Now let's talk a little bit about the laws that regulate franchising.
Franchising is regulated at both the state and federal level. Under the federal law, we've got the Federal Trade Commission rule on franchising that covers all franchise sales in the United States. The FTC rule on franchising is basically a disclosure requirement. The rule requires that you disclose twenty three different items of information in a particular format in "quote" plain English that the franchisee will be given at least fourteen calendar days before they can either sign a binding contract or give the franchisor any money. It's a cooling-off period.
Let me give you a list of some of the things that are included in that disclosure document.
The first item is just general background information about the franchise, any predecessors, its affiliates, how long you been franchising, how long you've been in the business that that you're trying to franchise; so there's some background information.
Item two talks about the background, basically a five-year employment history, of the franchisor's officers, directors, and people with management responsibilities.
In item three, the franchisor has to disclose litigation that relates to either a violation of franchise laws, securities laws, fraud claims, or any material litigation. Certainly, if the franchisor has litigation with its franchisees, or being sued by its franchisees, that would have to be in the disclosure document, so it's a deterrent for a franchisor to get involved in litigation, because they're going to have to disclose that in a disclosure document and explain it to a prospective franchisee.
Item four talks about bankruptcy. The franchisor has to disclose whether it or any it's officers or directors have filed bankruptcy in the last ten years, or if any company with which they were affiliated filed bankruptcy in the last ten years. Not a big deal to me.
In item five, the franchisor has to disclose the initial franchise fee and any other fees that the franchisee has to pay to the franchisor before the franchisee opens for business. Usually, there is an initial franchise fee, and sometimes there is a startup package, which might include inventory, furniture, fixtures, equipment, which are sometimes purchased from the franchisor and sometimes purchased from third parties designated by the franchisor. All of that would be included in item five, so that's pretty simple.
Item six is a chart where the franchisor has to describe all of the fees that the franchisee will pay to the franchisor over the life of the franchise agreement, so that's typically going to be, again, the initial franchise fee, the ongoing royalty fee, the marketing fee, if there's audit fees, training fees, renewal fees, all kinds of fees; whatever it is, that has to go into item six, and keep in mind again this is all in plain English as well.
Item seven is probably the most useful to a franchisee prospect. Here, the franchisor has to provide in a chart form all of the expenses the franchisee might incur or expect to incur in opening the business and operating it for the first three months; so that's going to include, again, the initial franchise fee, it'll include construction costs, leasehold improvements, deposits, advertising signage, software, hardware, licenses, attorneys fees, you name it; so and this is a very useful for the franchisee, because it's going to give the franchisee a range of dollars that they're going to need.
In item eight the franchisor has to describe any restrictions on the goods or services that the franchisee will be selling. The franchisor might have certain proprietary items that the franchisee must purchase from the franchisor or from sources designated by the franchisor. It is important for the franchisee to know where it can buy its inventory, where it can buy its equipment, etc., and there may be restrictions where they have to buy. Item eight also includes the a table for the training, so the franchisee will know how long the training program is, what's involved, what subjects are taught, and who is teaching and training.
Some of the other important items in the disclosure document would be items 12 and 13 regarding the territory and the trademarks that the franchisor owns. From a franchisee's perspective, he wants to make sure the franchisor is the owner of the trademarks, and that they're strong trademarks. With regard to territory, I think we already discussed that the franchisee is usually given some exclusive or semi exclusive at least territory within which to operate their business so they know they're not going to have competition from the franchisor or other franchisees in the system.
I'm going to skip over to item 20, which is important. Item 20 contains five different charts of information about how many units the franchisor has, and particularly over the last three years; so you get to see how many franchises are sold in the last three years, how many franchises were terminated, not renewed, and then ultimately how many franchises the franchisor expects to sell in the next twelve months.
The last thing I want to touch on is the financial statements. In item 21 the franchisor has to provide audited financial statements on the franchise company, actually the last three years worth of audited financial statements; so if you're the franchisor, you want to keep that in mind you're going to need to have and budget for audited financial statements each year. From the franchisees perspective, they want to know that the franchisor is financially viable and is going to be around for a couple years to support the franchisees' business.
You have approximately 15 states where you have to register your franchise before you can offer a franchise in that state. There's a registration fee, or a filing fee, involved, and there's usually a government administrator that reviews the franchise agreement and disclosure document, which might require some modifications and or an addendum to the to the disclosure document or the franchise agreement. Then you register and can start to offer franchises in that state.
The other laws that regulate franchising are what are called relationship laws. Some states have laws that regulate the relationship between the franchisor and the franchisee; for example, it the state law may say that the franchisor cannot fail to renew a franchisee or cannot terminate a franchisee without "quote" good cause, those are some of the relationship laws.
The bottom line is the first thing you need to do is figure out is "do you offer a franchise"? You look at the definition of a franchise under the federal law, and it's a pretty simple three-step process. The three elements of a franchise under the federal law are, number one, the licensing of a trademark, so the franchisor is going to license to the franchisee the right to use the franchise or trademark; that's pretty simple; it's pretty much going to be prevalent in in all situations. The second element is the payment of a fee: under the federal law the fee is $500 or more; so if the franchisee is required to pay the franchisor $500 or more between the time they sign the franchise agreement and and open for business then that meets the second element of the definition of a franchisee. Then you go to the third element: the third element is a little bit more subjective; so if the franchisor either exerts or has the right to exert significant control over the franchisee; or if the franchisor is going to provide significant assistance to the franchisee, then that meets the third part of the test your franchise. If you meet all of those, if your business model meets all of those three elements, then your a franchise regardless of what the parties label the agreement. You can call it whatever you want, but if it's a franchise, you're going to have to comply with the state and federal laws.
At the state level the laws that define franchising are pretty similar to the federal law. Some states do not have the fee element, or don't have the $500 minimum, so, for example, in Illinois, the payment of any money might be considered a franchise. Some state laws have different definitions of what constitutes a trademark element: some use what's called a community of interest definition; others say that, well, if your your business is substantially associated with the franchise or is trademark, then that constitutes the trademark element.
You need to analyze how you're going to structure your business, and whether or not it's going to be a franchise, because a lot of times we come across businesses that say they're not a franchise, but they meet all three of the definitional elements of a franchise, and therefore they are a franchise whether they like it or not, and they may be what we call an unintentional franchise, and may be violating both state and federal laws by doing so. If you want to structure your program to avoid the franchise laws, there are ways to accomplish that, but you've got to be careful that you don't become an inadvertent franchisor.
Now we're going to turn back to the business side of franchising. Probably the first thing I do is to register your trademark. The trademark is one of the most important aspects of your business, one of the most important assets of your business; so you want to register your trademark with the US Patent and Trademark Office. You may have more than one trademark. It takes a long time to get that process through: most of the time, it takes at least a year to get it actually registered, so you want to start that process right upfront.
The other thing you want to talk about initially is a budget. We need to figure out how much it's going to cost us to launch this franchise program. There's a lot of aspects to it; so, for example, you're going to have legal fees to prepare the disclosure document and franchise agreement, perhaps state registration fees, if you're going to be registering in the registration States, you may have to pay someone to prepare the operations manuals that we talked about, you're going to have expenses in selling the franchise of marketing the franchises, you're going to have selling costs and marketing costs; so you need to create a budget and determine how much money am I going to need to launch this program.
And it will take time. Operations and trainimg manuals can take 2-3 months. Your marketing and sales program about the same. Usually I tell clients 60 to 90 days to prepare the disclosure document and the franchise agreement and get you at least lawfully offering franchises in the non registration states, of which there's about 37; so you can get it going fairly quickly, but you want to start all these these steps as soon as possible. [In our Franchise My Business Master Class, we show you have to reduce these time frames.]
In some cases, you're also going to need to create some standardized construction plans or floor plans if you've got fixed location franchises; so you want to get started on that, and then you may want to start negotiating agreements with your suppliers to get the best prices for you and your franchisees. When you're operating your business before you start franchising you may not have had the benefit of higher purchasing volumes,which will give you better pricing; so once you start franchising, and start talking to vendors, and start negotiating better prices, and and let them know you're in a franchise, and you're going to have a lot more business for them, they'll be glad to hear that.
Next thing I want to talk about is what goes into the franchise business model, what you need to think about from the business side to create this franchise; so I've got a list of a bunch of things here.
1. The first thing we'll talk about is the initial franchise fee. Most franchises charge an initial franchise fee, which can range anywhere from $5,000 to $50,000 or more. From the franchisor's perspective, this initial franchise fee is typically not a profit center: it allows the franchisor to recoup its marketing and selling costs and its training costs to get that franchisee up and running; most franchisors hope to make money on the ongoing royalty fees, or product sales, or both.
2. Most franchisors charge an ongoing royalty fee, which is usually either a percentage of gross sales or sometimes a flat fixed fee, weekly or monthly or some other period of time; so the ongoing royalty fee is something that you're going to give serious consideration. There's a couple factors to consider. One would be your competition: well, if you're in the restaurant business, let's say, you're a sub shop, and all the other sub shops are charging somewhere between 8 to 10 percent royalty, if you charge 15% royalty I think you're going to have a hard time selling franchises; if you stay with a 5 percent royalty fee, you may be leaving some money on the table, so to speak, or you may not even be recouping enough money to make this franchise concept profitable for you. You also want to factor in that your franchisees need to make a good living, because the bottom line is that franchising only works if both the franchisor and the franchisee are making money, if they're both successful.
3. Another factor to consider is whether or not you're going to have some sort of national or regional advertising program. Most franchisors today charge their franchisee somewhere between one to three percent towards an advertising fund that the franchisor typically controls to use for, maybe, television ads, radio ads, print ads, national ads, regional ads, etc. As a franchisor you need to figure out what you you would do with that money, and what benefit it is going to give the franchisee, because if it doesn't benefit the franchisee, I'm not sure why you're spending the money.
4. Another important business aspect to determine when you set up your franchise is granting any exclusive territory to the franchisee. In most businesses the franchisee is going to want to know that you're not going to cannibalize their store and and open up additional outlets that are going to compete with the franchisee and make him or her less successful. You want to consider what territory would be fair to both you and the franchisee.
5. Another issue to consider is the term of the agreement. I've seen agreements anywhere from three years to 20 years or more. Most of them are ten years, and most of them have renewal rights, as well as under what circumstances.
6. Another factor is what kind of computer and hardware requirements you're going to impose upon the franchisee. A restaurant franchise may be required to purchase a particular brand of POS system, and the franchisor is going to have access to all of the information on that POS system, and maybe as well to their back-end computers. You may have proprietary software that you're going to require the franchisee to use. In some franchise systems, the franchisor provides some of the "quote" back-end services, such as billing and collection services; so you need to figure all that for your for your business, and what is it that you're going to require the franchisee to have in terms of computer hardware and software.
7. Another factor to consider is what warranty you might give to the consumers, and how one franchisee may be affected by a breach of warranty by another franchisee. Maybe the consumer goes to another market and wants the franchisee in the second market to fix what the franchisee in the first market messed up. You need to address that properly in your operations manual.
8. Similarly, how do you handle things like gift cards? What about a gift card bought in one location and used in another location: how is the second franchisee going to be compensated? Same for loyalty card programs.
9. Another factor to consider, and this all goes into your franchise agreement, is what it's going to be post term termination obligations of the franchisee; meaning, are you going to impose a non-compete the franchisee after the franchise agreement expires or is terminated? Now, keep in mind that in some states, like California, these non-competes may not be enforceable; so be careful there, and know what your rights and obligations are before you enter into another state.
10. Another important factor to consider from the business side when you start franchising is how you're going to handle social media. I've seen the franchisor controlling all of the social media; in other franchise systems, the franchisor gives the franchisee the right to conduct its own social media programs. Even in the latter situation, you may want to have a social media policy to prohibit the franchisee from posting objectionable material and things like that; so you want to control to a certain extent your brand and your trademark; but you want to give the franchisee some flexibility that they can communicate with their market.
11. And lastly, in some some franchise systems, you're going to have to consider licensing requirements and how long it's going to take for the the franchisee to get all the necessary licenses to operate their business.
Now let's talk about marketing and selling franchises. There's a number of different ways that franchisors award franchises. The first and simplest is what we call a single unit franchise, where the franchisor is selling one unit at a time; that is, the franchisee is only able to open one unit. This is the model that I recommend to my clients when starting, because it's the simplest, and your one-on-one with the franchisee.
The second business model would be what they call multiple units; so, again, a franchisor grains to one franchisee, or one franchisee entity, the right to open multiple stores or multiple territories under the franchiseor's trademark. This is not too complicated: it's really just the single unit multiplied.
The next way to grow your business is through what they call area development rights. Area development rights are where the franchisor grants to an area developer the right typically to operate one or more units in that territory and to sell or solicit prospective franchisees for the franchisor within that territory. The area developer will typically provide some or all of the initial training and some or most of the ongoing assistance to the franchisee in his territory. The franchisor will compensate the area developer by having the area developer sharing in both the initial franchise fee and the ongoing royalty fee; maybe anywhere from a 50/50 bases to a 75/25 split, or whatever; this has become a very popular way of growing a franchise, because what you now have is not only your own in-house sales people, but you've got these area developers out there both opening their own stores or territories as well as enlisting new prospects in their territory; so this is a way to grow your business faster than individual units or multi units. I don't recommend you start out that way, however, because you can wind up in a situation where the tail is wagging the dog, so to speak; your area developer can get bigger than the franchisor sometimes, and that can create problems.
They're an off-shoot to the area development program called an area representative program, and that's really where the area developer is not operating any stores themselves; you're really just appointing a sales rep in a particular territory. This is not something I would recommend: if you're going to hire people just to "quote" sell for you, or get prospects for you, I think you're better off using a brokerage system rather than an area representative system.
[We take exception to the terms and advise used above. We reserve the term "area developer" for a franchisee developing franchised businesses within an area on his own account, similar to a multiple unit franchise, except that the area development agreement is an option agreement, not multiple franchise agreements, although it is meant to result in multiple franchise agreements, as options are excersized. It is, of course, possible to have the same entity act as an area representative, and prospect for or sell franchises within or without the same area, but that is a separate agreement and relationship, for which compensation can be structured in any number of ways, most of which will trigger a brokerage or sub-franchise, see below, relationship.]
And finally, the last model that we see in the franchise arena is something called sub franchising or master franchising. These are mostly used for international transactions. What we mean by sub franchising or master franchising is basically a grant to to stand in your shoes in a territory; so they become the franchisor, and they have to prepare their own disclosure documents, and they have to sell and train and support the franchisees. What the franchisor gets is usually an up front fee and a small percentage of the initial franchise fees and ongoing royalty fees. There are a couple of systems here in the United States that use that structure: Fantastic Sams is one, as is Gen Pro International; but typically that's reserved for international markets where the franchisor is really not going to have the ability to promote and to support franchisees in a foreign country.
So those are the different models that we use in franchising.
Now let's talk now about how do we market and sell franchises.
Traditionally they were marketed and sold, I guess, through trade shows, and we still have trade shows today. The International Franchise Association has trade shows, and there are others out there; but that's fairly expensive: you have a booth fee, travel expenses, you have people sitting there manning the booth.
Another option would be the print media: Wall Street Journal has one day a week where they advertise franchises for sale, USA Today has franchises for sale, so most most print publications. Magazines, trade magazines, again, for me, are fairly expensive ways of advertising and marketing your franchise.
For the last 15-20 years, we have the Internet, and the Internet is probably the number one way to attract candidates; the Internet is certainly a big part of your marketing program.
But, certainly, you can't rely solely on the Internet, and finally, another way franchises are sold is through franchise brokers. There are franchise brokerage firms, like Frannet and firms like that, and what they do is try to find and recruit franchisees. These brokers are paid by the franchisor, usually a percentage of the initial franchise fee.
So those are ways we market franchises.
Next, I want to talk about what is the process, how it all works from from start to end.
Let's say you get a inquiry, someone's interested in my franchise. Maybe you got the inquiry off of the internet, maybe at a trade show, wherever. One of the first things you want to do is have that prospect fill out an application, because you need to be screening the franchisee, just as the franchisee should be screening you. They fill out some basic information: you want to know a little bit about the the person's background, what their skills are, you're certainly going to need to know their financial situation, to see if they can afford your franchise.
You'll have a whole sales process where you have different touch points with these prospects. Once they fill out the application, and they're still interested, and you're still interested, you would usually send them the franchise disclosure document; you want to start the 14 calendar day cooling-off period; so you want to get that started as soon as possible; so you're going to give the franchisee a franchise disclosure document as soon as you believe he is qualified and you both are still interested.
If both parties are still interested, you're usually then going to have what's called the discovery day where the franchisee is going to come to the franchisor's headquarters and meet the principles and operational people of the franchisor; because up until then the franchisee has only been dealing with the franchisor's development personnel, or salespeople; so now the franchisee has an opportunity to come to the franchisors headquarter to meet everybody else and get a better feel for the franchise and a better feel for both parties whether or not there's a fit to move forward.
If both parties are ready to move forward, then you would you would have a closing. The franchisee signs a franchise agreement, and that franchise agreement will govern the relationship between the franchisor and the franchisee from that day forward.
Now that we have sold a franchise, I just want to touch on a few things about the ongoing relationship between the franchisor and the franchisee. As I said, the franchise agreement governs the relationship from a legal point of view, what the franchisor can and cannot do, and what the franchisee can and cannot do; but, more importantly, the business issues in the relationship must be nurtured. What I would like to encourage my franchisor clients to do is to recognize the time effort and money that the franchisee puts in to helping to build the franchisor's business, and what I see quite often, unfortunately, is franchiseors more concerned with getting their royalty fees from the franchisee, and not worrying about is the franchisee being successful or the franchisee following systems.
Conversely, one or two bad franchisees can spoil the whole system, particularly early on; so when you're selling you first franchises it is very important to be selective. Some franchiseors will sell a franchise to anyone who comes up with the initial franchise fee. They're happy they got their twenty five thousand dollars, and they don't care what happens thereafter. Well, obviously, that's very short-sighted; so you really need to select the right franchisees and support them.
Now, if they're not doing their job, then you need to step in and correct it. You have to have a little bit of a balance: you want to protect your trademark, and you want to protect your brand, you want to make sure the franchise is doing everything that they're supposed to do; but on the other hand you need to help them to achieve that, because it's really really a partnership [carful not to use that term], and if it doesn't work one, it won't for the other; so I want you to keep that in mind if you're a franchisor, and if you have a failure, that has to be disclosed in your documents. Your document must list all franchisees in the system, as well as those franchisees who have left the system within a certain period of time after the end of the year, so the franchisee prospects are going to have the ability to call some of your former franchisees and find out why it is they're no longer a franchisee. Maybe it's because they were successful, and they sold their business; or maybe it's because they were unsuccessful; maybe it was because the franchisor terminated them, and you're going to hear from that former franchisee why they think they were terminated; so it's a the only way this business model works is if both parties can be successful, and I and I encourage you to always keep that in mind if you're going to franchise your business.