How To Develop A Franchise System: Part 8: Key Preparations
Before you begin to franchise your business, there are some preliminary steps you must take. The starting place is protecting your intellectual property, branding, and ideas. In this video, we will go over what those specific steps are before you begin franchising. Make sure you are prepared before you begin franchising your business:
- Evaluate and protect intellectual property
- Understand accounting for franchising
- Model and validate startup costs and economics
- Systemize your brand experience and product or service delivery
- Create your franchise manual and set the standards
Video Transcript:
Before you begin to franchise your business, there are some preliminary steps that you really do need to take, and the starting place is to evaluate what intellectual property you have and to protect it. So going through and understanding whether you own your own name, and whether that name can be registered, and whether you’re going to be able to cleanly license the name, it is the first step. If you’re going to be franchising a business, you want to make certain that somewhere in the middle of it you’re not having to change your name.You want to take a look at your accounting; and generally what happens in franchising is that a new franchisor will set up a new corporation specifically for the franchise entity. The reason is that in franchising, under the rules, the franchisor is going to have to be audited. So you want to make certain that the books are set up correctly, that you have an annual audit that’s done by a CPA firm, and you also want to look at whether you’re going to need additional corporations set up for your supply chain company and the company that will own the intellectual property, because often the company that owns the intellectual property now may not be the company you want to involve in the franchise flow.
So you’re usually setting up additional corporations, you want to make sure they’re following GAAP and all that. That company’s going to be capitalized, the franchisor will be capitalized because in several of the registration states, the state registrar is going to look and see if you’re adequately capitalized - do you have enough resources in the company to meet the obligations that you are going to be giving to the franchisees in the agreements?
Sit with your accountant and understand the accounting that takes place for franchise fees. Generally in the United States, when you receive the money from the franchisee for your initial fee, that’s not income until the franchisee actually opens up their doors, it’s carried as a liability on your balance sheet. You want to sit with your accountant and make sure that things like your accounting fees, your initial franchise fee, your development fees, how are you properly accounting for them?
You want to get an understanding of the sites that are working for you today, you want to look at the sites, evaluate the sites, because you’re going to be telling franchisees what type of sites they should use for your business. So it’s not every site, you want to know if you’re going to be in Class A centers, whether you’re working best in D Class centers, understand that and start to document the type of sites and demographics of the sites and those issues.
Take a look and see what it costs you to develop a location. We’ll be talking about the disclosure document in a little while, and the disclosure document has an Item 7 in it. Item 7 is the initial investment that the franchisee is going to need to make, and you want to be as accurate as you can with a low and a high range based upon what the franchisee’s investment will be. A lot of that investment is their capped cost in getting into their location. How much it costs to build, what does the equipment cost and all the other attributes.
You want to look and see what your manuals, your preliminary manuals will have; most new franchisors getting into franchising may have bits and pieces of manuals, some may actually have full-blown manuals. The issues around the manuals are: are they adequate enough for franchising? Generally they’re not. The reason for that is, even in well developed manuals, is they were written for a different audience. Your audience for manuals in a company-owned situation will say a lot of “you must do this, you must do that,” it’ll have your benefits laid out. Franchisees are running their businesses independently on a day-to-day basis. So a lot of the things that you say you “must” do, well now, “we recommend” you do, or “you should do.” Because you’re going to be measuring the franchisee based upon their performance, not really based on how they got to that performance.
So you want to take a look at your manuals and you want to start looking at whether the manuals need to be rewritten, or what sections need to be rewritten.
The last thing you want to understand, preliminarily, is what exactly you’re franchising. Certainly you know what your product and service is, but do you truly understand the culture of your business, because part of what you’re franchising to the franchisee is not just the product and service, it’s also the culture and the way that you want the brand to be perceived by the consumer.
We discussed earlier the federal definition of a franchise, and again, it’s the commercial relationship with a licensee substantially associated with a licensor’s trademark. You are giving use of your brand to a third party. The franchisee is going to agree to meet your brand standards; you’re going to have either some significant controls or you’re going to provide assistance to the franchisee along the way so that they can deliver to your brand promise, and they’re going to pay you a fee. The fee is quite modest, it’s only $540, today it’s adjusted every year, and that fee can be tripped not just by a check but by purchasing of advertising, purchasing of racks, purchasing of anything that they have to pay you or are required to pay anybody else on your behalf.
Keep also in mind that some of the states have a broader definition of franchising which may include things like community of interest and marketing programs. So don’t except the fact that just because you’re not a franchise in one state, you may be in another state, and it is critical that you work with qualified consultants and qualified lawyers in making certain in which states you meet the definition of a franchise. In some states you may be a license, in some states you’re going to be a franchise, so be real careful about that.
As far as your trademarks go, it’s relatively simple today to determine whether you have ownership of your brand or can get ownership of your brand. But remember, it’s not sufficient just to have a federal mark, there may be people out there with a common law ownership of the mark, or common law usage of the mark which predates your filing. You want to do a trademark search, really what you want to do is have your lawyers do a trademark search. While you can go on Google and search for your brand, it’s not going to pick up the depth that you may need in local usage, and while often as not it’s not critical that one or two people are using the brand, you want to see whether you have clean use of the brand.
So engage legal counsel, it’s not expensive, any good franchise lawyer or trademark lawyer can do that, you want to make certain that you have ownership or can get ownership of your trademark, which is basically going to be over the goods that you do, or your service mark if you’re in restaurant services or cleaning services. You want to make sure that you have the ability to have ownership and be able to license cleanly those marks. You want to make certain that any of your taglines are protected - all of that is going to be filed for by your lawyer. Keep in mind it’s going to take about 13 months generally for that process to take place.
Even while it’s in the process of being registered and going through that, you can still be franchising, you’ll just be telling people that it’s in the process. In the 21st century, different than the 20th century, when a lawyer goes through and does this search and a qualified lawyer gives you an opinion that the mark can be registered, most of the time you can rely on that so there’s not a lot of risk of putting into your agreements the fact that if you have to change the mark, the mark will need to be changed.
You’re going to file your trademark or your service mark application with the United States Patent and Trademark Office, you can even do it yourself if you go to USPTO.gov. You’ll get a trademark registration and in the interim you’ll be putting a “™” behind your name, which means that you’ve filed for it, and once you get notice that your trademark is registered, you’ll be able to put that famous ® next to your name.
The basics of franchise law are really simple. It’s very difficult to get around the laws, because they’re quite clear in most cases. It’s very difficult also to trip over the laws because the laws are quite clear. Just understand that if there’s a grey area, there’s no reason to run away from franchise rules, they’re not that onerous.
So at the federal and state level there are disclosure requirements. You’re going to provide prospective franchisees with information about you - the business, the terms of the franchise agreement - so that they can make an informed decision. The Federal Trade Commission is responsible for all of the 50 states and the U.S. territories. So places like Puerto Rico and the U.S. Virgin Islands are going to still fall under the FTC Rule.
Then you have states that have their own rules, state franchise registration laws. These are states which will require you to send the franchise disclosure document to those states. Some of those states will just review it as a registration, some are just accepting it and filing because quite frankly all they want is your filing fee. In the registration states, those states will send you back an approval letter. Keep in mind that no matter which law firm you work with, whether it’s the best law firm or lesser law firm, you’re still generally going to get some comments, it’s the nature of the filing with any state regulator. So it’s not going to be, you send it in and you get a letter saying it’s approved, that will come later, on renewals, most of the time.
Keep in mind, in addition to the federal and state disclosure laws and the state registration laws and the state filing laws, some states have relationship laws. Those relationship laws are the only place, really, where some of your actions, primarily dealing with renewal and termination, will fall under a state law, and you’ll have addendums to your franchise disclosure documents and other areas. It may sound complicated and it may sound a little odd because you have a little bit of a fragmentation to the laws, but quite frankly, in the hands of a good quality franchisor lawyer or franchise lawyer, it’s relatively simple and over time you’ll be more experienced in it.