Franchise Law Q&A

With David L. Cahn – Whiteford Taylor & Preston L.L.P.

Posted: 10th October 2013 09:14

Can you summarise the advantages and disadvantages of franchising for both the franchisor and franchisee?
 
For the franchisor, an advantage is obtaining a steady stream of revenue over a period of time without having to assume the same level of risk as expanding the business through other methods, such as purchasing or leasing assets and hiring employees.  A disadvantage is that the level of net cash flow received from each operating location may be less than through “direct operations,” and franchises sometimes can be difficult to control. 
 
How do you assess whether a business has franchise potential?
 
The first question is whether the potential franchisor has a track record of operating the business successfully, ideally under the trademark being licensed but if not under other names.  Generally a business that is unproven is not a model that anyone would be interested in owning.  Another “franchise-ability” factor is whether the methods of developing and operating the business can be taught to others in an efficient manner.  Also, is the brand or business method distinct, or just a “knock off” of an existing concept?  Early entrants often dominate the market. 
 
How can you effectively calculate the initial fee for setting-up each franchisee in business?
 
Most franchisors do not treat the initial fee as a profit centre.  One measure of calculating this fee is to look at what the competition is charging, since it will be difficult for a new franchisor to charge more.  The fee should be sufficient to allow you to recoup your expenses to recruit and train the franchisee and to cover some of the costs you incurred in starting the franchise program.  If you will be granting large exclusive geographic territories, you should consider requiring increased payments based on the size of the territory, such as $x per 100,000 in population.
 
What should be included in a well-drafted franchise agreement?
 
While there are too many key provisions in a franchise agreement to describe here, some particularly sensitive areas are personal guarantees required from the franchisee’s owners; the term of years and renewal rights; transfer or assignment by the franchisee or its controlling owners; covenants not to compete; ownership and control of customer lists and data; controls over sources of supplies, equipment and ingredients used in the business; geographic territory rights and restrictions; grounds for termination and other remedies; liability for damages if there is termination for cause; and dispute resolution methods. 
 
How important is it to develop a financial model?
 
If your pilot operation or operations are not profitable, then typically implementing a franchising program is an effort in futility and a recipe for disputes.  Successful franchisors have a financial model that allows franchisees to make money and an eventual return on their investment.  Specifically, a typical franchisee expectation is that not more than one-third of the operating net cash flow to the owner (earnings before interest, depreciation and amortization) will be paid as franchise royalties.  Will the business that you want to franchise be able to meet that expectation, if its financial performance is similar to the pilot operations?
 
How can you break down how a franchisor should analyse franchisee performance and what are the methods for identifying the warning signs?
 
Using “mystery shoppers” is critical to making sure that the customer experience is up to your brand standards.  If there are problems with surly employees, missing supplies or menu items, or sub-standard facilities, these are warning signs of problem franchises.  It is also critical to keep an eye on financial performance.  The obvious step is monitoring gross sales, which typically is the measure of royalties, because low sales usually equal financial trouble.  However, best practice is to scrutinise the franchisee’s key cost drivers such as labour and supply costs to make sure that they are at the right level to maintain both franchisee profitability and quality operations. 
 
What are the advantages and disadvantages of a Work Out?
 
Advantages of working out a deal with a struggling franchisee is that, if the Work Out results in a solution satisfactory to the franchisee, he will be an ally and a spokesperson for your franchise system, and also will not have to be disclosed to future prospects as a termination.  That needs to be weighed against the costs of the Work Out.  For example, if the problem is with the site selected for the business, can you help the franchisee buy out the lease and move to a better location?  If you are confident that the franchisee can run a successful store, it might be worth the investment.  If not, you will be expending resources on a person who will simply fail at the next attempt. 
 
Can you outline the main legal issues facing franchise owners?
 
 The most pressing issues facing franchisees concern employment and labour matters.  In many heavily franchised industries, including restaurants and lodging, there is much unrest concerning wage levels and unionisation activity.  There have been numerous lawsuits against franchisees as employers alleging failure to pay overtime, and U.S. governmental enforcement concerning employment of foreign nationals without work authorisations.  Some franchisees have faced liability for treating workers as independent contractors rather than employees.   However, franchisees also have difficulties with their franchisors, particularly over new requirements imposed without a demonstrative need or likelihood of return on investment.   
 
David L. Cahn, Esq.

Whiteford Taylor & Preston L.L.P. in Baltimore, Maryland  
David can be contacted by phone on +1 410 347 9442. For more information please visit www.wtplaw.com

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