Franchise Rules You Should Know

There are few U.S. towns so small that they don’t have at least one set of golden arches, to say nothing of Burger King, Wendy’s and KFC. Franchises are clearly profitable businesses—but they can be tricky ones. Misunderstandings can sour the relationship for both franchisor and franchisee.

Individuals and companies pour substantial capital into a franchise, so informed investing is critical. Two factors are essential for success: a careful assessment of the initial offer and a harmonious relationship between the parties. To fulfill their roles as key advisers to business, CPAs need to be aware of the latest franchising developments.

Two documents in particular govern the formation of the franchise relationship:

• The Franchise Rule of August 24, 1979, published by the Federal Trade Commission and reexamined by franchisors and franchisees in 1995. This rule applies to franchisers and franchise brokers and is the result of criticisms of deceptive and unfair practices.
• The Uniform Franchise Offering Circular (UFOC) developed by the North American Securities Administrators Association (NASAA) and issued by the International Franchise Association (IFA). It was adopted September 2, 1975-and revised April 25, 1993-for states to use in franchising regulation.

Development of the rules. In 1995, some 20 franchisor and franchisee representatives attended a workshop in Minneapolis. Franchisee representatives encouraged greater focus on creating a solid, harmonious relationship between buyer and seller, while franchisor representatives asked that potential franchisees become better informed about the ramifications of the franchise alliance. A broad consensus emerged to develop a more useful offering circular for investors. Accordingly, NASAA representatives encouraged the FTC to adopt a national disclosure standard, using the revised 1993 UFOC, that would be effective no later than 1995. This would replace the UFOC of September 2, 1975.

KNOW THE RULES
The UFOC is the principal disclosure document to guide prospective franchisees with their investments. The NASAA required its use effective no later than 1995, in response to criticisms from franchisee representatives, who said the 1979 rule for presale disclosure did not adequately address the ongoing franchisor/franchisee relationship. (The complete document, published by the International Franchise Association, can be obtained for $21.95 from the IFA in Washington, D.C., by calling 800-543-1038. The IFA has educational materials about the UFOC as well.) These revisions simplify the evaluation process and enhance the franchising relationship. The revised document addresses general instructions and 23 specific disclosure items. The most significant changes are

Format and structure. Franchisors should disclose material facts in accurate and unambiguous language and avoid archaic and awkward legalese. (See exhibit 1 , for a detailed list of suggested changes.) The document should be well organized, with tables when appropriate.

Investments/restrictions/obligations. To simplify the contractual relationship, franchisors should use we for themselves and you for the franchisee. Franchisors should disclose in tabular format the initial investment (includes inventory, supplies and equipment), the initial fee (the franchise fee) and continuing fees (royalties on sales and assessments for advertising, for example).

Franchisors must list any restrictions on supply sources for goods and services, disclosing the goods and services they will supply exclusively; cite specific sections of the agreement and offering circular for each franchisee obligation; and disclose in detail any obligations they must perform before the business opens.

The franchisee’s market. Market is critical. In past years, lack of territorial protection was a major complaint of franchisees, because franchisors opened company stores or franchise outlets relatively close to each other. The franchisor must address the location and market territory for the franchise and make it clear whether it is granting protection. If it is granting protection, a franchisor should disclose

• Whether it has or will establish another franchisee using the franchisor’s trademark.
• Whether it has or will establish another company-owned outlet or channel of distribution using the franchisor’s trademark.
• The area granted the franchisee, including the specific territory, new company-owned outlets or other channels of distribution and any plans for an affiliate to open a channel under a different trademark.
• The conditions under which the franchisor will grant a relocation.
• Restrictions on the franchisor regarding use of company-owned stores.
• Restrictions on the franchisee from accepting orders outside its defined territories.
• Restrictions on the franchisor from soliciting or accepting orders inside the franchisee’s territory.
• The franchisee’s options to acquire additional franchises within the territory or contiguous territories.

Franchisor/franchisee relationship. A smooth relationship can lead to success for both parties. To avoid arguments later, franchisors should write a document containing the following items and present them in tables with citations to the exact section of the agreement:

• Clear statements on all requirements for termination, whether by franchisor or franchisee.
• Definitions of cause , curable defaults and noncurable defaults that lead to termination.
• A definition of transfer and the conditions for franchisor approval of transfer.
• The franchisor’s option to purchase the business.
• Noncompetition covenants during and after the franchise term.
• The forum and choice of law for resolution of disputes by arbitration or mediation.

Earnings claims. These can refer to a range of actual or potential sales, costs or profit. They are not mandatory, but if the franchisor makes earnings claims, it must clarify its definitions. Franchisees should look closely for hidden costs that significantly affect profitability, such as all costs associated with a lease. Earnings claims language should include assumptions made and a summary of the basis for the claim—which should include actual experience if applicable. A claim needs to have a reasonable basis at the time it is made . Any statement of future performance must follow applicable AICPA guidelines, available from the Institute by calling 888-777-7077. (AICPA members wanting accounting or auditing information can call this number for the free technical hotline.)

Also, the document ought to clearly state whether a new franchisee’s results will differ from results stated in the earnings claim. Franchisors should make data available for inspection.

List of outlets. The franchisor also must provide the total number, names, addresses and telephone numbers of similar franchises and company-owned outlets. They can be limited to the state of operation but should total at least 100. This list should include outlets

• Canceled, terminated or reacquired within the past three years.
• That have transferred controlling ownership.
• The franchisor canceled or terminated.
• That otherwise ceased to do business in the prior three years plus the most recent fiscal year.

Franchisees should ask about unprofitable outlets that the franchisor consequently reacquired. The franchisor has a vested interest in maintaining as many outlets as it can; generally, a franchisor will reacquire an unprofitable outlet and seek another buyer.

Financial statements. The franchisor must submit its balance sheet for the last two fiscal yearends plus the statement of operations, equity and cash flow for the last three fiscal years.

Receipt and review of documents. The franchisor should attach to the offering circular all agreements, including the franchise contract and lease. The franchisees should receive the offering circular at least 10 days before signing and the franchise agreement at least 5 days before signing.

Exhibit 2 , is a checklist for both parties in a deal to help ensure they cover all points in enough detail. It also allows both to judge the level of detail of disclosure compliance.

REINFORCE THE ROLE
Much has been said in recent years about the CPA’s role as an adviser to business. CPAs who know the ins and outs of the franchise business can do much more than just take care of the financial details at the end. In fact, they can play an integral role in the selling, buying and continued management of an operation.