So you have built a successful business and you are ready to franchise it. Franchising can be a powerful engine for growth — but it is also one of the most heavily regulated industries in the United States. Before you award your first franchise, there is substantial legal, financial, and operational groundwork to complete. The following is an overview of the key steps a prospective franchisor should take to launch a franchise system and begin making lawful franchise offers and sales nationwide.
Retain Experienced Franchise Counsel – – First
Before anything else, retain a franchise attorney. Launching a franchise program requires the preparation of a Franchise Disclosure Document (“FDD”) that complies with federal and applicable state franchise laws, and a suite of related agreements – – including the unit franchise agreement, and potentially an area development agreement for multi-unit developers. The FDD is a complex, heavily regulated document, and an improperly prepared one can expose a franchisor to significant legal liability. This is not the place to cut corners.
Form a New Franchisor Entity
Most franchise attorneys recommend that a client form a brand-new entity to serve as the franchisor company. A primary reason is practical: a newly formed entity generally avoids the requirement to provide three years of audited financial statements in the FDD – – a costly and time-consuming undertaking. Your accountant can help determine the most appropriate entity structure.
Protect Your Intellectual Property
Your trademarks, trade names, and service marks are among your franchise system’s most valuable assets. The franchisor should apply for federal trademark registration with the United States Patent and Trademark Office before launching. Federal registration is important not only for brand protection, but also because it triggers certain exemptions from business opportunity laws in some states, reducing the number of state-level filings required.
For systems with significant proprietary content – – copyrighted materials, patentable processes, or trade secrets – – additional IP protections should also be considered. Many franchisors also choose to house their intellectual property in a separate legal entity to shield it from any future judgments or liabilities that may arise against the operating franchisor entity.
Engage a Qualified Accounting Firm
The FDD must include audited financial statements. For a newly formed franchisor entity, this means an audited opening balance sheet. Thereafter, the franchisor must arrange for updated audited financials annually within 120 days (a bit shorter in certain states) of the close of its fiscal year if it wishes to continue offering and selling franchises.
Not just any CPA will do. The accountant must be familiar with franchise-specific accounting standards – – including, for example, FASB’s Accounting Standards Update No. 2014-09 (Topic 606), which governs how franchisors recognize revenue from initial franchise fees, area development fees, and renewal fees. In New York, only a registered CPA firm (not merely an individual CPA) that has completed the required peer review process may perform these audits.
Capitalize Adequately
Prospective franchisors should carefully assess whether they have sufficient capital not only to launch the franchise program, but to sustain it. Initial franchise fees alone are unlikely to cover the costs of supporting a growing system. If state franchise regulators determine that the franchisor entity lacks sufficient assets on its financial statements, they may require additional financial assurances as a condition of registration. Sound capitalization from the outset is essential.
Brand Standards – – Build the Operational Infrastructure
A franchise system is, at its core, a system – – and that system must be documented and teachable. Franchisors need to develop and be prepared to disclose a structured franchisee training program, covering the subject matter, duration, and format (classroom versus on-site) of each training module. Equally important is a comprehensive, confidential operations manual that gives franchisees a detailed how-to guide for running their franchised outlet consistently with the franchisor’s brand standards. In fact, the sum total of these materials, and any new brand / system guidance materials that a franchisor issues in the future, are often defined in the franchise agreement as the “Brand Standards” (formerly what was typically called the “Operations Manual,” but there is a general awareness now that such a term is too narrow). Both documents (the training program and the operations manual) must be in place before the FDD is finalized. The Brand Standards should be treated as a living set of documents, updated on a continuous basis. Note that certain states require the table of contents of the franchisor’s training program to be submitted with the Franchise Disclosure Document when seeking franchise registration.
Franchisors should also establish clear site selection criteria for brick-and-mortar concepts, and have qualified personnel capable of evaluating proposed locations.
Navigate State Registration Requirements
Fourteen states require a franchisor to register its FDD with a state regulator before making any franchise offer or sale in that state – – unless a specific exemption applies. Several additional states have business opportunity laws that may impose independent filing obligations. The registration process requires executed (and in some cases notarized) state-specific forms and filing fees, and in some states, a review period during which examiners may issue comment letters requesting FDD modifications. This process can take weeks, and the timing must be carefully managed to ensure the franchisor does not make any premature offers.
Develop a Compliant Sales Strategy and Marketing Program
Franchisors must also think carefully about how they will market and sell franchises. Franchise sales advertising is regulated – – certain states require specific disclosure language in ads or advance filing of advertising materials. Franchise sellers must be trained on legally permissible sales tactics, including the strict prohibition on making any earnings claims not properly disclosed in the FDD.
A well-constructed franchise sales program will also include a robust digital presence: a franchise development website, a prospective franchisee inquiry form, and a structured process for “Discovery Days” or other interactions with candidates.
Implement a Franchise Compliance System
Perhaps the most underappreciated step for new franchisors is putting a formal compliance system in place before the first sale. Franchising’s regulatory scheme exists to protect prospective franchisees from deceptive sales practices, and regulators take violations seriously. A compliance system should track, among other things, what representations were made during sales discussions, whether and when the prospective franchisee executed the FDD receipt, and whether the required waiting period between receipt and signing was honored. A documented compliance process is not just good practice – – it is a critical risk management tool.
Additional Considerations
Beyond the steps outlined above, franchisors should also consider applying to have their brand listed on the U.S. Small Business Administration’s Franchise Directory, which can facilitate franchisee access to SBA-backed financing. Establishing supply-chain relationships with vendors, POS providers, and distributors will also be important to the system’s long-term success. And once the FDD is registered, franchisors must remember to renew their registrations annually and amend the FDD whenever material changes occur – – a process that requires year-round attention.
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Launching a franchise system is a significant legal and business undertaking. The steps outlined here are interconnected, and the sequence matters. With experienced franchise counsel and the right team of professionals in place, a well-prepared franchisor can bring its brand to market with confidence – – and the legal foundation needed to grow.
ATTORNEY ADVERTISING. The attorneys at Kaufmann Gildin & Robbins LLP regularly counsel emerging and established franchisors on all aspects of franchise system development and compliance. Contact us to learn how we can help you build your franchise program the right way. Call David B. Ramsey at 212-705-0816 or email [email protected].