A HISTORY OF FRANCHISING - HISTORIC & ECONOMIC PRINCIPLES OF FRANCHISING
© 1985-2008, Kevin B. Murphy, B.S., M.B.A., J.D. - all rights reserved
EARLY FRANCHISE ENTRANTS
Author Lloyd Tarbutton believes the first chain store concept began as early as 200 B.C. in China and that franchising may have started even earlier when rickshaw drivers were granted specific routes.
Credit for the first company to franchise in a traditional business sense is generally given to the Singer Sewing Machine Company. In the 1850's, the young company, short of cash and unable to afford salaried salesmen, established a network of franchised dealers who paid a fee for territorial rights and $65 for all sewing machines purchased for resale.
This was the first example of a product franchise where distribution and sales of a product line sold to franchises are primary, as opposed to business format franchises, like McDonalds, that specify the look (trade dress) and uniformity of all business operations. In the business format franchise, a franchiser supplies brand names, techniques, or other intellectual property assets and services, instead of complete products. The business format franchiser may provide certain production and distribution services, but its primary role in the arrangement is careful development and control of marketing strategies.
In 1898, two young companies, General Motors and Ford Motor Company, also lacked the capital to open retail outlets. They used a network of franchised product dealers to buy, sell and repair their products. Henry Ford's assembly line mass production techniques made a former high-priced luxury item, cars, affordable for everyone. His assembly line mass production techniques were applied in other industries and accounts for America's meteoric rise to become the world's number one economy, a position it enjoys to this day.
One year later, in 1899, two young men, Thomas and Whitehead, in a 600-word contract, obtained a license to sell a beverage known as Coca-Cola in bottles. Although invented in 1886, Coca-Cola was principally sold in soda fountains until the young men promised to open a bottling plant to achieve greater distribution. In 1901, realizing they lacked the capital to establish their own bottling plant, the young businessmen came up with an innovative solution - awarding product franchises for bottling plants also based on assembly line mass production techniques. Their idea was a success, and by 1919 there were 1,000 thriving franchised Coca-Cola bottlers.
FRANCHISING IN THE 1930'S - KFC
In the Depression era of the 1930's, Harlin Sanders operated a gas station in Corbin, Kentucky. The main petroleum industry players operated company-owned gas stations, but converted to the franchise model in the 1930's to escape a national tax on company-owned locations and be more responsive to price changes by independent gas stations.
Going back to KFC, to earn extra money, Harlin Sanders served meals to hungry travelers in a back room kitchen of his gas station. After his tasty chicken became legendary in the region, Governor Ruby Laffon made him an honorary Kentucky Colonel in recognition of his contribution to the state's cuisine. With this boost, the Colonel closed his gas pumps and opened a 142-seat restaurant featuring his moist and tasty chicken.
In the early 1950's, he promptly turned down a $164,000 offer for his restaurant, anticipating a prosperous retirement in a few years funded by the increasing profits from his eatery. Suddenly, in 1955 his business was destroyed by the construction of a new Interstate highway, taking traffic seven miles west of his restaurant. The Colonel was forced to auction his property. The same day, he received his first social security retirement check for $105. At the age of 66, the Colonel from Kentucky began seriously thinking about franchising.
In 1956, retired and having lost his business, the Colonel traveled the highways of Kentucky, Indiana and Ohio, persuading restaurant owners to sample his chicken. If they showed interest after the meal, he taught them his cooking techniques and charged five cents for all birds cooked using his methods. Business boomed at these restaurants following the Colonel's instruction, and people began approaching the Colonel, eager to open an outlet. The Colonel's traveling ceased, and he managed the infant franchise company with his wife from their home in Shelbyville.
By 1960, there were 200 franchised KFC outlets earning $100,000 per year. By 1963 the number climbed to 600 franchised outlets earning $300,000 per year. At this point, the Colonel had 17 full and part-time employees overseeing his growing franchise empire from an office he built behind his home. By 1980 the chain mushroomed to 6,000 franchised outlets. Today there are over 10,000 KFC locations.
THE MIGHTY MCDONALDS
In 1940, no resident of San Bernardino, California thought the new McDonalds hamburger stand would be the genesis of a franchise chain that would change the eating habits and perceptions of customers throughout the world. Brothers Dick and Mac McDonald, inspired by Henry Ford's assembly line, were the first to apply his mass production techniques to a service business. The outstanding results of their prototype catapulted the brothers to a level of wealth and prosperity they'd never dreamed of - a large estate overlooking the San Bernardino valley, $70,000-plus a year in income, a huge amount in those days, and ownership of two Cadillac luxury sedans. The McDonald brothers were entirely content and had no aspirations or inclination for franchising.
Their paths crossed with an astute salesman named Ray Kroc, who visited their location in 1954 to see the small hamburger stand that ordered eight of his company's milk shake multimixers capable of blending five milk shakes at one time. Why, Kroc wondered, did such a small establishment need to produce forty milk shakes at a time? He found the brothers were doing a remarkable business selling only hamburgers, french fries, and milk shakes. Kroc, an outside-the-box thinker, was very impressed with the San Bernardino prototype and realized its potential for franchising. He convinced the brothers, who did not share his vision, to charge him with this responsibility. After further refinements to the business model that included charting procedures, defining recipes and establishing uniform standards, Kroc achieved a level of standardization, trade dress and brand appeal that would create fortunes for the company and its future franchise partners. He opened the first of the chain of McDonalds restaurants on April 15, 1955, in Des Plaines, Illinois. On that first day, Kroc's restaurant had sales of $366.12, less than a tenth of the average daily sales of a McDonald's restaurant today. By 1957 there were 37 locations; in 1959 the number increased to 100. McDonalds went on to become the world's largest chain of fast-food restaurants with over 31,000 locations in 120 countries worldwide.
MCDONALD'S McCAFE - CO-BRANDING IN ACTION
McDonalds, besides its ubiquity, constantly demonstrates it’s strategic planning ability. Consider McCafé, the brainchild of Charlie Bell, the late McDonald's President-CEO. He opened the first McCafés more than 20 years ago in his native Australia, then took them international when he moved to McDonalds U.S.A. Visitors to a McCafé find 11 kinds of coffee and tea, hot chocolate and mineral water.
McDonalds realized it’s initial market for McCafé was overseas, and the concept is in 33 countries so far. McCafés are all over Australia (406), ramping up fast in Germany (306) and just starting in Japan. Fifteen McCafes debuted around Tokyo in late August of 2007. About one in every four McDonalds in Germany includes a McCafé area. Five hundred McCafés are planned in Germany by 2008, and between 600 and 700 by 2011.
In Germany, McCafé is the market leader in coffee shops. Its biggest competitor, Starbucks, opened in Berlin in 2002 and now has 98 outlets, less than a third of the current number of McCafes. It was only a question of time when McDonalds decided its McCafé concept was ready for the U.S. market. McDonald's is now pushing a nationwide expansion of the McCafe band name. It plans to add its espresso coffee drinks at McDonald's restaurants across the U.S., but from existing service counters, so a Big Mac and a latte can be ordered at the same time. The expansion of the McCafe concept signals the Mighty Mac's desire to pursue the $12 billion specialty coffee market.
FRANCHISING LEGITIMIZED
By the late 1960's the success of business format franchise companies like KFC and McDonalds were well known. KFC is credited with creating hundreds of millionaires through its franchise program, and McDonalds produced at least as many of the new wealthy. All this success legitimized franchising and fueled the fantasies of aspiring as well as existing entrepreneurs. Adding fuel to this fire was the growing impact franchising has on the U.S. economy, now accounting for over 40% of all retail sales.
IDEAS FOR SALE
Young franchise companies sell the concept of a powerful formula they have developed, along with a catchy name and uniform operating standards. For an initial franchise fee plus ongoing royalty payments, the franchise owner receives instruction in the company's proven business system, assistance in selecting a site, and help building a duplicate of the successful prototype. Initial training is provided, along with varying forms of ongoing consultation and advice. Over time, economies of scale develop, enabling volume purchasing power and extensive media advertising.
MEGA-GROWTH - FRANCHISE DEVELOPMENT VIA THE "OPM" PRINCIPLE
The fast-food chains - including the likes of McDonalds and Kentucky Fried Chicken - symbolize the explosive growth potential of franchising, expanding from a single location to hundreds of stores within a few years. And thousands of locations within a decade. This mega-growth is possible because franchise owners provide all expansion capital, assume all operating and management responsibilities, and shoulder virtually all risk. Franchising has been called expansion using the "OPM" (Other People's Money) principal.
EARNING MORE FOR DOING LESS
In addition to being the most economical way for a company to open identical units across the country, franchising offers substantial and highly profitable revenue streams from initial franchise fees and ongoing royalty payments. A franchise company only needs a limited number of personnel to sell franchises and then provide training and ongoing assistance. As franchise owners learn how to operate the business, they require less and less attention. Yet they continue to pay an ever-increasing sum to the parent company as a royalty based on a percentage of their growing sales. So, franchise companies earn more and more, for doing less and less.
FRANCHISE PROFITABILITY - COMPANY-OWNED VS. FRANCHISE-MANAGED
A study highlighting the disparity in profitability between operating company-owned versus managing franchised locations in the fast-food industry by a mature franchise company discloses the bottom line franchise profitability advantage:
Company-Owned Statistics
No. of Units 1,550 restaurants
Revenues $1.69 billion
Expenses $1.42 billion
Pre-Tax Profit $270 million (16%)
Franchised-Location Statistics
No. of Units 4,550 franchises
Revenues $486 million (royalties, etc. paid to the franchise company)
Expenses $ 78 million (incurred operating the franchise company)
Pre-Tax Profit $408 million (84%)
In operating 1,550 company-owned restaurants, the firm begins with much greater revenues ($1.69 billion), but ends up with significantly less, both in total dollar profit and margin compared to the royalty, franchise fees and other revenues received from its 4,650 franchise owners and resulting in $408 million in bottom-line profit.
To the business community the message about franchise profitability is clear: why assume the administrative headaches and cost of running locations making 16% profit, when more money can be earned at 84% profit, with a fraction of the personnel, by providing management consulting advice? Jack In The Box was entirely company-owned until 1980 when it saw the franchise light. The chain now has over 1,000 units. Increasingly, business owners are jumping ship with their company-owned locations, selling them to franchise owner-operators. They’re getting out of the trenches and becoming highly-paid generals overseeing their soldiers.
REASONS FOR THE FRANCHISE PROFITABILITY DISPARITY
Two of the major reasons accounting for the franchise profitability disparity have already been mentioned. First, franchise companies find themselves in the enviable position of earning more for doing less. Second, a franchise company can manage a large number of franchised locations with a skeleton team of personnel, and few significant operating expenses.
In 1963, Colonel Sanders managed 600 franchised locations from an office built in the back of his home, employing 17 full and part-time employees. Kumon U.S.A., Inc., a learning center business with over 900 operating franchises, is able to fulfill its management responsibilities with 9 persons (source: Kumon's 1998 Uniform Franchise Offering Circular). In the fast-food industry, Carl's Jr. has a management team of 19 individuals managing its 669 quick service franchised restaurants (source: Carl's Jr. 2000 Franchise Offering Circular).
Essentially, a franchise company provides management consulting advice on an as needed, diminishing basis. Management consulting firms generally have very high profit margins due to low operating expenses, and this advantage is compounded in a franchise environment. Initial franchise fees, for example, tend to be highly profitable. A company charging an initial franchise fee of $25,000 only needs to sell 20 franchises to generate an immediate $500,000 in income, with comparatively limited marketing expenses. As franchises open and learn business operations, the increasing stream of continuing royalty payments over a 20 year period creates an annuity that vastly exceeds the amount of the up-front initial franchise fees.
For example, in the fast food industry a franchised restaurant generating only $500,000 in sales (about one-third the sales of an average McDonalds restaurant) typically pays the franchise company a 5% royalty of $25,000 per year. Over 20 years, that amounts to a staggering $500,000 for each and every franchise in the network. And this total is likely to be much higher given yearly increases in sales volumes as well as C.P.I. (consumer price increase) adjustments over the 20-year period. So, franchise companies enter into millionaire (or quasi-millionaire) relationships with each franchise member brought into the network.
MANAGEMENT STRATEGY - COMPANY OWNED VS. FRANCHISED
Considerations other than franchise profitability also factor into a company's decision to use what is called "dual distribution" - the penetration of markets by a mix of company owned and franchised units. The company owned units test and build market demand and brand identity, while developing system-wide standards and uniformity. The franchisee-owned units lead to rapid market penetration as well as innovation. Some of the best, new product lines in many franchise chains originate from their franchise operators, such as the Filet-O-Fish and Big Mac in the McDonalds chain. The dual distribution strategy produces a whole that is greater than the sum of its parts, allowing the entire network to quickly adapt to opportunities as well as threats.
REFRANCHISING - CONVERSION FRANCHISING STRATEGIES.
Large, established franchise chains are heeding the message as well. Refranchising and conversion franchising are strategies increasingly utilized by the big players in the franchise industry. 7-Eleven, a franchise chain operating more than 31,500 company-owned and franchised stores worldwide, decided to become fully-franchised in the U.S. It implemented a franchise conversion program in 2002 to sell all U.S company-owned stores as franchises. Yum! Brands, which operates and franchises the KFC, Pizza Hut and Taco Bell fast-food chains, announced in December, 2007 it will reduce its company-owned restaurants by 50% in the U.S. by 2010 by refranchising them. For several years, Yum has been selling off hundreds of its U.S. restaurants to franchise owners. Refranchising improves profit margins because the company collects more in franchise fees and royalties without having to operate the units. The new franchise owners also pay for the value of an existing unit with an established track record and customer base, which can be a very substantial amount, running into hundreds of thousands or even millions of dollars. In April of 2008, CKE Restaurants, Inc., which operates Carl's Jr. and Hardees restaurants, announced a strategic refranchising program. Already, it has sold more than 60 of its company-owned restaurants as franchises.
INTERNATIONAL FRANCHISING
International franchising is another strategic way to reduce dependence on domestic demand and build new, future franchise profit centers. For example, Burger King opened 12 locations in China since 2005, but will launch hundreds more in the next three years under a new franchising plan. McDonald's operates about 900 sites in China, while Yum! Brands has more than 2,000 KFCs there - probably because The Colonel looks like a twin brother of Ho Chi Minh. In Vietnam, locals don't even call the chicken chain KFC, but refer to it as Ho Chi Minh.
Faced with falling domestic U.S. sales, Yum! Brands is mounting an aggressive expansion drive in China to make the country its biggest source of profit within a decade. Yum’s KFC was the first foreign fast food company to move into China, opening the first outlet in 1987. Now, Yum is China’s biggest restaurant chain, with some $2 billion in annual sales and over 2,500 KFC and Pizza Hut stores. This compares to about 900 McDonalds outlets, Yum’s nearest rival in China’s $28 billion fast food market.
Adapting to local customs is always a strategic challenge for any international franchise effort. For example, Colonel Sanders secret recipe of herbs and spices isn’t a draw factor for many Chinese customers. For health reasons, they shy away from the fried chicken and prefer to eat the fish, porridge and egg tarts featured on the KFC menus. David Novak, chief executive officer of Yum! Brands, has forecast 20,000 restaurants in China. “We’re in the first inning of a nine-inning ball game in China,” he told investors in February, 2008. Yum will test 24-hour KFC’s and expand home delivery services to target the huge nocturnal citizens of China’s crowded cities.
HOW TO FRANCHISE - EFFECTIVE PLANNING & MANAGEMENT OF FRANCHISE SYSTEMS
© 1982-2008, Kevin B. Murphy, B.S., M.B.A., J.D. - all rights reserved
ENTERING A NEW BUSINESS
A company planning to franchise must realize it is entering a new business, offering an entirely different service (training & support) to entirely new customers (business owner-operators). This new business requires different skills, abilities and expertise. In the new business of franchising, it is critical to develop effective evaluation, documentation, training and consulting skills. Since these new skills are rarely present within existing personnel, an outside franchise expert is needed to plan the transition. The first step involves determining whether or not a business can franchise, and if so, what needs to be developed. Next, strategic franchise planning is necessary to create a "blueprint" for successful expansion efforts. Experience shows that, just like a building, the foundation developed at the beginning will create lasting consequences affecting the relative success (or failure) of the entire venture. Legal (franchise offering circular, franchise agreements) and operational documents (franchise operations manual, franchise training program) are prepared and drafted and finally a franchise registration process is required in some 14 states, depending on which state(s) the company sells franchises. These phases are discussed below.
THE FRANCHISE FEASIBILITY PHASE
An indispensable step before any franchise development program gets underway is an analysis of the concept and business model. Has the concept been sufficiently proven in the marketplace? How profitable are existing prototypes or company-owned outlets? Franchising will not solve existing problems, it will only intensify them - and usually at a serious cost to franchise investors. Franchising should not be viewed as a method to raise capital, expand a business that has existing problems, or a way to get rich quickly. There must be sufficient profitability in the business model so that royalty and other payments can be made and leave the franchise investor with a sufficient profit. With a franchise feasibility analysis, a determination can be made about: (a) whether franchising or licensing expansion ideas should be pursued, postponed or abandoned; and
(b) assuming a positive result in (a), what needs to be fine-tuned or developed from scratch for the franchise program.
Besides determining if and when the business can franchise, the analysis should also include providing guidance and direction so as much of the groundwork as possible can be done by existing personnel. This has proven to be a very effective approach and significantly reduces franchise development costs. If the feasibility analysis is positive, the other phases discussed below follow. My twenty-eight years of experience in the franchise industry lets me share a valuable insight about franchise feasibility studies. Too many companies leap into franchising without doing a feasibility study, or if one is done it is performed by a franchise consultant or group that tells everyone good news - they're all "franchise-able." The vast majority of franchise feasibility studies I've done either identify areas that need attention before franchising makes any sense or tell the client to forget about it and pursue other options.
THE FRANCHISE STRATEGIC PLANNING PHASE
A successful franchise development program begins with a solid plan - a foundation for franchising. The long-term goal is to establish balanced, integrated, successful business relationships with qualified individuals who support the company's goals and image. Creating an enduring relationship requires a comprehensive strategy that addresses all aspects of the franchise endeavor.
The starting point is a detailed analysis that covers: (1) identifying profile characteristics of who will be the best franchise owners for the particular business;
(2) competitive positioning to make the franchise stand out from the other 3,000+ franchise companies;
(3) geographic scope - where and when will franchises be sold;
(4) analysis of the company's organizational strengths and weaknesses relative to franchising;
(5) identifying the appropriate franchise organizational structure as well as staffing requirements and responsibilities; and
(6) structuring the franchise relationship for a balanced, win-win scenario.
What should emerge from this detailed analysis is a specific strategic plan and framework for guiding virtually all franchise efforts. Despite the long-term importance of the franchise planning step, too many emerging franchise companies enter franchising with no plan or planning - other than "let’s try and sell a lot of franchises." They rush through (or neglect entirely) the strategic planning process, thereby creating future franchise litigation land mines that are ticking franchise lawsuits waiting to happen.
Often, this is because they only utilize the services of a franchise consulting firm or franchise attorney, where little or no attention is paid to critical strategic planning, operational and organizational issues. Normally, these firms draft "boilerplate" franchise offering circulars, franchise agreements and franchise operations manuals based on a questionnaire completed by their client, who is presumed to have made all strategic decisions. The franchise documents are presented, along with an invoice and a handshake - hardly the ingredients for success in the new business of franchising.
THE FRANCHISE DOCUMENTATION PHASE
If the company has made doing a good job at the planning stage the number one priority, franchise documentation goals will be apparent. Proprietary and intellectual property assets (like operating techniques, customer information, recipes, formulas and methods) need to be identified and protected. A trade secret protection program is developed and implemented. The name, logo and tag lines should have been previously registered as trademarks or service marks.
franchise operations manuals
Franchise operations manuals and training programs are developed, often from scratch, to impart business operating skills to the franchise owner as well as ensure uniformity of products and services. The franchise operations manual and training program curriculum must be drafted with a particular focus. Certain topics, chapters and policies found in manuals for a company-owned chain, for example, are entirely inappropriate in a franchise environment, creating significant liability (lawsuit) issues for the franchise division.
I routinely find franchise operations manuals drafted by franchise consultants containing inappropriate chapters or topics. Not knowing where the bullets come from in franchise litigation, they proceed blindly ahead using "boilerplate" manuals where most (but not all) instances of "hamburgers" are changed to "tax returns." The support aspect of the franchise relationship needs to be carefully considered, structured and reflected in the franchise operations manuals.
Deciding who writes the franchise operations manual is a relatively simple question to answer, yet many new franchise companies also fall into a trap here. Bewildered by the new business of franchising, with its legal requirements, franchise operations manuals, training programs, etc., they decide to “delegate responsibility,” usually to a high-priced franchise consultant who produces the operations manual and sometimes even the legal documents. Putting aside the practicing law without a license issue on the legal documents, does using someone to write your franchise operations manual who knows literally nothing about your business, ever make any sense?
The best practice approach, developed over almost three decades of my writing, editing and reviewing hundreds of franchise operations manuals is based on common sense. Let the true “expert” in your business write the operations manual. And who is that expert? It’s usually the founder of the business or a handful of your management personnel who know the business inside and out. It’s true, an outside franchise expert should be involved in the process, but this should be limited strictly to an editing capacity – helping develop the Table of Contents, then reviewing each chapter after it’s drafted by you or your management team. This approach produces a professional, easy to use and update franchise operations manual. It also ensures the most efficient use of resources and talent.
franchise offering circulars - franchise disclosure documents
Finally, and only after all of the above are underway, a Franchise Offering Circular (Franchise Disclosure Document), similar to a securities (stock offering) prospectus, is prepared by competent franchise counsel and registered with various regulatory agencies to comply with applicable federal and state laws. This document can contain thousands of discrete disclosures within its twenty-three chapters and attached exhibits, and obviously needs to be prepared by a franchise attorney. In addition, a franchise registration process is required before any franchises can be advertised or sold in those 14 or so states having a franchise registration requirement. Having one firm author, edit and review all documents is not only cost-effective - it also avoids inconsistencies that can plague the franchise company as franchise legal pitfalls in the future (see discussion below).
RECOMMENDATIONS
My twenty-eight years of experience has demonstrated that in order for a franchise company to get off to a good start, a heavy emphasis should be placed on strategic franchise planning to manage future franchise relationships. Then, before the franchise program begins, management needs training in how to effectively operate a franchise organization. At a minimum, the following programs should be in place before franchise marketing efforts begin:
1. Franchise Lead Processing System (sm):
Two key considerations for all franchise companies engaged in franchise marketing are the careful screening of franchise applicants and adopting the proper media plan, schedule and budget. Only the cream of the crop should be allowed to join the franchise network. Eliminating applicants at the entry stage is far easier than waiting for inevitable and costly problems later on. An examination of franchise networks plagued by troublesome franchise owners (who often ripen into future lawsuits) shows a lack of planning and attention to this relatively simple concept. Given the unlimited personal liability risk inherent in franchising, companies neglecting this important concept, or those using franchise brokers, are simply asking for trouble.
Before franchise marketing efforts start, a company should adopt a customized Franchise Lead Processing System that includes instructing key personnel in: (1) adopting the proper organizational structure;
(2) defining the appropriate profile characteristics of prospective franchise owners;
(3) developing effective interviewing techniques, marketing materials, procedures and checklists;
(4) using a series of tests and other measures to ensure that inappropriate candidates are disqualified before joining the franchise network;
(5) detecting (and then avoiding) red flags that arise in the franchise marketing cycle; and
(6) adopting the appropriate media plan, schedule and budget.
2. Legal Compliance Program (sm):
A franchise lawsuit can result if inconsistent or misleading communications occur when a franchise is first sold. Most of the legal risk is franchising centers around what happens during the marketing cycle: the twenty-three chapters of disclosures in the franchise disclosure document as well as who said what, and when. Defending any franchise lawsuit, even a frivolous one, can be enormous. Franchise companies involved in franchise litigation are shocked to discover they have fallen into a quicksand that swallows up time and money without limit. The cost of prosecuting even a "small" franchise lawsuit can easily exceed $100,000, and up. Exposure can run into the millions. Although one study of franchise offering circulars indicated 27 percent of franchise companies have a history of franchise litigation (slightly greater than 1 in 4), the real percentage is much greater and probably north of 50 percent. This is because only pending litigation and final judgments must be disclosed in franchise offering circulars. Most franchise litigation cases, like other litigation cases are settled, so they’re only required to be in the franchise offering circular from the time they’re filed until settled. After that, they vanish without a trace. And whether the chances of getting sued in a franchise lawsuit and getting embroiled in franchise litigation is greater than 1 in 2 or 1 in 4, who wants to get involved in a time-consuming, stressful and expensive mess?
It is almost impossible to avoid potential franchise liability unless a genuine program of education and instruction is conducted with marketing personnel as well as middle and executive franchise management. An integrated Disclosure Compliance Program that specifies rules and expectations, manages disclosure documents and controls the dissemination of all information is absolutely essential. It is also one of the best investments a franchise company will ever make. For all of the above reasons, the use of franchise brokers is definitely NOT recommended. Their statements (or other actions) made to "close the deal" will make the franchise organization (and the personal assets of its officers) liable for violations of federal or state franchise laws. This also explains why the overwhelming majority of successful franchise organizations set up their own in-house franchise marketing department so that actions and statements made during the franchise marketing cycle can be monitored and controlled within the framework of a Franchise Sales Control System (sm).
3. Franchise Sales Control System (sm):
Franchise Sales Control is the other half of the entire compliance equation. While legal compliance specifies rules and expectations, franchise sales control is the mechanism for detecting gaps and inconsistencies. When detected, their causes can be identified and corrected before injuring the franchise effort. A Franchise Sales Control System should be designed with this in mind, and should include a variety of feedback mechanisms to monitor performance and retrieve pertinent information for review by management. This not only increases the effectiveness of franchise marketing efforts - it also greatly reduces the likelihood that sales personnel will deviate from established procedures in selling franchises. Finally, a well-designed Franchise Sales Control System creates a complete back up file for every franchise sold that will qualify as business record evidence in the event of a future franchise dispute. It also satisfies the legal requirement of various states that franchise companies maintain a complete set of books, records and accounts of franchise sales. Since most of the legal risk in franchising arises during the franchise marketing cycle, a comprehensive Franchise Sales Control System is the company’s best protection against the quicksand of franchise litigation.
4. Managing Franchise Relations:
As franchises are sold, the communication lines that develop between the parties will have a major impact on the success or failure of the ongoing franchise relationship. Controlling who is brought into the network through the steps outlined above is the critical first step. Once inside the franchise network, franchise owners must be taught to realize they are members of a system of mutually dependent outlets, each working for the better of the entire network. Developing an awareness of this concept early in the relationship and implementing a franchise feedback system will create a positive attitude, encourage innovative ideas from franchise owners, ensure timely royalty payments and prevent franchise relationship problems later on.
FRANCHISING VS. LICENSING A BUSINESS (FRANCHISE VS. LICENSE) AND BUSINESS OPPORTUNITY EXPANSION OPTIONS
© 1990-2008, Kevin B. Murphy, B.S., M.B.A., J.D. - all rights reserved
The starting point in the franchising vs. licensing a business analysis is to consider the legal aspects, then the business aspects. In considering the legal aspects, begin with the following premise that applies to both options. If you put someone into business (or allow them to use your business name/mark) this transaction will normally be a regulated activity, subject to substantial penalties for noncompliance. This guiding principle, coupled with the business aspects of selling a franchise vs. a license (discussed below) will answer most franchise vs. license questions.
BACKGROUND OF FRANCHISE & BUSINESS OPPORTUNITY LAWS
Why does regulation exist? The government, due to documented past abuses where tens of thousands of individuals lost all of their net worth by investing in nonexistent or worthless business endeavors, has devised two principal consumer protection mechanisms:
(1) franchise disclosure-registration laws; and
(2) business opportunity laws.
It doesn't matter what terms are used by the parties in contracts or other documents to describe their relationship. For example, the contract may call the relationship a license, a distributorship, a joint venture, independent contractors, etc., or the parties may form a limited partnership or a corporation. This is entirely irrelevant in the eyes of governmental regulators, in particular the Enforcement Division of Federal Trade Commission (FTC). Their focus is not on semantics, but on whether a small number elements are present or not. Today the industry is subject to a complex web of regulations that differ from the Federal level to the state level and differ widely from state to state.
Firms or individuals that say calling it a “license” dispenses with legal regulations are delusional and wrong for at least three reasons:
(1) common sense - if it was really that easy, everyone would have done it that way;
(2) if the relationship is not regulated under franchise law, business opportunity laws (discussed below) will apply, and complying with these will be a lot more expensive than going the franchise route; and (3) any analysis must include federal as well as applicable state laws.
This all reminds me of some financial planners who still advise clients filing U.S. income tax returns is not required under their interpretation of the U.S. Constitution. It just doesn’t work that way. This is not to say licensing isn't a viable option in foreign (out of U.S.) transactions, in situations where U.S. laws don't apply - but these are a very small minority. Most transactions and contracts cover U.S. activities and residents, so the franchise vs. license question is an easy one to answer.
The list of required elements is quite short, and although certain franchise exemptions and exclusions are available, the franchise statutory framework was designed to pigeonhole these relationships, when certain defining elements are present, into either a franchise or business opportunity box. Normal license agreements contain certain "control" provisions (right to audit, require reports, mandate suppliers, etc.) and the presence of ANY control or assistance provision (operations manual, training, site or other assistance) is enough to satisfy the Rule. In fact, the title of the FTC Rule says it all: "Disclosure Requirements & Prohibitions Concerning Franchising and Business Opportunity Ventures." So, the focus must be on which box is better to use, not on how to avoid using either box.
THE FRANCHISE BOX - REGULATION BY THE FEDS
Let's consider the franchise box. Under FTC regulations that became effective in 1979 a thick document (now called a Franchise Disclosure Document) must be prepared and given to prospective buyers for a minimum of 14 calendar days before any money is paid or contracts are signed. This document now contains 23 items or chapters of information, as well as current financial statements and a copy of the actual contracts used.
It is designed to give prospective buyers enough pre-sale information about the company, its financial condition, the proposed contract, investment requirements, trademark rights, etc., so informed decisions can be made before long-term contracts are signed. For companies that attempt to disregard federal law, the FTC Act authorizes the Commission to recover civil penalties of up to $10,000 for each violation of its Rule, plus injunctive relief, consumer redress (obtaining complete refunds, canceling contracts), etc. Because each sale can involve multiple violations of various regulatory provisions, these fines can be substantial and far outweighs the cost of doing it right the first time.
Selling "disguised" franchises (an illegal franchise) as "licenses" can be the most expensive mistake a company ever makes. One need only consult the franchise registration filings of various states to see the significant number of companies that fall into this trap. They started out selling "licenses," operating under misguided advice, in a vain attempt to save money. Then, they either get sued for selling an unregistered or illegal franchise. Or, the finally get competent legal advice that what they've really sold are illegal franchises, even though they were called a "license." The governmental agencies require them to offer full rescission rights (cancel the license, refund all money that's changed hands) to all persons they've sold "licenses" to. Defenses that "we didn't sell a franchise - we just sold a license" are unavailing. In the end, they pay a lot more to have it done the way it should have from the very beginning. Not a pretty picture.
STATE REGULATION OF FRANCHISING
Because regulation of franchising is at the federal and state level, the effect of state regulation must also be considered. The FTC Rule sets minimum standards and applies in all states, unless a particular state sets higher standards, and then that state's law applies. In 1971, eight years before the FTC Rule went into effect, the State of California was the first to enact a franchise disclosure-registration law where a franchise registration process is required before franchises can be offered (i.e. advertised) or sold. The California Franchise Investment Law was in response to a wave of consumer franchise complaints. Other states soon followed California’s lead, leading to a situation where franchise companies had to follow different rules in each franchise registration state.
To alleviate these difficulties and achieve a uniform format, a group of Securities Commissioners from various states adopted a Uniform Franchise Regulation, effective in 1977, known as the Uniform Franchise Offering Circular (UFOC) format. All states requiring franchise registration followed the UFOC format, a thick document also containing 23 chapters of information. None of these states accepted what was then known as the FTC's Basic Disclosure Document. To ease the obvious predicament created by UFOC vs. FTC format, the FTC allowed companies to use the UFOC format as an alternate to its Basic Disclosure Document. In 2007, the FTC adopted its own version of the UFOC format, known as the Franchise Disclosure Document or FDD. That format will be THE required format beginning July 1, 2008.
FRANCHISE BOX SUMMARY
Bottom line on the franchise box: By preparing a single franchise disclosure document (at a cost of about $30,000), a company satisfies the federal requirement and is positioned to offer and sell franchises throughout the United States. Although certain state-specific information and disclosures may be required in the minority of states having a franchise registration-review process, this can normally be accomplished in a couple of extra hours per state.
THE BUSINESS OPPORTUNITY BOX
Now, let's consider the business opportunity box. At the state level, there are approximately 24 states that regulate and register business opportunities. Unlike the franchise box, there is no such thing as a uniform business opportunity disclosure format. Business opportunity rules and registration requirements differ in each business opportunity state. Many of these states also have a "cooling off" period, usually a couple days after the sale where buyers can change their mind for any reason and receive a full refund.
For a company that's going the business opportunity route two different documents may need to be prepared and provided: the FTC's Basic Disclosure Document (if the business opportunity fits the FTC’s definition of a business opportunity) and a state's more abbreviated business opportunity disclosure document. Also, different timelines may need to be observed: the FTC's 14 calendar days before, and a business opportunity state's cooling off period after.
Bottom line on the business opportunity box - if you're an attorney with a business opportunity or "licensing" client, get ready for hundreds of billable hours, you've just landed a big one. But, if you're the business paying the legal bills, it's going to be a lot less money to go the franchise route. Prepare a single, Franchise Disclosure Document, register in a state or two as expansion efforts begin, and you're essentially done.
There are also other factors to consider in the franchise vs. business opportunity analysis, including liability issues (definitely a greater risk in the franchise arena) but these are beyond the scope of this article, which is not intended to offer legal advice. Companies should consult with competent, informed legal counsel about the specifics of their particular situation before making any decision.
THE BUSINESS ASPECTS OF FRANCHISING VS. LICENSING AND BUSINESS OPPORTUNITIES
The business aspects of the franchise vs. license and business opportunity options are relatively straightforward. It all boils down to image from a marketing standpoint. From a credibility standpoint, does your company want to stand toe to toe with the likes of McDonalds, Radio Shack, H & R Block and other franchised household names? These are the mental images formed in the mind when an average consumer hears the word franchise, along with familiar, highly advertised slogans like "being in business for yourself, but not by yourself," "complete training," "support where and when you need it," etc.
This, coupled with the complete package of training, start up and ongoing support services offered by franchise companies, makes a franchise a more attractive commodity in the eyes of the prospective buyer and an easier sale. The same applies to firms that sold "licenses" then switched to selling "franchises." These companies say they attracted considerable interest and far more inquiries when offering "franchises" compared to "licenses." So, even from a business standpoint, the franchise vs. license question is easy to answer. In addition, and as discussed above, a "license" is almost always a franchise in disguise, a ticking bomb creating significant legal issues if the FTC Rule (and corresponding state franchise registration laws) are not followed.
Business opportunity, on the other hand, suffers from definite image problems that translate into difficult marketing issues. If you ever need proof of this, just attend any business opportunity show. You'll see a host of fly-by-night opportunities such as worm breeding in backyards, exotic plants raised in glass bowls, condom vending machines (not a bad idea these days) and the like all promoted by fast-talking, high pressure salespersons. Does your company really want to be associated with these companies and the reputation they project? Poor image, coupled with the fact that business opportunity ventures typically provide little training and no ongoing support, make them a much more difficult sale to prospective buyers. In a business opportunity, the buyer is just thrown a ball, and it's entirely up to them how to run with it.
FRANCHISE ATTORNEYS & FRANCHISE CONSULTANTS: CRITICAL EVALUATION QUESTIONS TO ASK
©1990-2008, Kevin B. Murphy, B.S., M.B.A., J.D. - all rights reserved
Evaluating franchise attorneys and evaluating franchise consultants can seem a daunting task. But the firm a company selects to assist its entry into franchising, refine existing franchise efforts or make franchise investment decisions will have profound consequences. While asking for a list of "references" is one approach (and when is anyone ever dumb enough to provide a bad reference?) there are more objective criteria that are not dependent on selectively disseminated information. By addressing the nine Franchise Questions, topics and subcategories of information discussed below, you will eliminate virtually 95% of the individuals or firms you are considering. Then efforts can concentrate on evaluating the 5% cream of the crop that truly merit consideration:
A. FRANCHISE EXPERT:
The #1 factor in evaluating so-called expertise - are the principals really franchise experts? There are objective criteria to determine this: (1) Have they qualified and been allowed to testify as a franchise expert in court and arbitration proceedings? Being involved as a franchise expert in the franchise litigation process gives a sensitivity and radar for avoiding future franchise problems.
(2) How many books on franchising have been written by the principals?
(3) How many franchise articles have been published in journals or magazines?
(4) What is their teaching experience? (see topics E and F below)
(5) What is their depth of experience in the franchise industry? (see next topic below)
B. EXPERIENCE IN THE FRANCHISE INDUSTRY:
(1) Length of time the firm has operated exclusively in the franchise industry?
(2) Experience on both sides of the franchise fence - working with franchise companies (franchisors) as well as with individual investors (franchisees) who have purchased a franchise?
(3) Past experience principals have owning and operating a franchised business? This factor is absolutely critical. If the principals have owned and operated a franchise, they bring a unique perspective and radar for avoiding future franchise relationship problems from disgruntled franchise owners.
C. COMPREHENSIVE TRAINING & ONGOING SERVICES; CONTROL SYSTEMS:
(1) Can (and will) the firm train your personnel to operate and manage your new franchise company? Remember, you're entering an entirely different business, one requiring new skills and abilities. If this topic is not addressed in detail, you might as well earmark the franchise fees received when you sell franchises for a future franchise litigation war chest;
(2) Will the firm help you review and update operational (franchise operations manual) and legal documentation (franchise offering circular) on an ongoing basis?
(3) Has the firm developed, and will they help you put into place, franchise marketing, sales control and legal compliance programs during the critical implementation (start-up) phase of your franchise program?
The existence of these programs is essential to ensure only the cream of franchise applicants are allowed to enter the network, and to create a series of documented files should a dispute arise in the future. Most of the legal risk in franchising occurs during the franchise marketing cycle when franchises are sold. If your company's done a good job here with these programs, then you've eliminated most of the risk.
D. LEGAL: FRANCHISE ATTORNEY
(1) Is the law practice devoted exclusively to franchising?
(2) Total number of franchise offering circulars (franchise disclosure documents) drafted and reviewed?
(3) Experience filing franchise registrations and working with state examiners in all 14-plus franchise registration states?
E. ACADEMIC: UNIVERSITY & COLLEGE
Experience teaching franchise courses at graduate and undergraduate university levels?
F. ACADEMIC: PROFESSIONAL
Experience teaching franchise courses to franchise attorneys and general practice attorneys?
G. BLEND OF BUSINESS & LEGAL SKILLS:
Specialist franchise attorneys and law firms produce tight legal agreements (sometimes overly so leading to future franchise relationship problems) and usually adequate franchise offering circulars. Setting aside the overly tight contract issue, the problem is most franchise attorneys - franchise lawyers are not capable of making sound, strategic business decisions and providing practical, ongoing advice. Some franchise consultants, on the other hand, have good business sense, but lack the requisite legal skills. Questions: (1) Does the firm have the proper blend of business savvy and in-house franchise legal expertise?
(2) Can the firm produce good legal documentation (franchise disclosure documents) and help you edit (or create) consistent operational documents (such as the franchise operations manual, training program, etc.) If your franchise agreement says "x" but your franchise operations manual or advertising materials say "y" about the same issue, be prepared to pay hefty franchise litigation fees and deal with franchise litigation attorneys in the future.
(3)Can the firm provide competent and practical ongoing advice in critical areas like effective franchise marketing, media decisions, interviewing franchise buyers, adopting the best franchise organizational structure, implementing a franchise advisory council, etc? Mistakes made in these areas can easily cost the franchise company tens, if not hundreds of thousands of dollars.
H. CONTRACT FAIRNESS:
Does the firm give you an option of choosing between:
(a) an hourly rate and
(b) a flat contract amount, where you don't have to worry about accumulated hours and an unknown total amount?
I. RED FLAGS - BEWARE OF ANY OF THE FOLLOWING:
• Combination teams where one entity does one part of the project and another the other part. For example, a consulting firm does planning, and operational documentation, while an attorney "they know very well" writes the legal documentation.
• Or, a variant of the above, the company in the “fine print” of its contract, requires your attorney (who you obviously have to pay) to review and approve everything they do because the company is not rendering legal advice. Actually, by providing documents that affect legal rights, they are rendering legal advice, but in an illegal manner. It’s called the unauthorized practice of law.
• Firms that advise you to franchise your business, and they've never seen your business! You'd be surprised how often this happens.
• Firms that say they'll write your franchise operations manual for you. How someone, who knows absolutely nothing about your business, could ever come close to anything but a mediocre product at best, is a frightening thought. The use of boilerplate manuals produced by consulting groups is yet another future litigation time bomb. You are the true expert in your business. With competent guidance and editing, you'll be able to produce a professional and workable operations manuals, if you don't have these already.
• Pricing quotes that seem exceedingly high or low (especially "do-it-yourself" franchise kits).
• Firms (or individuals) that have EVER been sued for fraud, misrepresentation or violating any franchise law. DON'T FORGET TO ASK THIS CRITICAL QUESTION!!
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