9 QUESTIONS TO ASK YOURSELF BEFORE FRANCHISING
Some aspiring entrepreneurs may believe that franchising a business is an easy decision. If you had some success with your first store, you may think that franchising is the next logical step. A positive bottom line at one business in one location, however, will not always translate to widespread acceptance of a particular brand or concept. For that reason, it is imperative that you take a close look at the wide variety of factors unique to the franchise model to determine whether franchising is the right choice. This article will explore a number of those factors to consider when taking the plunge into franchising, however it is by no means an exhaustive list of the elements involved in starting up a franchise.
Who Is On Your Franchise Team?
Your initial team of advisors should, at a minimum, include expertise in legal affairs, accounting and franchise sales and development.
The lawyer’s role is to help you determine the model of franchising that best suits your objectives, be it unit franchising, area development franchising or master franchising, and then capturing those concepts and requirements in franchise agreements and a disclosure document, where one is required by law (more on what all of these terms mean below). The accountant’s role will be primarily to create your financial statements and opening balance sheet which are essential components of any valid disclosure document, again, where one is required by law, and will also help you plan your finances generally. With respect to sales, you may want to consider retaining the services of a franchise consultant with specific expertise in the franchise industry, or hiring a sales or development manager who has demonstrated experience selling brands to franchisees in other systems.
Is Franchising Right For You?
You should ask yourself a number of questions about your business to determine whether it even makes sense to start franchising. Taking the time to give these ideas some thought, and even putting pen to paper, is likely to get you to better organize not only your business plan, but also to help you better understand the foundation upon which your system and concept will be built:
- What exactly is the product or service?
- What is the competition like? Is your product or service unique enough to stand out in a crowded field?
- Are there any hurdles to entering the market that you should be aware of? Are there any regulatory obstacles to franchising a business in your particular industry?
- Will it be manageable for someone else to copy that model under your supervision, or does it only work under your direct implementation?
- How many corporate-owned units do you have, and how are they doing financially?
- What are your financial resources?
- Where will you find franchisees?
- Do you have the right internal team in place to help locate franchisees, build the brand and generally execute your vision?
What Kinds of Franchising Options Exist?
There are several franchising options available to you, the availability and advisability of which will depend on the nature of your franchise system, the territory within which you can conduct business and your overall business acumen. The following is a list of three examples:
Direct Franchising: Direct, or unit, franchising is the purest form of franchising a business. Under this model, the franchisor grants the franchisee the right to open one franchised business at one location, with a specified geographic range that will be protected from other franchised businesses of the same system, for instance the right to open one fast-food restaurant at a particular address. Additional franchises may be granted based on the performance of the first location. In most cases, it will be rare for the franchisee under this model to be required to satisfy performance criteria or sales quotas.
Area Development: Under an area development agreement, the franchisor grants the franchisee (or, area developer) the exclusive right to open and operate several franchised businesses within a much broader geographic territory. For instance, an area developer may be granted the right to open coffee shops within a particular neighbourhood of Toronto, or perhaps throughout the entire province of Manitoba. Area developers typically will be required to open a certain number of stores within a specified time frame, as set by the franchisor.
Master Franchising: Master franchising is similar to area development in that the franchisee (in this case, the ‘master franchisee’) is granted the right to a wide territory. However, as a master franchisee, the territory will generally be larger than under the other franchise models, i.e. an entire province or all of Canada. Master franchising is frequently employed by foreign franchisors so that a resident of the territory can expand the system in areas which the franchisor may not be familiar with. As well, master franchisees (though franchisees of the franchisor) will generally be given the right to “sub-franchise”, meaning that they can grant franchises to franchisees within their territory, rather than only operate them themselves. In this case, the master franchisee actually becomes the franchisor.
What Is A Disclosure Document?
In a franchise relationship, there is invariably an imbalance of power favouring the franchisor. This is understandable given that it is the franchisor who owns the brand, has spent considerable time and effort in developing operating standards and needs to exert a sufficient degree of control to ensure consistency in the delivery of products and services to customers of the franchise system.
Franchise law recognizes this tilt towards the franchisor and, in those provinces where franchise law has been enacted, very specific rights are afforded to franchisees which cannot be waived.
One right, in particular, is the cornerstone of franchise law and that is the franchise disclosure document. Not to be confused with an operations manual, the disclosure document is a compendium of various categories of information, all of which are specifically prescribed by law. In order to assist a franchisee in determining whether to enter the system, the disclosure document requires the franchisor to provide the prospective franchisee with its company history, litigation history, a description of all fees and costs necessary for the franchisee to start and continue to operate its business, a summary of restrictions and obligations contained in the franchise agreement and, perhaps most importantly, the franchisor’s financial statements. This list is far from exhaustive as there are many more headings of information required by law, however it should give you a sense of the level of detail that a disclosure document is to contain in order to aid a franchisee in deciding if the franchise is for them.
In addition, franchisees are under no obligation to buy into the franchise when they receive a disclosure document. In fact, the law requires that a minimum of 14 days pass before a franchisee can be required to pay any money to the franchisor, or sign any agreement relating to the franchise.
Franchise disclosure legislation currently exists in Ontario, Alberta and PEI and New Brunswick, with Manitoba anticipated to enact similar legislation later this year. Disclosure documents are not yet required in any other province or territory.
What Fees Should I Charge?
The fees which you intend to charge your franchisees need to strike a balance between being fair to a franchisee while still providing you with the opportunity to be profitable. The fees should be structured so that both of you can realize a reasonable return on your respective investments.
Generally, franchisors will charge an initial franchisee fee payable on the franchisee signing the franchise agreement. Franchisors often assume that this is straight profit for them, but the typical business reality is that the franchise fee should be an amount which compensates the franchisor for its own administrative, legal and accounting costs to grant the franchise, assist in getting the new franchised location operational and provide any agreed-upon training.
A monthly or weekly royalty fee will typically be calculated as a percentage of the franchisee’s gross sales and is the main source of a franchisor’s profits, but again, must be calculated with a view towards ensuring the franchisee’s financial stability and success.
Some other fees which may be chargeable by a franchisor include: an advertising fee (more on this a little further down), a sublease administration fee where a franchisor subleases the premises to the franchisee; a software maintenance fee; an ongoing training fee; or a waste diversion fee (in provinces where such charges are owed by a franchisor to the provincial government).
Is Location As Important As I Think It Is?
A vital consideration will be how to handle construction of the premises. As a franchisor, you may be failing your franchisees and doing a disservice to your brand if you are not assisting in the approval of a particular location. Given the critical importance of location to a business’s success, a franchisor may elect to go on the head lease of a particular location and then sublease that location to the franchisee, or make it a system-wide policy to always do so.
The benefit of this model is that, if the franchisor has found a location that has worked well for the system or that the franchisor anticipates will succeed, that location will remain with the franchisor if the franchisee ever leaves the system. When the day comes that a franchisee sells its business, or has its franchise agreement terminated by the franchisor, it will be the franchisor’s option as to whether it will continue to operate the business from that location itself, or whether it will sublease it to another franchisee.
Franchisors should, at a minimum, be providing advice or resources for setting up a turnkey operation and may build the location themselves or require the franchisee to build, at the franchisee’s own expense, and in compliance with the franchisor’s standards.
Do I Need to Register My Trademark?
One of the first things a franchisor should do is protect their trademarks by applying for federal registration under the Trade-marks Act. While registration is not mandatory for demonstrating trademark rights in Canada, you have more remedies available to you and somewhat stronger proof of your entitlement to the mark if you do register. You will need to conduct a search of the trademarks database to ensure that your mark and name will not be confusing with one already registered. Entitlement to trademark rights in Canada is based on first use, so it is important to have a clear picture of other claimants to your proposed name and mark.
How Can I Finance Advertising?
For a franchisor to ensure that there is consistency across its brand, certain system controls have to be in place, and this becomes particularly apparent in the area of advertising.
Franchisors need to be certain that any advertising being conducted by a particular franchisee does not vary from the message and brand which the franchisor has expended much time and resources to develop and sustain. As a result, most, if not all, franchise agreements will stipulate that all of the franchisee’s advertising activities must be approved by the franchisor, as well as typically requiring a certain percentage of the franchisee’s gross sales to be spent on advertising.
This will generally mean two things:
- the franchisee must expend a set amount of its gross sales (typically 1 – 2%) on local advertising within its territory. This may be as simple as creating flyers or purchasing a print ad in the phone book or local community newspaper, however the objective is to promote that particular franchisee’s location and business; and/or
- the franchisee must contribute a set amount to the franchise system’s advertising fund. The fund will be administered by the franchisor and sustained by the financial contributions of franchisees across the system. The franchisor will then use those dollars to create advertising programs and promotions that tout the brand generally and aim to benefit the system as a whole, as opposed to one particular franchisee.
Franchising is an exciting path for many businesses, and it is a form of distribution that suits a variety of concepts, not only the traditional restaurant or retail outlets. However, you should think carefully about the control that you will be forfeiting when you hand the brand to your franchisees and determine whether that suits your long-term business objectives.
Chad Finkelstein is a partner in the Franchise Law practice group at Dale & Lessmann LLP in Toronto. He can be reached at firstname.lastname@example.org or (416) 369-7883.