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A franchise may sound appealing if you want to be your own boss and you have limited resources or business experience. However, you could lose a significant amount of money if you don’t investigate a business before you buy.
Definition of a Franchise
A franchise is any continuing commercial relationship or arrangement, whatever it may be called, in which the terms of the offer or contract specify, or the franchise seller promises or represents, orally or in writing, that:
- The franchisee (person granted a franchise) will obtain the right to operate a business that is identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the trademark of the franchisor (person who grants a franchise and participates in the franchise relationship);
- The franchisor will exert or has authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation; and
- As a condition of obtaining or commencing operation of the franchise, the franchisee makes a required payment or commits to make a required payment to the franchisor or its affiliate.
Benefits and Responsibilities
A franchise enables you to operate a business. You pay a franchise fee and you get a format or system developed by the franchisor, and the right to use the franchisor’s name for a limited time and assistance.
Generally, the franchisee will pay an up-front fee as well as continuing fees based on the dollar amount of goods or services sold. The franchisor offers services such as training the franchisee and providing market research to determine a favorable location for the business. The franchisor typically has strict rules and standards as to how business is conducted, the goods and services to be sold and the design and construction of the business location.
Financing the Franchise
Lenders may be more willing to finance the franchisee of a reputable and established franchisor than the entrepreneur desiring to open an unproven business. Although by no means free from risk, a franchise from a franchisor with well-known and well-accepted products or services can significantly reduce business risks and enable you to own and operate a business on your own with no previous training.
Before you invest in a particular franchise, think about how much money you have to invest, your abilities and your goals. You’ll want to carefully investigate:
- The specific costs
- Whether financing is available
- What your expected earnings might be
- How long the franchise agreement runs
A franchise business must follow both federal and state regulations adopted to guard against abuses in the franchisor-franchisee relationship.
At the federal level, franchising is regulated by the Federal Trade Commission (“FTC”), which requires franchisors to give an extensive disclosure document to prospective franchisees so that they can evaluate the financial and business risks associated with the business to be operated.
Before you invest in any franchise system, get a copy of the franchisor’s disclosure document. Under the Franchise Rule, which is enforced by the FTC, you must receive the document at least 14 days before you are asked to sign any contract or pay any money to the franchisor or an affiliate of the franchisor. You have the right to ask for and get a copy of the disclosure document once the franchisor has received your application and agreed to consider it. The disclosure document includes:
- Names, addresses, and telephone numbers of at least 10 previous purchasers who live closest to you;
- A fully audited financial statement of the seller;
- Background and experience of the business’s key executives;
- Cost of starting and maintaining the business; and
- The responsibilities you and the seller will have to each other once you’ve invested in the opportunity.
If the seller doesn’t give you a disclosure document, ask why. Verify the explanation with an attorney, a business advisor or the FTC by calling its toll-free helpline at 1-877-FTC-HELP (877-382-4357).
The company’s disclosures may change between the time you receive the disclosure document and the time you sign the franchise agreement. For example, the company may have updated its disclosures; it is required to do that at least annually after its fiscal year ends. You have the right to ask for a copy of any updated information before you sign the franchise agreement. An updated disclosure document may indicate the filing of new suits by or against the franchisor, changes in the franchisor’s management team, new financial data and more current financial performance data, among other information.
Currently, there are fifteen states that have enacted laws adopting franchise registration and offering disclosure requirements:
- New York
- North Dakota
- Rhode Island
- South Dakota
These state laws give franchise purchasers important legal rights, including the right to bring private lawsuits for violation of the state disclosure requirements.
Well-established and successful franchisors are usually unwilling to make significant changes to their standard franchise documents. Less established franchisors, needing to expand their business base, might be somewhat more flexible. In setting up a franchised business, third parties, such as landlords and lenders, may also be involved.
Consult with Attorney and Accountant
Because of the complexity and length of the franchise agreements and the added complexity of third-party arrangements, you should consult with a franchise attorney and accountant early in the process of considering or negotiating a franchise agreement. An attorney can help you understand your obligations under the franchise contract. An accountant can help you understand the company’s financial statements, develop a business plan, assess any earnings projections and the assumptions they’re based on, and help you pick a franchise system.