the applicable State regulations, and its changes, as some laws may take effect upon first contact with a potential franchisee. Communication between these individuals, and compliance counsel (or personnel) is extremely important.
Ready, set, go!
The legal aspects of franchising are a very technical process at the outset, but once established, compliance and any additional tweaking is all that is necessary. This is only a general overview of the process of franchising, and a business should have an attorney and an accountant guide them through the process of franchising their business.