As the economic recovery begins to take hold, franchising remains an attractive business opportunity – but a Warner Norcross & Judd LLP partner cautions would-be entrepreneurs to pay careful attention to franchise contracts before signing on the dotted line.
Jennifer Dudley, a corporate attorney with an emphasis in franchise law, notes that franchising can be a very attractive option for someone who wants to start a business. The International Franchise Association is predicting modest growth of approximately 2 percent in the number of franchises expected to open this year, as well as an increase in employment and revenue, which should top $868 billion in 2010.
But entrepreneurs need to step cautiously into the world of franchising, Dudley warns. Prospective franchisees need to pay careful attention to disclosure documents and related franchise agreements to ensure they are truly comparing apples to apples when evaluating opportunities.
"A franchise is an excellent way to step into the world of running your own business. Established national or regional franchises come with a pre-set business plan, known trademarks and step-by-step guides for success – all of which can be very beneficial to a new business.
"But when you go in to buy a franchise, you don't have a lot of negotiating power, so it’s critical to spend the time upfront reviewing agreements. I have seen a lot of buyer's remorse after the ink is dry on the signatures and it's too late to turn back."
Before deciding on a franchise option, Dudley recommends looking at four to five contracts and evaluating key components in each to determine the best fit. Some of the prime things to review include:
Trademarks: Dudley says it's very important to ask questions about the corporate trademark which is, after all, key to the goodwill of the franchised business. Who owns it? Is it protected on the state level? Nationally?
Geographic scope and exclusivity: The devil is in the details, and Dudley says that franchisees need to read this section of any contract very carefully. For example, in the service industry, where coffee shops are all the rage, a standard franchise agreement might promise that there will not be another facility within a five-mile radius. While that might seem ideal, she said the fine print may say "freestanding facility," which means that the grocery store next door to the franchisee could add a store-within-a-store or start selling the branded coffee on its shelves.
Fees: All franchisees are interested in the start-up costs to get their business off the ground. Dudley cautions that some contracts are more realistic than others in spelling out the details. For example, franchisors are required to give an estimate of how much a new operation will spend in its first three months, but these can often be radically underestimated, particularly the amount of working capital needed. Dudley said that other franchisors will look at six months out, often providing a more realistic assessment of early capital needs. Whatever the case, she recommends digging into those numbers to ensure they are realistic – and as comprehensive as possible.
Fees (part 2): Dudley also said that it's important to understand what the fees entail. Will the business be able to lease a site or need to build one? What types of supplies are required? Must they be purchased from mandatory or affiliated suppliers where you won't be able to negotiate on fees?
Term of the franchise: Since franchises require a significant influx of capital up front, Dudley says that its important to make sure that the franchise term you are granted gives you a sufficient amount of time to earn back your investment. Additionally, knowing the renewal terms is very important – first, whether there even is a renewal term and for how long, and second, the conditions and obligations involved in renewal.
Compare documents: Always compare the disclosure document, which spells out a summary of the major franchise terms, with the franchise agreement, which details the actual agreement and terms to which the franchisee will be bound. Dudley notes that she has seen potential franchisees who read the disclosure document and ask questions of the franchisor, like what they see or hear, and sign the franchise agreement. They can wind up sorely disappointed when they find out that something was not completely and accurately described or a separate agreement promised orally didn't make it into the written agreement.
Professionals: It's worthwhile to start with trained professionals – an accountant and an attorney – on day one, Dudley recommends. Having someone who has worked with franchises and understands contracts, budgets and related issues will ensure that a new franchise gets off on the right foot and the new franchisee has the proper tools and support to make an informed decision.
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