Key issues in developing the fdd business terms (apr 2018) (dh hk)

Franchise Fee

Royalty Territorial Protection

Operational Standards

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Key Issues in Developing the Business Terms for Your FDD

Panel Participants Harold Kestenbaum Harold L. Kestenbaum P.C.

 Franchise experience since 1977  Based in New York, but supports franchisors nationally  Supports both new and existing franchisors  Former General Counsel to Sbarro, Inc.  Active in the American Bar Association and International Franchise Association  Author and speaker on various franchising topics

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Panel Participants Dave Hood, Ph.D. President The iFranchise Group

 Founded: 1997  The iFranchise Group assists both start-up and established franchisors  35 full time consultants focusing on strategy, operations, training and marketing  Dave is the former President of Auntie Anne’s Pretzels  Active advisor in the franchise industry since 1985  Current Board member of Harris Research (ChemDry and N-Hance brands)

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Essential Building Blocks for Creating Success What are the most critical things a new franchisor needs to do in order to be successful?  Ensure the business decisions drafted in your FDD and Franchise Agreement are optimized for your business model, and will allow you and your franchisees to both succeed in the relationship.  Make sure that you have sufficient capital to recruit franchisees and build a solid support infrastructure.  Recruit franchisees using a targeted profile and a sound evaluation process.  Provide strong leadership to your staff and the franchisee community.  Understand and adopt best practices in franchising.

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The Importance of Planning for Growth

The business decisions in your FDD are important, because they:  Help define the economics your franchisees will operate under  Define the revenue you will receive as the franchisor  Clarify the types of franchises you will award  Summarize the pre-opening and ongoing support you will provide to franchisees  Outline the broad operational standards franchisees must follow  Clarify any restrictions on how the franchisee can operate their business  Describe how disputes will be handled with your franchise owners

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Step One: Is Franchising the Right Expansion Vehicle?

Three Elements Define a Franchise Relationship Use of a Common Trademark

Payment of Fees or Mark-ups

Operational Control or Assistance

Franchisees operate under the franchisor’s trademark

Franchise fees

Operations manual

Renewal fees

Operational training

Transfer fees

Site approval

Royalties

Site design

Advertising fees

Hours of operation

Design service fees

Production techniques

Training fees

Accounting practices

Technology fees

Personnel policies

Help desk fees

Required marketing

Convention fees

Territorial boundaries Central websites

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Step One: Is Franchising the Right Expansion Vehicle?

Alternative Independent Retail Strategies Name

Franchise

Name

Fee

Fee

System

System

Name

Business Opportunity

Name

Fee

Fee

System

System

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Trademark License

Dealer or Licensee

Step Two: Select the Right Franchise Expansion Model Assuming franchising is right for you, what types of franchise opportunities should you offer?  Will your business model perform better with owner-operators? Multi-unit owners?  What skill sets are needed by your franchisees?  What is the investment required to open a franchise?  What are the potential economic returns from a single franchised location?  How far away will you be developing markets?  Are you developing new markets or ones where your brand already has some traction?

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Step Two: Select the Right Franchise Expansion Model Single Unit Franchising Advantages of Single Unit Agreements  Greatest control over unit-level operations.

Franchisor

Single Unit Franchise Agreement

 Individual operators are more likely to be active in day-to-day operations and focused on the franchisor’s culture.  Single store candidates are more easily identified than multi-unit prospects.  High degree of control over the selection of existing franchise owners for additional locations.

Disadvantages of Single Unit Agreements Franchisee

 Slower rate of growth compared to more aggressive sales strategies.  Ongoing support is more expensive given the large number of individual franchise owners that must be supported

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Step Two: Select the Right Franchise Expansion Model

Area Development Franchise Structure Franchisor Payment of Fees and Royalties

Area Development Agreement

Area Developer Franchisee Single Unit Franchise Agreements

Direct-Owned Franchise

Direct-Owned Franchise

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Direct-Owned Franchise

Step Two: Select the Right Franchise Expansion Model Area Development Franchising Advantages of Area Development Agreements  Ability to work with more sophisticated owners  Fewer franchise relationships for the franchisor to manage, lowering the franchisor’s support costs  Potentially faster growth within a market  Greater consistency in advertising since one franchisee can advertise across multiple locations

Disadvantages of Area Development Agreements  Area developers likely to act more independently than single unit owners  Risk that development schedules are not met  Risk that the area developer may not be a strong operator or a positive contributor to the franchise community

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Step Two: Select the Right Franchise Expansion Model

Area Representative Agreement Structure Franchisor Area Representative Agreement & Fees Unit Franchise Agreement

Area Representative

Unit Franchisee

Unit Franchisee

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Royalty Payments

Unit Franchisee

Step Two: Select the Right Franchise Expansion Model Area Representative Franchising Advantages of Area Representative Agreements  Faster growth  Less capital intensive for the franchisor  Area reps are locally based in each market

Disadvantages of Area Representative Agreements  Highly complex form of franchising  Fees are split with the area representative, lowering revenues for the franchisor  Less control over quality in unit-level operations  Need to develop separate training and support systems for area representatives

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Overview of Key Business Terms for the FDD

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Federal Disclosure Requirements There are 23 separate items of disclosure required under the Federal Trade Commission’s mandated disclosure format. Those items include: Information about the franchisor and any parent or affiliate companies

Details of the anticipated investment to open a franchised location

Status of any trademarks held by the franchisor

Information on past financial performance of franchised or company-owned locations

Business experience of the franchisor

Restrictions on sources of products and services

Status of any patents or copyrights held by the franchisor

Information on the number of locations in operation

Past litigation

Franchisee obligations

Obligation of the franchisee to work directly in the business

Financial statements of the franchisor entity

Details of any bankruptcies

Franchisor provided financing

Restrictions on what the franchisee can sell

Other contracts/exhibits the franchisee may need to sign

Initial fees to be paid

Franchisor assistance

Contract renewal and transfer provisions

A copy of a receipt to be signed by the franchisee

Ongoing fees to be paid

Territorial protection offered

Use of public figures in the franchise program

As a franchisor, you must provide the disclosure document to the franchisee candidate at least 14 days prior to the execution of the agreement or the payment of any fees.

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The Geography of Franchise Legislation in the US

Franchise Legislation Within the US ‐ 2018

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Business Terms Defining the Early-Stage Relationship

Site Location:  Assigning responsibilities for the site selection process  Designated or approved vendors the franchisee must use  Site criteria  Process for site selection  Site acceptance process

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Business Terms Defining the Early-Stage Relationship

Lease Development:  Defining the process to be followed  Letter of intent stage  Required lease inclusions  Requirement for the franchise owner to have their own real estate attorney  Franchisor review of the lease before execution  Maintaining copies of fully executed leases

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Business Terms Defining the Early-Stage Relationship

Facility Design:  Need for written design criteria  What flexibility should be given to franchisees in terms of design options?  Will the franchisee be permitted to use their own architect?  Who pays for the cost of design documents?  How are approvals for the franchisee’s store design handled?

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Business Terms Defining the Early-Stage Relationship

Facility Construction:  Standards for contractors to be used by franchisees  Recommended bid process  Mandating suppliers of construction items that franchisees must use  Franchisor visits to the site during construction  Approving the location for opening  Required timeframe for completing construction and opening for business  Tracking construction costs to ensure Item 7 of the FDD is updated as needed

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Business Terms Defining the Early-Stage Relationship Pre-Opening Training Process:

Pre-Work Prior to Attending Training

Training at the Franchisor’s Location

Training at the Franchisee’s Opening

Brand History

Duration of Training

Length of Onsite Training

Product Knowledge

Who Must Attend

Operations Overview

Details of Training Schedule

Composition of the Franchisor’s Opening Team

Web-Based Learning Initial Testing

Information About the Franchisor’s Trainers

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Certification Standards That Must be Met

Business Terms Defining the Early-Stage Relationship Setting expectations (or requirements) regarding how active your franchisees must be in their business:

Mandated Involvement

Absentee Owners

Part‐Time Involvement

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Business Terms Defining the Early-Stage Relationship Mandating Sources of Supply:

Products Specified, but not the Suppliers

Approved Suppliers

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Designated Suppliers

Determining the Initial Franchise Fee Issues to consider when setting your franchise fee:

Franchisor’s Value Proposition

Cost to Onboard a New Franchisee

Impact on the Franchisee’s ROI

Competitive Franchisee Fees

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Determining the Initial Franchise Fee

The franchise fee should typically cover the franchisor’s cost to….  Recruit the candidate and put them through the evaluation process  Finalize the franchise agreement (e.g., outside legal costs)  Assist the candidate with site selection and lease development  Work with the candidate and their contractor as the franchised location is being constructed  Assist the franchisee in setting-up their relationships with approved vendors  Train the franchisee and their team at the franchisor’s training facility  Provide initial training and opening support for the franchisee when they begin operating

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Determining the Royalty Fee

Royalties can be structured in many different ways Percentage of Gross Sales, Less Tax and Discounts Percentage of Gross Margin

Flat Dollar Fee

Variations of the Above

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Determining the Royalty Fee The final royalty structure and rate should be based on a financial analysis of both the franchisee’s and franchisor’s business.

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Other Fees To Potentially Consider

Depending on the industry and business strategy adopted, the following types of fees may also be relevant to a franchisor:  Training fees  Grand opening marketing  Local marketing fee  Co-op marketing fee  System marketing fund contribution  Transfer fee  Successor fee  Relocation fee  Technology fees  Mystery shop/quality assurance fees  Various fees for non-performance (e.g., insufficient funds, audits, etc.)

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Requirements for the Franchisee to Reinvest in Their Business

Day to Day Maintenance

Equipment & Technology

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Trade Dress Updates

Preparing the Estimated Range of Initial Investment

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Business Terms Limiting How and Where the Franchisee Operates

Territory Definition:

Restrictions on the Franchisee:

 Will the franchisee receive a protected area?

 Is the franchisee restricted from serving certain types of customers in their territory?

 What protection is being given to the franchisee?

 Can the franchisee market outside of their territory?

 How will the geography of the protected area be defined?

 Can the franchisee service customers outside of their territory?

 Is the protection dependent on the franchisee meeting any minimum performance requirements?

 Can the franchisee undertake any business within the territory, but outside of their four walls?  How much flexibility can the franchisee have around the types of products they sell in their local market?  Controls over retail pricing.

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Business Terms Limiting How and Where the Franchisee Operates

Minimum performance requirements:  When are minimum performance requirements typically mandated?  Options for establishing minimum performance 

Revenues



Royalty payments



Product purchases



Sales calls



Marketing spend



Market share



Service crews/vehicles



Other

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Business Terms Limiting How and Where the Franchisee Operates

Social Media

Website Marketing

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Rebates From Suppliers to the Franchise System

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Accounting Standards for the Franchisee  Why standards for accounting are important  Evolution of standards within franchising  Best practices today that should be documented in your FDD

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Franchise Agreement Term and Successor Agreement Options

Issues to Consider:  Defining the initial term of the Franchise Agreement  Successor Agreement terms  Form of the successor Agreement document

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Item 19: Franchise Performance Representations

 Why is this disclosure item so important?  Do most franchisors provide historical performance information?  What should I disclose?

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Item 19: Franchise Performance Representations If you don’t have an Item 19 disclosure

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Item 19: Franchise Performance Representations The FTC has updated its rules for Item 19 disclosures: (Highlights – not a complete list)

 If a franchisor has both company-owned and franchised locations, it must include revenue data from both groups.  Expense or net profit data can, however, be provided for only companyowned locations.  Subsets of data (e.g., mall versus non-mall locations) can only be provided if each subset contains at least ten locations.  Any “average” performance numbers must be accompanied by “median” numbers as well.  Projections may be used within an Item 19 disclosure, but they must be based on historical operating data. However, almost no franchisors elect to provide projections.

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Item 19: Franchise Performance Representations Use of Item 19 data within franchise advertising:

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Questions

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