Structuring and managing franchising agreements

December 2013 | TALKINGPOINT | BANKING & FINANCE

financierworldwide.com

FW moderates a discussion on franchising agreements between Sheilah Mackie, a partner at Blake Lapthorn, Joyce Mazero, a partner at Perkins Coie, and David J. Kaufmann, a senior partner and founding member of Kaufmann Gildin & Robbins LLP.

FW: In broad terms, how would you describe the current franchising market? Is there a strong appetite for franchising, with buoyant levels of activity in this area?

Mackie: The franchising market in the UK continues to remain buoyant, with significant numbers of brands looking to enter the sector whether through franchising an existing part of their business or bringing a new brand to larger markets. Appetite for new overseas brands looking to enter the UK market also remains strong, although the premiums being achieved by overseas franchisors granting rights to a UK master franchisee are no longer as heady as they were a few years ago. The demand from people looking to enter the market as franchisees also remains strong but prospects are taking much longer to convert than previously seen as people spend more time carrying out due diligence on potential opportunities and shopping around.

Mazero: Franchising tends to be an opportunistic method of business development thriving in both economically fortunate times as well as under challenging circumstances. In times where cash is readily available, buyers look for opportunities to exploit promising emerging brands or invest in existing operations, gaining market presence and many times, obtaining additional development rights to gain market share. In all cases the goal is to obtain a return on investment in the brand value created by a franchisor who has done the ‘heavy lifting' in creating, testing and implementing the franchise business system. In economically difficult times the prospective franchisee may take advantage of offerings made more attractive because the franchisor is willing to reduce fees for entry, provide marketing funds for investment in the local market or permit a franchisee to take over an existing company market in need of focused investment in return for the rights for future development in additional markets. The current activity in franchise sales reflects the pace of anticipated economic growth especially in franchises serving the energy, healthcare and technology markets, in non-traditional venues such as universities, transportation and business centers and in connection with international expansion.

Kaufmann: Franchising’s dynamic growth throughout the US and the world continues unabated. Just 50 years ago, franchising was barely a blip on the radar screen on the American economy –and virtually unknown outside of the US. Today, franchising is an economic force so remarkably powerful that it accounts for over $1 trillion a year in retail sales in the US alone, and key markets in Europe, the Middle East, China, Japan and Central and South America are heading in the same direction. In the US, and increasingly throughout the world, every time you stay in a hotel; frequent a restaurant; purchase an automobile; have it repaired; buy or sell a home through a real estate broker; have your taxes prepared; utilise a home health care service; or, fill up your car with gasoline, among many other things, the odds are very strong that you are dealing with a franchised business.

FW: Could you outline some of the key advantages of a franchising arrangement?

Mazero: A successful franchise system should provide the prospective franchisee with opportunities to exploit economies of scale in the areas an independent operator would find very difficult to exploit alone. These areas include collective purchasing , marketing and advertising leverage, brand identity and value and operating systems supported by research and development. The franchise relationship should be collaborative, based on transparent reporting, communication and inclusion, in order for the franchisee to maximise the benefits of such economies of scale.

Kaufmann: Franchising is a means of establishing a national or international business network in a matter of years, not decades. Until franchising’s advent, the only way a business could establish a network of units operating under its brand name was to itself go out and find each location; purchase or lease that location; build and equip the unit; hire all personnel necessary to operate the unit; procure all required inventory; and, then open and operate that unit, all at staggering expense. Through franchising, the economic burdens of establishing a regional, national or international chain are shared between the franchisor and its franchisees. It is the franchisor which develops the business unit model and the network brand. It is the franchisee who actually builds and operates a network unit under the franchisor’s brand name and in strict compliance with brand standards. Franchising enables extraordinarily rapid network expansion and market penetration, a rapidity measured in terms of years rather than decades.

Mackie: One of the key advantages is the opportunity to expand a brand and market share using other people’s capital and effort. Franchisees shoulder the time and costs of setting up their franchise outlet, obtaining staff and premises, promoting the brand within their territories and maintaining working capital, amongst many other things. Typically the franchisee will have invested capital from their own pockets but franchised systems are also favoured by banks in the UK – it has been shown over several decades that they generally have a higher success rate than independent businesses – and banks will lend significant proportions of set-up capital needed – often up to 70 percent. This leaves the franchisor free to concentrate on developing the franchised system, updating products and services, marketing on a national level and managing the overall operation – hopefully with leaner overhead costs and a good ROI. As franchisees benefit from the success of their business far more so than employees, franchisors also benefit from their increased drive meaning greater financial returns for all.

FW: What risks and challenges does the process entail, and how can parties on both sides manage and overcome them?

Kaufmann: Most of the risks and challenges inherent in franchising can be anticipated and avoided through the use of experienced advisors and counsel. The threshold issue to be addressed is not how to franchise a business but whether it should be franchised at all, a question too frequently overlooked. Will there be a demand for the product or service in question? Does the business considering franchising possess the experience, proven profitability, protectable intellectual property, sufficient funding and skilled personnel sufficient to successfully expand through franchising? If so, the next critical issue that a business must consider is “how do we franchise?” Regionally? Nationally? Internationally? What structures should we use and what should the economics be ? And who should – and should not – be considered for the grant of a franchise? Only advisors with a proven track record of establishing successful franchise networks can furnish competent answers to these and a host of other questions.

Mackie: The greatest risk and challenge for a franchisor lies in the loss of control over its brand and business secrets. Franchisees need to use a franchisor’s trade names and logos and its confidential operational processes to run their outlets but, as much as a brand’s expansion can benefit from the time and effort put in by franchisees, a brand’s reputation also depends heavily on the franchisees’ behaviour and performance and their adherence to brand guidelines. A strong, well-drafted franchise agreement, policing of adherence to standards and early intervention by the franchisor should quell most problems quickly but this needs the franchisor to have the ability and funds to offer a reliable and supportive head office function and the ability to manage a network of independent third parties rather than an employed workforce. This, coupled with a fair but firm hand and engagement with the franchise network, can resolve many issues that arise.

Mazero: The challenges of the franchise relationship typically fall into two categories. First, franchisee acceptance of the franchisor’s standards, requirements and rules for operating a business under the franchise system, including standards applicable to the types of products and services offered; approved purchasing sources for such products and services; collection and use of franchisee funds for marketing and advertising, granting of territorial development rights, including exclusive rights; and innovation and market expansion. The franchise relationship is more of a ‘membership’ model and is not an ‘ownership’ model. A franchisee who approaches a franchise relationship with the goal of making unilateral changes to the system will find that to be an unrealistic and unrewarding one. Second, franchisees should participate in the evolution of the franchise system including testing, cost and timing of changes required to keep the system competitive and relevant in the market. At a minimum, franchisees expect the franchisor to make a solid business case for change and franchisors who use a ‘command and control’ relationship approach to implementing system change will typically be met with significant resistance and an incomplete integration damaging to system value. Many franchisors use various methods to solicit franchisee input and increase support for changes including advisory councils on menu, marketing and product innovation, buying groups and cooperatives for sourcing and purchasing, and mediation and ombudsman programs for dispute resolution.

FW: What role does intellectual property play in franchising agreements?

Mackie: Intellectual property forms a fundamental part of a franchise system and, to be successful, it must be properly protected. The most crucial aspect is its branding so trade names and logos, including all variants of them, should be registered. Unregistered marks do have some protection by law in the UK but registered marks have many more and skimping on registration fees at the outset is not a wise move. Thought should also be given to future expansion and early application made to secure protection in target countries. The other crucial aspect of a franchise system is its operational manuals and processes and customer databases. Copyright will arise automatically in many materials and database rights may also attach to customer lists but franchisors should take care – through appropriately drafted agreements and technical measures – to minimise unauthorised use or disclosures. Some systems will use patented products or processes so advice should be sought from a patent agent if relevant.

Mazero: Trademarks identifying the brand and system, trade secrets and know-how representing the system methodologies and processes and sometimes, patents protecting certain designs, processes and equipment, are hallmarks of true franchise value. This value should be recognised in increased customer awareness, increased customer count and market share and increased revenue.

Kaufmann: Intellectual property plays a key role in franchising arrangements. The economic underpinnings of franchising centre on brand names and the public’s perception of quality and uniformity associated with those brand names. Branding of products and services has evolved to convey not only the source and identification of a company’s product or service, but also to invoke an emotional relationship and response in consumers. Brand loyalty to the franchise network is the goal and can be a powerful economic force. For example, some studies reveal that children under the age of 10 in the US have 100 percent name recognition for only two ‘persons’ – Ronald McDonald and Santa Claus.

FW: To what extent is important to plan at the outset for the possibility of having to enforce a franchise agreement down the line?

Mazero: The franchise relationship is a serious business relationship and tensions concerning the operation and profitability of the business are typical. Critical to managing these tensions is creating an environment in which disagreements can be aired and resolutions based upon the parties aligned expectations implemented. Most failed franchise relationships are shaped by ineffective or lack of meaningful communication. This is the rationale for inclusion of franchise advisory councils and committees in discussions about material areas of the business. Regardless, attempts at avoiding litigation on claims arising from the franchise relationship can fail and in those situations the parties will be forced to support their position. This requires the franchisor and franchisee to insist on agreements which accurately and clearly describe the parties’ obligations, the types of conduct that constitute failure of such obligations and the remedies available to the parties for such failure. A written record including a timeline of any material communications, agreements or disagreements is critical to success in any action to enforce the terms of the franchise agreement. This applies to any requests for approval, notices, waivers or excused performance. It is also important for each party to understand the impact of the law selected to govern the interpretation of the agreement and have negotiated a dispute resolution method and a venue for disputes that is relevant and manageable for it.

Kaufmann: It is critical that every franchise agreement anticipate strict compliance therewith by all franchisees – and enforcement against those franchisees who do not adhere to the franchisor’s system, with the ultimate penalty being termination of the franchise. The essence of franchising is uniformity. Each franchisee must strictly adhere to its franchisor’s systems of operation, standards and prescribed methods of doing business. It is common knowledge in franchising that if a customer has a bad experience in one franchised outlet, not only will they not visit that outlet again, but that customer will likely never visit any of that network’s units. So, franchise agreements require very stringent franchisee adherence to the franchisor’s systems and methods, freely permit the franchisor to modify its systems and standards to adapt to changed demographics and consumer preferences, and permit the franchisor to inspect each franchisee’s operation in every respect and require changes thereto if compliance with the franchisor’s systems and standards is found lacking.

Mackie: Litigation is not cheap and a well-funded disgruntled franchisee or, increasingly a group of franchisees, is one of the biggest threats to a franchisor, so it is hugely important to plan ahead for this possibility. Many franchisees are happy to follow the franchisor’s processes and update their businesses as directed but often franchisees decide that they can do better by subverting the system in some way or operating an independent competing business using the franchisor’s know-how and goodwill. Franchisee disputes are almost impossible to avoid in any network so a well thought through and tailored agreement drafted by an experienced franchise solicitor is the best starting point. Side letters are also best avoided as they are generally ill-considered in terms of future consequences on the main agreement. Regular policing and record keeping are tasks that should be embedded in the management of any network but franchisors should also remember that litigation is best fought with clean hands so should keep their end of the bargain.

FW: Are there any specific regulatory or legislative issues that need to be addressed as part of these deals?

Kaufmann: The offer and sale of franchises, and the ensuing relationship between a franchisor and its franchisees, are closely regulated by laws designed to stamp out fraud in the franchise marketplace and protect franchisees from perceived abuse. In the US, both the federal government and two dozen state governments have franchise laws, rules or regulations. Internationally, 17 countries have laws governing franchise activity. And, naturally, franchisors must adhere to EU competition law and antitrust prohibitions. Further, intellectual property law requirements must be adhered to to ensure that the franchisor’s name, trademark, service mark, trade dress and other intellectual property are adequately protected both nationally and throughout the world. Antitrust laws pose a particular concern to franchisors and must be properly navigated. And, of course, there will be a myriad of business specific laws which may or will be applicable to any given type of franchise network.

Mackie: Some legislation will touch on franchising deals, including UK and EU competition regimes if the network’s market share is large enough; the Carbon Reduction Commitment Energy Efficiency Scheme rules if the system is property based; and Trading Schemes legislation if the franchise is multi-level but, unlike other countries with large franchising sectors, franchising is not subject to any particular regulation within the UK. It is possible, however, for franchisors to submit themselves to voluntary regulatory by joining the British Franchise Association, a trade association started in 1977 to promote ethical business format franchising. Members must comply with the BFA’s Code of Ethics, derived from the European Franchise Federation’s code of ethics, as well as certain technical requirements promulgated by the BFA and also undergo initial and on-going accreditation checks. Members who fail to comply or lose membership status may suffer reputational damage but there are rarely any legal consequences for failing to do so, as very few franchisors contractually bind themselves in their franchise agreements to comply with the Code of Ethics.

Mazero: There are franchise sales and relationship laws that impacted the rights and obligations of the franchisor and franchisee in the US and numerous other countries. It is important for the franchisor and franchisee to obtain the advice of experienced franchise counsel on the implications of such laws on their respective rights and obligations, and with respect to their understanding of the franchise agreement.

FW: What general advice would you offer to parties deciding whether to undertake a franchising arrangement in today’s market? What are the essential elements of a successful structure?

Mackie: Franchising does not suit everyone – managing a network requires different skills to running an existing business. In addition, many businesses are not suitable for franchising – the margin may be too low for franchisees to make a living, the skills required take too long to acquire or the product is of a fad nature. Thought should therefore be given to the suitability of a business and its owners for franchising before launching into the process. Parties should also avoid the temptation of thinking that a non-profit making part of their business can be offloaded into a franchise structure in the hope of making some money that way, as that is generally a recipe for failure. Ideally, an arms length pilot operation should be run for at least 12 months to see how things work in practice and allow processes to be streamlined and made relevant. Expert advice should also be sought from experienced professionals – solicitors, franchise consultants and banks etc – to help ensure that robust foundations and sufficient capital are in place. But, most of all, franchisors should devote on-going time and energy to managing, developing and supporting their franchised system.

Kaufmann: Franchising has generated vast amounts of wealth, but it is not something to be undertaken lightly. Most critical of all is the need to determine whether there will be enough consumer demand to sustain franchised units over the long haul. We in franchising must always try to divine what the future holds in terms of consumer preferences, changes in demographics, economic trends, constantly evolving technology and governmental predilections. These must be anticipated in a properly structured franchise agreement, one which reserves to the franchise network the ability of the franchisor freely to modify its system as change transpires. Two other critical elements must also be kept in mind. The first is ascertaining the proper economics of the forthcoming franchise relationship. If not properly calculated, the franchise network will ultimately fail. As well, it is critical that standards are established for who should qualify as franchisees. Simply selling franchises to the first individuals or business entities whose checks will clear is a recipe for disaster.

Sheilah Mackie is a partner at Blake Lapthorn and head of their nationally ranked franchising practice. She was also the first solicitor in the UK to obtain the British Franchise Association’s Qualified Franchise Professional qualification. She advises on the full range of issues faced by those in the sector including setting up and managing franchise networks, complying with relevant regulatory requirements, dealing with underperforming franchisees and extracting franchisees from networks. Ms Mackie is qualified in Scotland and England and Wales and is recognised in Chambers UK as a leading individual in franchising. She can be contacted on +44 (0)23 8085 7039 or by email: sheilah.mackie@bllaw.co.uk.

Joyce Mazero is partner at Perkins Coie. She has substantial business experience as lead project partner assisting clients in developing strategy, structuring, negotiating, implementing, and resolving disputes for product and service-based domestic and international license, franchise, distribution, and shared services systems. Among her various honours and awards, Ms Mazero was named by Chambers USA as one of the nation's leading franchise attorneys for 2007 and received the prestigious Band 1 national ranking annually from 2008-2013. She can be contacted on +1 214 965 7702 or by email: jmazero@perkinscoie.com.

David J. Kaufmann is a senior partner and founding member of Kaufmann Gildin & Robbins LLP, and partner-in-charge of the firm’s franchise team. He represents many of America’s largest and most prestigious franchisors, as well as innumerable start-up and midrange franchisors, in every significant sector. He has also represented numerous investment banks and private equity concerns. Mr Kaufmann has been featured in every edition of The Best Lawyers in America and was named the New York Area Franchise Lawyer of the Year by New York magazine. He can be contacted on +1 212 755 3100 or by email: dkaufmann@kaufmanngildin.com.

THE PANELLISTS

Sheilah Mackie

Blake Lapthorn

Joyce Mazero

Perkins Coie

David J. Kaufmann

Kaufmann Gildin & Robbins LLP