SHOULD YOU USE A THIRD PARTY FOR THE SALE OF FRANCHISES?

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SHOULD YOU USE A THIRD PARTY FOR THE SALE OF FRANCHISES?

With more than 3,500 active franchisors encompassing over 75 different industries, how can franchise companies compete for new franchisees? The very essence of this question may explain why one of the fastest evolving areas in franchising has been that of franchise sales.

Although many franchise companies still use an in-house sales department or the traditional franchise broker, the recent trend has been to employ several different combinations, including area representatives, development agents, franchise lead referral networks, business brokers and franchise consultants. These third party intercessors provide relief for some franchisors and total frustration for others.

Frustration because of the cost of familiarizing third parties with a franchisor’s particular system and the increased compliance cost to manage a sales process in which third parties are a major part of a franchisor’s plan for adding new franchisees to its system. Keep in mind that the third party intercessor is usually compensated by the number of leads generated or on franchises actually sold. Thus, some third party intercessors merely focus on generating leads – quantity with no responsibility for quality. Obviously this process of generating leads fails to adhere to a franchisors usual qualification process hopefully designed to analyze whether a prospect is likely to be a good long term fit in the franchise system. Over time, a bad fit will in all probability result in failure. Not only does a failing franchisee cost a franchisor significantly more time and energy trying to make the poor fit franchisee successful but when new prospects talk with the failing franchisee that new prospect will very likely not buy or at least be discouraged from buying a franchise. In addition, a poor fit often breeds legal battles that require a significant diversion of personnel and financial resources.

Before choosing a third party company to assist with aiding in the franchise sales process, carefully look at the qualifications of the third party. Obtain a copy of their client list and when appropriate, interview their clients. Franchisors should also follow the golden rule in franchising – communication is the key to a company’s success, the lack of communication is an interstate to litigation. It is incumbent upon franchise companies to develop a franchise sales compliance program. Make a summary of the program and incorporate it in your contract with the third party company assisting you. Make sure your compliance summary includes rules, procedures, processes and the training program provided to the third party. Franchisors must be cognizant that the use of third parties to generate leads or sell franchises creates inherent conflicts. Because you pay for leads or pay a commission on sales, the third party becomes focused on the number of leads whether they are quality leads or not. Furthermore, a third party selling franchises has no skin in the game – the natural tendency is not to care about the franchisor’s long term relationship with a franchisee.

The franchise sales process can be a franchise company’s life line or its anchor. The result depends upon how a franchisor approaches franchise sales. In next month’s Franchisor Alert we will review the advantages and disadvantages of different approaches to selling franchises.


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RECRUITING NEW FRANCHISEES

Looking for additional ideas to grow and build your franchise system? One idea to reach your magic goal is finding individuals who are already in your type of business. I am not referring to conversion franchising, although for some franchising companies this method has proven quite successful. Of course, the down side to conversion franchising is that the converted facility has to be reformatted to your trade dress, and the prospective franchisee normally has a closed mind to a different system of doing business. In many cases, if we really analyzed conversion franchising, we would find that if the individual in business were successful, they normally would not be interested in converting.  Since conversion franchising may not be the most beneficial way to obtain franchisees, other means of prospecting should be explored.

Perhaps a more successful means of obtaining prospective franchisees is to look for a person that has worked for some other company in the same or similar business and now wants to have their own business. This concept is really not new; it has been used in many other areas. When my favorite college, Auburn University, hired a new football coach, he found the program lacked the quality athlete for the football program to be competitive. To build the program he used the traditional approach of recruiting from high school. He also recruited Junior College players. This last step put the booster rockets on the program and helped it climb back to the top as one of the elite football schools. This coach in essence did what we are talking about. He found a prospect who had worked in a similar line of
business (Junior College) to be his franchisee. The chances that the new athlete (franchisee) would be successful were greatly enhanced because of the athlete’s previous experience.

One of my clients tried this concept of recruiting prospective franchisees from the same or similar business by giving a discount on the initial franchise fee based upon the number of years experience the prospect had in its type of business.  They not only increased the number of franchises sold but the success rate for these franchises was much greater and thus, their bottom line increased.

There are all kinds of wrinkles but the idea is to generate a new way of adding numbers to your system. Because the prospect already has had experience in a similar business they will not require the extensive training of someone with no knowledge of your business. The likelihood of the prospect’s success is also much greater since the learning curb will not normally be nearly so great. Further you are now marketing to attract a particular segment and your dollars are much better spent to reach those individuals most likely to choose your industry.

There are a number of avenues to target prospects in a particular market. Give us a call if we share any ideas or consult with you on a particular need you may have.


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SUPPLYING THE FRANCHISE SYSTEM

No matter how big or small the franchise system, the heart of its success or failure lies with the public’s perception of the system’s brand. That perception comes in large part from the quality of goods and services offered by the franchise. Suppliers chosen or approved by a Franchisor must have the capability of consistently providing the products and services that meet or exceed a Franchisor’s quality standards.

Determining the best method of supplying Franchisees and of developing supplier relationships, raises a number of business and legal issues. In this issue of Franchisor Alert we focus on different supplier relationships and advantages and disadvantages of those structured relationships. In our next issue we will concentrate on the legal implication arising from the supplier relationship chosen by a Franchisor and the legal issues of pricing restrictions, volume commitments, supplier capacity, incentives, rebates, warranties, federal and state disclosure issues and federal (antitrust, intellectual property, trade secrets, trade dress) and state law claims.

In all likelihood the methodology used for supplying products and services to Franchisees will evolve over time. Franchisors should therefore be very careful to make sure all relationships with suppliers and with Franchisees are capable of evolving with the franchise system needs. Both the source of supply and the manner of distribution to Franchisees is sure to change as the franchise system matures.

Different Models
1.Designated or Approved Vendors

Perhaps the most prevalent model of supplying the franchise system is one where

Franchisees must purchase products and services from designated or approved suppliers. The use of designated or approved suppliers gives a Franchisor control over the quality of those products and services offered by the franchise system and at the same time, enables a Franchisor to take advantage of economies of scale by negotiating lower pricing for the franchise system as a whole. Additionally, Franchisors may use this model as a source of revenue by collecting rebates, commissions or other fees from the vendor. The use of this model may however, increase a Franchisor’s exposure to supply breakdowns, delivery problems, disruptions and product quality issues. Consequently Franchisees may attempt to hold a Franchisor legally accountable. Franchisors may also find themselves in the middle of a Franchisee/supplier dispute. When Franchisees become disgruntled they look for ways to challenge the legality of the supply system and potentially the Franchisor’s system.
2. Supply Standards – No Supplier Restrictions

Another model used is the very basic system which requires that products and services alone, meet the standards set by a Franchisor. Unlike the first approach there are no restrictions on the suppliers used byFranchisees as long as the products and services meet the Franchisor’s standards. While this model is much easier to administer it does not allow a Franchisor to have much control over the quality and consistency of products and services, nor can the franchise system take advantage of the economies of scale or potential rebates.
3. Cooperatives

Normally parties participating in a purchasing cooperative agree to purchase products and services from certain suppliers, enabling the cooperative to take advantage of greater volume purchases and thus, the ability to negotiate pricing and other terms. A Franchisor who establishes a cooperative has the ability to make participation optional or mandatory. In some franchise systems the cooperative is owned and operated by Franchisees which has the advantage of designating the administration of suppliers to Franchisees and also, limiting the potential liability of a Franchisor from supplier disputes.
4. Blended Approach

Perhaps the most common method of supplying the franchise system is the blended

approach. Usually two or more of the 3 models listed above are combined or merged together requiring Franchisees to purchase certain products and services, normally proprietary products at a minimum, from designated or approved suppliers. A mandatory or optional purchasing cooperative may also be present under this arrangement for some or all of the products and services required for use in the franchise system.Frequently the blended approach is developed over time and joins the best features from each model. Often the determining factors used to structure a blended model include:
i. The industry in which a Franchisor operates;
ii. The number of products and services to be offered;
iii. The proprietary nature of the products and services essential to the franchise;

iv.The age of a franchise system; and

v.The size and geographical area of the franchise system.

Conclusion

Although the method chosen by a Franchisor to get its goods and services into the marketplace plays a substantial role in the success of the system chosen, it is often the Franchisor’s navigation of legal issues which results in the ultimate success or failure of a Franchisor’s chosen supply system. In the next month’s issue of Franchisor Alert we will explore many of the legal issues faced by a Franchisor supplying the franchise system, as well as resulting disclosure requirements.


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STATE INCOME TAXES – THE CONTINUED ASSAULT ON A FRANCHISOR’S PROFIT

George Washington said it best: “Government is not reason, it is not eloquence – it is a force! Like fire, it is a dangerous servant and a fearful master; never for a moment should it be left to irresponsible action.”

Do states actually have the constitutional ability to impose an income tax on out-of-state franchisors? The Commerce Clause and Due Process Clause of the Fourteenth Amendment to the U.S. Constitution set limits on a state’s ability to tax franchisors located outside their boundaries. The U.S. Supreme Court has certainly made it clear that a company must have a physical presence in a state to be subjected to a state sales and use tax. Unfortunately, Franchisors do not have the same clear road when exposed to a state’s income tax laws and regulations.

As states have lost valuable revenue sources over the years they have struggled to find replacement income. One substitute for the shortfall has been found by taxing the income out-of-state franchisor’s are receiving from franchisees. In the case of KFC Corp. v. Iowa Department of Revenue, the Iowa Supreme Court recently approved the state’s practice of imposing an income tax on franchisors where their only connection to the state was the use by franchisees of the franchisor’s intellectual property. Other states like Florida, Georgia, Minnesota, New Mexico, Oregon, Rhode Island and Wisconsin have enacted specific legislation or regulations imposing an income tax, regardless of physical presence, when there is a use of intangibles within the state. Some states like Colorado, Connecticut, and Ohio set a baseline amount before imposing an income tax on economic presence alone. The Department of Revenue in Maine is notifying out-of-state companies with solely an economic presence that they are subject to the state’s tax laws. Arizona, California and Delaware also appear to have taken the position that out-of-state franchisors are subject to their state income tax. Several other states whose statutes or regulations are silent on a physical presence appear to tax franchisors based upon the licensing of intangibles: Alaska, District of Columbia, Hawaii, Illinois, Kansas, Kentucky, Mississippi, Montana, New Hampshire, North Dakota, Pennsylvania, Utah and Vermont. Nebraska and Virginia seem to tax any activity that is constitutional or that federal law allows. The Arkansas Department of Finance and Administration of the Commissioner of Revenue has adopted a regulation similar in effect to that of Iowa.

Franchisors are no doubt faced with a heavy responsibility to determine whether a state’s tax laws are applicable to their business. Indeed, the responsibility is one that cannot be ignored. I recently was contacted by a franchisor seeking assistance in a royalty income tax dispute with a state other than its domicile, which wanted the franchise company to file 10 years of back tax returns. If you are contacted by a state agency do not ignore the questionnaire. If you never respond you will very likely be hit with an estimated assessment or an assessment based on an artificial amount constructed by that state. Uncontested assessments lead to judgments that can be enforced in your home state. If you receive a questionnaire consult your attorney or tax advisor familiar with multistate transactions. If your company had no physical presence in a state but had franchisees in the state, there are portions of the questionnaire that probably require a qualified response.

Perhaps the most economical way for franchisors to protect themselves and to cover all their bases is to include a provision in their franchise agreement requiring franchisees to pay any tax assessed by a state on the franchisor’s royalty income.

CONCLUSION

As states continue to search for replacement revenue franchisors must become proactive. Know the states that tax royalty income where a franchisor has no physical presence. Join other franchisors to actively engage in advocacy in those states, whether through new legislation or through the courts. Also, use franchise agreement provisions requiring franchisees to be responsible for state income taxes accessed against royalty income.

Remember the words of Thomas Jefferson – “A little rebellion now and then is a good thing.”

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FINANCIAL PERFORMANCE REPRESENTATIONS – AVOIDING THE LITIGATION TRAP

Just as Franchisors began to get comfortable foregoing the use of an “Earnings Claims” in their disclosure document, the rules of the game changed and a new name for Item 19 appeared – “Financial Performance Representation” (FPR) and with the new name, the information required changed, making it easier for franchise companies to make financial representations to prospective franchisees when selling their franchise. For the prospective franchisee, financial performance information is critical in the decision making process. Often the first question asked by a prospective franchisee is “how much money can I make.” But even though the FTC made it easier for Franchisors to use an FPR there still exist a steady stream of litigation from hungry plaintiff attorneys waiting for the neophyte or the overzealous Franchisor to make unsubstantiated, exaggerated, fraudulent or technically illegal FPRs. For the prudent Franchisor who desires to build the franchise company on a solid foundation, the question is – how do you incorporate FPRs into the sales process without encountering the snare of a hungry plaintiff’s lawyer.

First know the most common pitfalls leading to litigation. One of the most common Franchisor pitfalls is the use of data gathered too far in the past and which is no longer relevant or applicable to current market conditions and may not provide a reasonable basis for the FPR representation. This is particularly true in a tight economy. Today consumers are keeping a close eye on their spending habits. Franchisor’s that rely on consumer spending for non essential products and services are especially vulnerable to lawsuits from the use of outdated or no longer relevant information.

Another area in which Franchisors must proceed with caution is their use of cost data coupled with a percentage of sales. Although the Amended FTC Rule excludes cost information by itself from the definition of financial performance, Franchisors must not present cost or expense data as a percentage of sales. Presenting a prospect with cost data, coupled with sales or earnings figures which enable a prospective franchisee to calculate average net profits falls squarely within the definition of a financial performance representation.

Second – The Amended FTC Rule broadly defines financial performance representation to include any representation, whether oral, written or visual, that states expressly or by implication a specific level or range of actual or potential sales, income, gross profits or net profits. Therefore Franchisors are required to make an Item 19 FPR disclosure for cost of goods sold if expressed as a percentage of sales, assisting in the preparation of an FPR statement, or providing a prospective franchisee with a pro forma, or any representation regarding occupancy rates or transaction volumes. As a Franchisor you must be cognizant that FPR representations include not only what is contained in Item 19 of the FDD, but also information stated in your brochures, advertising materials, website, verbal representations made by you or your franchise sellers as well as, your assistance to prospective franchisees in preparing a pro forma, or reviewing a business plan.

Franchisors that fail to consult with franchise counsel regularly may also be caught in the disclosure trap where they provide an unaudited financial statement to a prospective franchisee and the statement breaks down revenue into royalty revenue or advertising fees. In cases where a franchisee’s fees are calculated as a percentage of gross revenue, a prospective franchisee can “do the math” to ascertain potential revenue.

CONCLUSION

The stage is set! There is no doubt that prospective franchisees want financial performance information as part of their due diligence and therefore those franchisors that provide it are ahead of the rest that don’t. But the Franchisor that fails to review all aspects of its sales process with franchise counsel may find itself in the jaws of a hungry plaintiff’s lawyer.