By Laura E. Liss, Attorney, Brown and Kannady, LLC.
Many attorneys who practice franchise law represent franchisors, the companies who license their intellectual property (“IP”) to franchisees, those who operate their own independent businesses using the IP. Other franchise attorneys, however, may represent the franchisees as they consider the investment in a franchised business.
The primary task during this stage is to review the Franchise Disclosure Document (“FDD”) and advise the client of its contents. While the entire (often 150+ page) FDD should be reviewed thoroughly, certain areas stand out for review and thorough discussion with the client:
Ongoing Fees
Most franchisee candidates will already know the royalty rate or the advertising fund fee that is due for the franchise. But fewer candidate clients are aware of the other ongoing fees that may be per-person (such as software licenses), or the costs for a new manager to attend training or a conference out of state (yes, the training is included, but not the airfare, lodging, car rental, meals, leisure activities, or wages for the worker attending a two-week program), or the fees due if the client sells the franchised business. Reviewing together gives a more accurate view of the operating costs.
The “Then-Current” Franchise Agreement References
One of the areas that many franchisees do not anticipate and therefore have many questions about is that in almost any FDD, there are many instances where the FDD will state that the candidate must sign or be bound by terms in the “then-current” franchise agreement. This is especially common in the language relating to renewal after the-initial license ends and terms relating to what a buyer of the business must be bound by.
Be sure to advise the candidate client that this means that anything in the agreement may change unless the current agreement says it will not change at renewal or the other occasion, i.e. the size or boundaries of their territory, minimum sales requirements, minimum staffing requirements, the royalty rate, new or additional fees, they may be obligated to offer new products or services, and more. This discussion may prompt your client to want to negotiate as well, which may or may not be possible depending on the size, experience, and needs of the franchisor in question.
Estimated Initial Investment to Open for Business
This is intended to provide a franchisee a financial snapshot of the estimated costs to open the franchised business, plus at least three months of working capital thereafter. Many franchisees rely strongly on this chart, so, a close review can assist a franchisee in making accurate projections of their expenses, which can in turn be a deciding factor for whether a franchisee will invest. For example,
- Rent and Security Deposit Estimates: For a business that will open in a retail space in the Denver metro area, often the franchisor’s estimated rent costs will be significantly lower than what is likely here and a candidate who has not owned a business before may be unfamiliar with this fact. The attorney’s advice on this point can significantly sway the outlook.
- Professional Fees: Most franchisors will estimate $2,000 – $4,000 for all professional fees a franchisee may need, including attorneys’ fees, an accountant, and their architect or engineer. This estimate is typically absorbed by attorneys’ fees alone, and therefore should be doubled or tripled depending on the concept.
- Travel and Living Expenses While Training: Many franchisors underestimate the cost to attend a training out of state for a few weeks, as previously mentioned. Depending on the number of people, these estimated costs may also need to be doubled or tripled.
- “Additional Funds” or Working Capital: This figure is intended legally to encompass all the amounts necessary to operate the franchised business from the date of opening for at least the next three months, but usually does not include salary or draw for the owner. Included in this are rent payments, debt service, wages, inventory costs, utilities, payments to the franchisor (royalties, etc.), advertising, etc.
Counsel reviewing the Additional Funds estimate will commonly suggest budgeting to have an additional $30,000 to $50,000 available above the high-side to cover unexpected expenses (such as construction overruns, staffing costs, additional advertising, and a longer than expected period before the business earns enough to pay its own expenses, etc.).
Summary
While the whole FDD’s contents should be reviewed with the candidate client, these topics often take up the majority of the discussion time. Be sure to have the client understand going in to the relationship that it is often challenging to exit, so, building an exit strategy during the initial review is important as well.
This article was previously published in the Colorado Bar Association Business Law Section Newsletter.