Legal Considerations for Running a Franchise
Last time we talked about the 7 things you need to do before starting a franchise
. In this post, I’ll cover the things your business needs to do to “be legal” as a franchisor.
1. Franchise Agreement. You will need to draft a franchise agreement to offer franchisees. When I started D.P. Dough Franchising, LLC after we bought the brand from the founder, there was a 7 page license agreement in effect with franchisees. I knew that I needed a real franchise agreement. I looked at franchise agreements from four top competitor brands and chose the provisions in their agreements that were more franchisee friendly (since big franchisor terms are notoriously not franchisee friendly). You will need to think about how you want to handle every situation in a franchise agreement. Do not use a template agreement that you found on the intranet. Franchise Agreements need to be very specific to the franchise business.
2. Franchise Disclosure Document. The Federal Trade Commission requires all franchisors to have a Franchise Disclosure Document (the “FDD”). The FDD has 23 sections, each of which covers a different specific topic related either to the business, the ownership, or the franchise agreement. (The franchise agreement itself is part of the FDD. But you must finish the franchise agreement first before you can write the FDD.) The FDD is usually hundreds of pages long. The initial FDD and Franchise Agreement can take anywhere from 25-100 hours. It all depends on how experienced the attorney is and how much help the client provides. With lawyer rates around $300, the initial FDD can easily be in the $20,000-$30,000 range. (This is not what I charge. It’s just what I have found other lawyers charge.)
3. Audited Financial Statements. One of the requirements in the FDD is to have audited financial statements. Luckily, for start-up franchisors, you the Federal Trade Commission does not require a year one audited financial statement (that requirement starts in year 2). However, pretty much all registration states now require audited financial statements before you even file for approval. You’ll need to budget around $10,000 per year for audited financial statements.
4. Special FDD Franchise Sales Rules. There are 3 rules you need to know about the FDD: 1) you need every franchisee to sign Item 23 and give you a copy, 2) you have to wait 14 days between when you sent the FDD and when the franchisee signs the franchise agreement, and 3) you are not permitted to discuss financial performance at all other than stating the information that is published in Item 19 of your FDD.
5. Enforcing Franchisee Compliance. You will need to have a strategy from day one for how you will handle non-compliant franchisees. I highly recommend having more options than just 1) sending a demand letter (basically a warning letter) or 2) terminating the franchise agreement. I view those options as akin to having a water gun or nuclear bomb as your weapons of choice. Those are not good options. It is much easier to enforce franchisee compliance by having some other intermediate punishment for franchisee non-compliance. Ultimately, you will need a lawyer for dealing with franchisee issues that escalate. But, you can avoid u many of those issues by having consistent communication with your franchisees and building trust over time.
All of the above considerations are in addition to the basic, day-to-day legal issues a franchisor encounters, such as franchisee renewals, vendor agreements, etc.