Franchising & licensing two powerful ways to grow your business

Financial Strategies 23112 Business and Strategic Planning for the Growing Franchisor 233 14 Management and Leadership Issues in Building a Successful Franchising Organization 281 15 The

F R A N C H I S I N G &

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Library of Congress Cataloging-in-Publication Data

1 Franchises (Retail trade)—United States 2 License

agreements—United States I Title: Franchising and licensing II Title.

HF5429.235.U5S54 2003

658.8 ⬘708—dc21

2003012749

 2004 Andrew J Sherman.

All rights reserved.

Printed in the United States of America.

This publication may not be reproduced,

stored in a retrieval system,

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Matthew Harris Sherman,

and to my wife, Judy Joffe Sherman.

I thank them for their

never-ending support and patience.

Preface to the Third Edition ix

Part 1 An Overview of Intellectual Capital Leveraging Strategy 1

1 Leveraging Intellectual Capital to Create Growth

Opportunities and Profitable New Income Streams 3

4 Developing System Standards and Enforcing Quality Control 37

7 Structuring Franchise Agreements, Area Development

Agreements, and Related Documents 105

8 Protecting the Intellectual Property of the Franchise System 135

vii

Part 3 Financial Strategies 231

12 Business and Strategic Planning for the Growing Franchisor 233

14 Management and Leadership Issues in Building a Successful

Franchising Organization 281

15 The Role of the Chief Financial Officer and Related Financial

and Administrative Management Issues 297

18 Strategic and Structural Alternatives to Franchising 347

Appendix Resource Directory: List of State Administrators and

Agents for Service of Process 397

It is hard to believe that nearly 15 years have passed since the publication of

the first edition of Franchising & Licensing in 1991 The impact of technology

and globalization has had a permanent effect on the dynamics of the chise relationship When the manuscript was being written for the first edi-tion in the late 1980s, I could not have envisioned the many changes in theevolution of today’s franchise relationships that can be managed or the diver-sity in the number of industries and companies that would pursue franchising

fran-as their primary growth strategy It hfran-as been an honor to work with nies launching franchising programs in dozens of different industries and atvarious stages of growth, ranging from start-up to Fortune 500 companies

compa-At the time of this writing, global events and geopolitical concerns areovershadowing and restraining some of the many successes that the franchis-ing community has enjoyed since the publication of the second edition Weare in the middle of war with Iraq, we now live with the threat of terrorattacks against our homeland following the events of September 11, 2001,our economy is as weak as it has been in over 10 years, and oil and energyprices are on the rise, making the cost of growing a business very high Intough economic times, the development of creative strategies to leverageyour intellectual capital becomes especially important

How have these conditions and events affected franchising and the all growth of a company?

over-❒ From the franchisor’s perspective, the weak capital markets have ited access to the resources needed for more organic or traditionalgrowth strategies, thereby making franchising the strategy of choice toaccomplish growth objectives and brand-building

lim-❒ From the franchisee’s perspective, more families in a post-9/11 ment (and with job losses averaging 300,000 per month) want to takegreater control over their own destiny and are pursuing many differenttypes of franchised opportunities as a way of owning their own business

environ-ix

❒ The threats of domestic terrorism, coupled with a very strong residentialreal estate market, has fueled the growth of many different types ofhome improvement and home services franchisors as Americans investmore money in making their homes safer and more comfortable This

trend has not helped the hospitality and restaurant industries, unless

carry-out or home delivery services are offered

❒ Fears of terrorism at home and abroad have also slowed the pace a bit ofinternational franchising expansion (although the number of attendeesand exhibitions at the 2003 International Franchise Expo in Washing-ton, D.C., in April were just as strong as prior years) These fears havehad an impact on franchise systems in the travel, hotel, car rental, andrelated industries

❒ The ease of access to technology as well as a desire to avoid the hassles(and fears) of going to a shopping mall have fueled an increase in on-line sales of products and services, forcing franchising systems to offersites that facilitate e-commerce as well as create a balance for sharingthe upside of these new sales and customers with the franchisees intheir systems The improvements in Internet technology and travel/lo-gistics concerns have also changed the ways in which franchisees arebeing recruited and data gathered The impact of the Internet on fran-chise sales (as well as the legal implications thereof) are discussed innew sections of Chapters 6 and 10 of this third edition

And yet, as volatile as the world and global and domestic economy havebeen since the publication of the second edition, franchising has remainedrelatively stable Each year, hundreds of new companies launch franchisingprograms for the first time and tens of thousands of families invest in the firstfranchised business as the first step in their journey toward achieving theAmerican dream Even with all of the new technology and all of the newdevelopments, franchising is, and always will be, about mutual commitment,trust, fairness, and communication in a uniquely interdependent relation-ship that has helped fuel our economy for nearly 100 years

The factors discussed above help explain the rationale for the new title to Franchising & Licensing: ‘‘Two Powerful Ways to Grow Your Business

sub-in any Economy.’’ History has shown that the leveragsub-ing of sub-intellectual tal can be an effective and capital-efficient way to perpetrate business growthwhether economic conditions are weak or strong Companies of all sizes and

capi-in many different capi-industries are realizcapi-ing that their capi-intangible assets can be asource of new revenue and profit centers that can also bring greater controland predictability and loyalty to their distribution channels The critical im-portance of adopting this more strategic perspective to the management andleveraging of intellectual capital is discussed in greater detail in the newchapters of this third edition

Andrew J ShermanWashington, D.C.April 2003

The concepts and issues discussed in this book are the result of over 25 years’experience in franchising, from both a legal and a business perspective Itwould be impossible to thank all of the people with whom I have had thepleasure of working along the way The support of my many loyal domesticand international clients and my colleagues at McDermott, Will & Emery,including Tim Waters, Grant Bagan, and Harvey Freishtat, deserve specialmention.

There are certain individuals whose time, hard work, support, and tience should be acknowledged I wish to thank Debra Harrison for her assis-tance in reviewing and editing several chapters and to Patricia O’Keefe forher assistance in updating Chapter 21 I owe special thanks to my assistant,

pa-Jo Lynch, who often serves as my right arm, and for her organizational skillsand patience The Franchising, Licensing and Distribution Department atMcDermott, Will & Emery makes it happen on a daily basis

There are also certain well-recognized individuals in the franchisingand emerging business communities who have been friends and mentorsover the years For their support, advice, and general friendship, I want toespecially thank Bob Gappa at Management 2000, Jerry Darnell, John Rogers

at Davis & Company, John Reynolds at the International Franchise tion, Tom Portesy and Richard Macaluso at MFV Expos, Verne Harnish ofGazelles, my partner of nearly ten years Al Schaeffer, Burt Alimansky at Ali-mansky Capital Group, Dr Eckhard Flohr of EF*LAW, John May at New Van-tage Partners and Bill Keating at the Dickinson School of Law

Associa-Ray O’Connell of AMACOM Books was there as always to provide moralsupport in pulling this entire project together He is an excellent orchestratorand sounding board I also want to thank Mike Sivilli at AMACOM for hismasterful editing, and Irene Majuk at AMACOM for her skillful mediarelations

Last, but certainly not least, I am grateful to my wife, Judy, and to myson Matthew, and daughter, Jennifer, who once again sacrificed time with me

so that I could complete this manuscript I couldn’t ask for a more supportivefamily

xi

A N O VERVIEW OF

Leveraging Intellectual Capital to Create Growth Opportunities and Profitable New Income Streams

Intellectual capital consists of human capital, intellectual property, and tionship capital and are the key assets for driving growth in all types of eco-nomic conditions

rela-The biggest challenge that many companies face is how to keep growing

in a slowing economy The focus of this book is on two key strategies—franchising and licensing—as methods for leveraging the intellectual capital

of a company into new revenue streams, market opportunities, and profitcenters For many years, companies of all sizes and in many different indus-tries did not understand how to harvest their intangible assets, and they tra-ditionally viewed these assets more passively as a way to defend marketshare instead of proactively as a source of new opportunity

The strategic views toward the use of intellectual capital have evolved

in the boardroom over the past three decades, as described in Figure 1-1

Figure 1-1 The evolution of strategic views toward the use of intellectual capital in the boardroom over the past three decades.

Traditional View IP assets enhance the company’s competitive advantage and strengthen its ability

to defend its competitive position in the marketplace (IP as a barrier to entry and

as a shield to protect market share) (Reactive and Passive Approach) Current View IP assets should not be used merely for defensive purposes but should also be

viewed as an important asset and profit center that is capable of being monetized and generating value through licensing fees and other channels and strategies,

provided that time and resources are devoted to uncovering these opportunities

(especially dormant IP assets, which do not currently serve at the heart of the

company’s current core competencies or focus) (Proactive/Systemic Approach) Future View IP assets are the premiere drivers of business strategy within the company and

encompass human capital, structural/organizational capital, and ship capital IAM systems need to be built and continuously improved to ensure that

customer/relation-IP assets are used to protect and defend the company’s strategic position in tic and global markets and to create new markets, distribution channels, and reve-

domes-nue streams in a capital-efficient manner to maximize shareholder value (Core Focus/Strategic Approach)

3

As demonstrated in Figure 1-2 below, the harvesting of intellectual

capi-tal is a strategic process that most begin by having the company’s

manage-ment team and qualified outside advisors take an inventory in order to get acomprehensive handle on the scope, breadth, and depth of the company’sintangible assets In these times of distrust and disappointment by share-holders in the management teams and boards of publicly held companies,corporate leaders have an obligation to these shareholders to uncover hiddenvalue and make the most of the assets that have been developed with corpo-rate resources The leadership of the company will never know if it has a

‘‘Picasso in the basement’’ unless it both: (1) takes the time to inventory

what’s hiding in the basement and (2) has a qualified intellectual capitalinventory team that is capable of distinguishing between a Picasso and yourchildren’s art project Once these assets are properly identified, an Intellec-tual Asset Management (IAM) system should be developed to ensure opencommunication and strategic management of these assets At that point, thecompany is ready to engage in the strategic planning process to determinehow to convert these assets into profitable revenue streams and new opportu-nities that will enhance and protect shareholder value

The strategic planning process will help uncover opportunities forgrowth Key questions include:

❒ What patents, systems, and technologies have noncompeting tions that could be licensed to third parties to create new revenuestreams, joint ventures or partnering opportunities, distribution chan-nels, or profit centers?

applica-❒ What brands lend themselves to extension licensing or co-branding portunities?

op-❒ What distribution channels or partnering opportunities can be ened if the company has greater control of or provides additional sup-port and services to the channel?

strength-❒ What types of growth and expansion strategies are being used by thecompany’s competitors? Why?

❒ Where are the strategic/operational gaps in the company’s current censing and alliance relationships?

li-Figure 1-2 The harvesting of intellectual capital: A strategic process.

Inventory of Intellectual Capital Assets Building Intellectual Asset Management (IAM) Systems Strategic Planning to Maximize IP AssetsFranchising Licensing

As you can see in Figures 1-3, 1-4, and 1-5, the strategic planning processwill help identify the different types of protectable intellectual property andthe ways in which it can be leveraged into new opportunities.

The balance of this book is devoted to the various types of intellectualcapital leveraging strategies, with a focus on business format franchising inChapters 2 through 17, licensing in Chapters 18 and 19, and joint venturesand strategic alliances in Chapter 20

Figure 1-3 Identification through the strategic planning process.

• Show-how and know-how

• Website design and content

• Customer and strategic partner relationships

• Proprietary processes and systems

• Knowledge and technical workers

Possible New Opportunities and Revenue Sources

• New independent ventures

in for-profit subsidiary Create new internal business area

Create new product with existing business area

License or sell to third party

• Is there revenue potential?

• Could someone make money

doing this?

Business Plan Development

• Product and market definition

• Detailed market analysis

• Competitive analysis

• Internal/external business decision

• Risk factors

• Financials

Product and Market Analysis

• Product and market definition

• Detailed market analysis

• What is likely value sharing required to attract and retain partners?

Capability Gap Assessment

Capability Gap Assessment

• What capabilities exist within our business area

to deliver this product?

• Are partners required?

• What capabilities are required to manage these licenses?

• How will we provide support?

Prepare for New Business

New Product Rollout

As demonstrated in Figures 1-5 and 1-6, a key part of the intellectualcapital planning process involves deciding your strategic development alter-native once the applications have been analyzed and after the fit with yourcore business has been determined.

Figure 1-5 IPPLA phase 2 analytical process.

Fit with current businesses?

NO YES

Patents and Trade Secrets

Research and Development Intellectual

to third party

NO

Create new external business via spin-off or newly established subsidiary

Create new internal business division

Figure 1-6 Phase 2 strategic options.

Create a new spin-off venture that involves seed investment from our firm

Create spin-off entity where costs will

be shared with a joint venture partner

License the product to a third party in exchange for an equity stake (instead of cash) Develop one or more business format

franchising programs based upon current brands, technology, and systems Brand merchandising

licensing

License technology to third party

F RANCHISING AS A

The Foundation of Franchising

Over the last five decades, franchising has emerged as a leading intellectualproperty leveraging strategy for a variety of product and service companies

at various stages of development Recent International Franchise Association(IFA) statistics demonstrate that retail sales from franchised outlets consti-tute nearly 50 percent of all retail sales in the United States, estimated atover $1 trillion and employing over 10 million people in 2002 Notwith-standing these impressive figures, franchising as a method of marketing anddistributing products and services is really only appropriate for certain kinds

of companies Despite the favorable media attention that franchising has ceived over the past few years as a method of business growth, it is not foreveryone There are a host of legal and business prerequisites that must besatisfied before any company can seriously consider franchising as an alter-native for rapid expansion

re-Many companies prematurely select franchising as a growth alternativeand then haphazardly assemble and launch the program Other companiesare urged to franchise by unqualified consultants or advisors who may bemore interested in professional fees than in the long-term success of the fran-chising program And still others move too quickly in the development oftheir franchising program without devoting the time and resources to theestablishment of an effective and viable business and economic model.* Thishas caused financial distress and failure at both the franchisor and franchiseelevel and usually results in litigation Current and future members of thefranchising community have a duty to take a responsible view toward thecreation and development of their franchising programs

Responsible franchising starts with an understanding of the strategicessence of the business structure As Bob Gappa of M2000 has been preach-ing for many years, there are three critical components of the franchise sys-tem—the brand, the operating system, and the ongoing support provided bythe franchisor to the franchisee The brand creates the demand, allowing the

* This should include a pro forma for both the franchisor as well as the typical operating franchisee to ensure fairness and economic viability for both parties to the relationship.

11

franchisee to initially obtain customers The brand includes the franchisor’s

trademarks and service marks, its trade dress and de´cor, and all of the tangible factors that create customer loyalty and builds brand equity Theoperating system essentially ‘‘delivers the promise,’’ thereby allowing the

in-franchisee to maintain customer relationships and build loyalty The

ongo-ing support and trainongo-ing provide the impetus for growth, offerongo-ing the

fran-chisee the tools and tips to expand its customer base and build its market

share The responsibly built franchise system is one that provides value toits franchisees by teaching them how to get and keep as many customers aspossible, who consume as many products and services as possible, as often

as possible

In fact, most litigation in franchising involves the gap between the

ac-tual needs of the franchisees to remain competitive in the marketplace and

the reality of what support the franchisor is capable of providing The genesis

of the disappointment begins during the recruitment phase of the ship and continues beyond the start-up as the franchisee struggles to remain

relation-competitive unless the franchisor delivers on its promises and is committed

to providing excellent initial and ongoing training and support

Reasons for Franchising

There are a wide variety of reasons cited by successful franchisors as to whyfranchising has been selected as a method of growth and distribution.Through franchising, they are able to:

❒ Obtain operating efficiencies and economies of scale

❒ Increase market share and build brand equity

❒ Use the power of franchising as a system to get and keep more and morecustomers—building customer loyalty

❒ Achieve more rapid market penetration at a lower capital cost

❒ Reach the targeted consumer more effectively through cooperative vertising and promotion

ad-❒ Sell products and services to a dedicated distributor network

❒ Replace the need for internal personnel with motivated tors

owner/opera-❒ Shift the primary responsibility for site selection, employee training andpersonnel management, local advertising, and other administrative con-cerns to the franchisee, licensee, or joint venture partner with the guid-ance or assistance of the franchisor

In the typical franchising relationship (see table below for examples), thefranchisee shares the risk of expanding the market share of the franchisor bycommitting its capital and resources to the development of satellite locationsmodeled after the proprietary business format of the franchisor The risk ofbusiness failure of the franchisor is further reduced by the improvement incompetitive position, reduced vulnerability to cyclical fluctuations, the exis-

tence of a captive market for the franchisor’s proprietary products and vices (due to the network of franchisees), and the reduced administrativeand overhead costs enjoyed by a franchisor.

ser-TYPES OF FRANCHISEES

Buy A Job (Home- Sales & Distributor- Retail Store (Busi- Management- Financial Based; Low Invest- ships (Product- ness Format Em- Driven (Multi-Unit) ment (Large-Scale ment) Driven) & Routes phasis) Larger Territory or Projects–Hotels,

Invest-Region who man- etc.) age or lead a team

of managers on a permit or district basis as well as sat- ellite carts, kiosks, etc.

Resources Needed/ Business Acumen Required/ Etc.

The Foundation of Franchising

Responsible franchising is the only way that franchisors and franchisees will

be able to harmoniously co-exist in the twenty-first century Responsiblefranchising requires a secure foundation from which the franchising program

is launched and a genuine commitment to the success of a franchisee Anycompany considering franchising as a method of growth and distribution, orany individual considering franchising as a method of getting into business,must understand the key components of this foundation:

❒ A proven prototype location (or chain of stores) that will serve as a basis

for the franchising program The store or stores must have been tested,refined, and operated successfully and be consistently profitable The suc-cess of the prototype should not be too dependent on the physical pres-ence or specific expertise of the founders of the system

❒ A strong management team made up of internal officers and directors (as

well as qualified consultants) who understand both the particular try in which the company operates and the legal and business aspects offranchising as a method of expansion

indus-❒ Sufficient capitalization to launch and sustain the franchising program to

ensure that capital is available for the franchisor to provide both initialand ongoing support and assistance to franchisees (lack of a well-writtenbusiness plan and adequate capital structure are often the principalcauses of the demise of many franchisors)

❒ A distinctive and protected trade identity that includes federal and state

registered trademarks, as well as a uniform trade appearance, signage, gans, trade dress, and overall image

slo-❒ Proprietary and proven methods of operation and management that can

be reduced to writing in a comprehensive operations manual, not be tooeasily duplicated by competitors, maintain their value to the franchiseesover an extended period of time, and be enforced through clearly draftedand objective quality control standards

❒ Comprehensive training programs for franchisees that integrate all of the

latest education and training technologies and that take place both at thecompany’s headquarters and on-site at the franchisee’s proposed location

at the outset of the relationship and on an ongoing basis

❒ Field support staff who are skilled trainers and communicators and must

be available to visit and periodically assist franchisees as well as monitorquality control standards

❒ A set of comprehensive legal documents that reflect the company’s

busi-ness strategies and operating policies Offering documents must be pared in accordance with applicable federal and state disclosure laws,and franchise agreements should strike a delicate balance between therights and obligations of franchisor and franchisee

pre-❒ A demonstrated market demand for the products and services developed

by the franchisor that will be distributed through the franchisees Thefranchisor’s products and services should meet certain minimum qualitystandards, not be subject to rapid shifts in consumer preferences (e.g.,fads), and be proprietary in nature Market research and analysis should

be sensitive to trends in the economy and specific industry, the plans ofdirect and indirect competitors, and shifts in consumer preferences It is

also important to understand what business you are really in For ple, many of the major oil company franchisors thought that they were in the gasoline business until they realized that they were in the convenience

exam-business and quickly jumped into mini-marts or fast-food and service restaurants either directly or via co-branding

quick-❒ A set of carefully developed uniform site selection criteria and

architec-tural standards that can be readily and affordably secured in today’s

com-petitive real estate market

❒ A genuine understanding of the competition (both direct and indirect)

that the franchisor will face in marketing and selling franchises to spective franchises as well as the competition the franchisee will facewhen marketing products and services

pro-❒ Relationships with suppliers, lenders, real estate developers, and related

key resources as part of the operations manual and system

❒ A franchisee profile and screening system in order to identify the

mini-mum financial qualifications, business acumen, and understanding of theindustry that will be required by a successful franchisee

❒ An effective system of reporting and record keeping to maintain the

per-formance of the franchisees and ensure that royalties are reported rately and paid promptly

accu-❒ Research and development capabilities for the introduction of new

prod-ucts and services on an ongoing basis to consumers through the chised network

fran-❒ A communication system that facilitates a continuing and open dialogue

with the franchisees and as a result reduces the chances for conflict andlitigation within the franchise network

❒ National, regional, and local advertising, marketing, and public relations

programs designed to recruit prospective franchisees as well as

consum-ers to the sites operated by franchisees

Strategic Prerequisites to Launching a Franchising Program

Typically, the most important strategic prerequisites for the success of anybusiness format franchise system are the operation and management of asuccessful prototype and a business and financial model that makes sensefor both franchisor and franchisee This prototype location is where virtuallyall operating problems are to be resolved, recipes and new products tested,equipment and design decisions made, management and marketing tech-niques tested, a trade identity and goodwill established, and financial viabil-ity proven The franchisor is in theory offering a tried-and-tested package to

a franchisee, and the contents of that package must be clearly identified prior

to sale It is irresponsible and potentially in violation of the law to ask one to part with his or her life savings to invest in a system that is not readyfor replication The financial aspects of the business model should be ana-lyzed and tested to ensure that both parties can do well and are fairly re-warded for their efforts

some-The concept of a system or prescribed business format that is operatedaccording to a uniform and consistent trade identity and image is at the heart

of a successful franchising program Therefore, a prospective franchisor must

be able to reduce all aspects of running the business to be franchised into

an operations and training manual for use by franchisees in the day-to-dayoperation of their business These systems must be adequately and clearlycommunicated in the initial and ongoing training program If a companyoffers services that are highly personalized or a product that is difficult toreproduce, then franchising may not be the most viable alternative for growthbecause of the difficulty in replicating these systems or products in the oper-ator’s manual or in the training program Similarly, if all the ‘‘kinks’’ in thesystem have not yet been worked out, it is probably premature to considerfranchising

There are a number of other important business and strategic factorsthat must be considered before franchising First, franchising should not beviewed as a solution to undercapitalization or as a ‘‘get rich quick’’ scheme.While it is true that franchising is less capital-intensive than is construction

of additional company-owned sites, the initial start-up costs for legal, counting, and consulting fees can be extensive Second, franchisors mustview franchising as the establishment of a series of long-term relationships,and the ongoing success of the company as a franchisor will depend on theharmony of these relationships A field support staff must be built to provideongoing services to the existing franchisees, as well as to maintain qualitycontrol and uniformity throughout the system New products and services

ac-must be developed so that the franchisee can continue to compete with ers in its local market Innovative sales and marketing strategies must becontinually developed to attract new customers and retain existing patrons

oth-of the franchised outlet If the franchisor expects the franchisee to continue

to make its royalty payment on gross sales each week, then an array of able support services must be provided on an ongoing basis to meet the fran-chisee’s changing needs

valu-Franchising as a Strategic Relationship

Prospective and current franchisors must always bear in mind that, first and

foremost, franchising is about relationships The franchisor and franchisee

knowingly and voluntarily enter into a long-term interdependent ship, each depending on the other for its success The exact nature of thefranchisor-franchisee relationship has been compared to many others Thereare parallels to the relationship between parent and child, between a footballcoach and his team, between a conductor and his orchestra, and between alandlord and his tenants The award of the franchise has been compared tothe state that grants a driver’s license—you may use and renew the privilege

relation-of driving, but subject to the rules relation-of the road and the payment relation-of ongoingfees Like the relationship between franchisor and franchisee, you have thefreedom to drive but not necessarily however or wherever you want There

has been much emphasis in recent years to avoid the ‘‘Them versus Us’’

mentality and to shift organizational culture for a refocus on the ‘‘We’’ as

well as the ‘‘versus.’’ The focus has been on how can we work together for

each other’s benefit, where the enemy is not each other but rather the tition

compe-The financial output of these parties working together can be very erful in a competitive marketplace In fact, some say that franchising hadtruly arrived in October 1997, when Warren Buffet, arguably one of the mostfinancially savvy men on the planet, announced that his holding company,Berkshire Hathaway, Inc., agreed to acquire Dairy Queen, with 5,800 fran-chised outlets worldwide For years, Buffet had also been one of the largestshareholders of McDonald’s and hinted that other franchisor acquisitionsmay be in the near future Franchising continues to be an alternative growthand acquisition strategy for sophisticated international conglomerates Com-panies such as Yum! Brands (owner of Pizza Hut, Taco Bell, KFC, A&W, andLong John Silver’s), Grand Metropolitan PLC (British-based owner of BurgerKing and Haagen-Dazs), Whitman Company (owner of Midas Muffler andThrifty Car Rental), Allied Domecq PLC (British-based owner of Dunkin’ Do-nuts and Baskin-Robbins), and Flagstar Companies, Inc (owner of Denny’sand El Pollo Loco restaurants) are all active players in the franchising com-munity

pow-Yes, franchising is about relationships And like the most sacred of

rela-tionships, marriage, if the parties are to stay committed to each other for thelong term, then both franchisor and franchisee must respect one another, stayloyal to one another, and each day search for ways to strengthen their bond

A recent survey seems to indicate that this new focus on the strategicaspects of the relationship seems to be working While over one-half of ournation’s marriages wind up in divorce, nearly 92 percent of the nation’s fran-chisees said they would get married to their franchisor again In a recentsurvey conducted by the Gallup Organization and published by the Interna-tional Franchise Association (IFA) Educational Foundation, more than nine

of 10 (92 percent) of the franchise owners surveyed said they were eithervery or somewhat successful Of those who had been in business 11 years ormore, 96 percent indicated they were very or somewhat successful Gallupsurveyed 1,001 U.S franchisees, nearly eight out of 10 of whom own onlyone franchised small business Women accounted for 28 percent and nearlyhalf of those who responded had a professional or managerial position beforepurchasing a franchise, while nearly two of 10 were involved in either ser-vices/labor or retail sales Given the high satisfaction ratings, it is not surpris-ing that nearly two-thirds (65 percent) of the franchise owners said theywould purchase the same franchise again if given the opportunity Of thosewho wouldn’t buy the same franchise again, nearly half (43 percent) saidthey would consider buying a different one Nearly two-thirds (64 percent)said they would be less successful if they had tried to open the same type ofbusiness on their own and not as part of a franchise system On average,franchise owners reported annual gross incomes of $91,630 Nearly one offour (24 percent) earned $100,000 or more during the past year

The franchisor who wants its system and franchisee satisfaction ratings

to meet or exceed these levels of success must build a culture of honesty,trust, passion, and genuine commitment to long-term success This often be-gins in the recruitment process by carefully screening and educating quali-fied candidates to ensure that your long-term objectives are truly shared andbest interests truly aligned This type of strategy will lead to mutually bene-ficial relationships and significantly decrease the chances of litigation Somedegree of franchisee failure will be inevitable and there are typically twofactors at play—one that you can control and one that you often can’t You

can control the quality of your systems, training and support tools, and

inno-vation of your marketing to help increase the chances of success Other than

through careful screening and continuous monitoring, you cannot typically

control local market conditions or changes in the franchisee’s personal lifethat may also affect their performance

Curbing the Failure Rate of Early-Stage Franchisors

One of the underlying premises of this book is that successful franchisingrequires a commitment to building a proper foundation and platform fromwhich to launch and build the franchising program My mission is to ensurethat each reader avoids the mistakes made by the hundreds of franchisorsthat have failed over the years That’s right, hundreds Each year since the

early 1990s, between 75 to 100 franchisors went out of business This figure

represents between 3 to 5 percent of all franchisors operating during thoseyears Figure 2-1 represents 40 of the more common reasons franchisors fail

Figure 2-1 Forty common reasons why franchisors fail.

• Lack of leadership by the franchisor • Difficulty attracting qualified franchisees

• Choice of the wrong professional advisory • Lack of proper disclosure documents

team

• Failure to provide adequate support or controls • An unproven and unprofitable prototype

• Lack of franchise communications systems • Premature launch into international markets

• Complex and inadequate operations manuals • Inadequate site selection criteria

• Inability to compete against larger franchisors • Lack of proper screening systemfor

prospec-tive franchisees

• Disregard for franchise registration and disclo- • Lack of effective business and strategic

• Not joining the International Franchise Associ- • Entering oversaturated markets

ation (IFA)

• Franchise systemfails to reflect the mission, • Failure to develop and enforce recruitment core values, and vision of the company selection and criteria

pressure to sell franchises

• Unworkable economic relationship with fran- • Lack of effective compliance systems chisees

• Royalty underpayments/nonpayments by fran- • Operational systems that can be easily

• Lack of effective financial controls • Lack of experienced management

• Inadequate training program • Lack of ongoing research and development

• Choice of the wrong subfranchisors or areas • Unprofitable and unhappy franchisees developed

• Lack of an effective public relations strategy • Unwillingness to enforce franchise agreement

• Inadequate relationships with key vendors • Improper earnings claims

• Premature termination of franchisees on high • Lack of market research

turnover rates

Read them carefully and read them often My goal is to mitigate the risk of

your company meeting the same fate in launching and building its ing program

franchis-Understanding the New Sophisticated Franchisee

One way to avoid failure is to genuinely understand the profile of today’sprospective franchisee A wide variety of marketing, planning, operational,

and strategic decisions can be made by the growing franchisor once certainbasic premises are understood As a general rule, franchisees in today’s com-

petitive markets are getting smarter, not dumber The better educated, better

capitalized franchisee is here to stay As franchising has matured, tive franchisees have more resources (seminars, media articles, trade shows,International Franchise Association programs, etc.) than ever before to turn

prospec-to for information and due diligence These new, sophisticated franchiseesare very different from their ‘‘mom and pop’’ predecessors of the 1970s and1980s This prospect is better trained to ask ‘‘all the right questions’’ and hire

‘‘the right advisors’’ in the investigation and franchise agreement negotiationprocess These new franchises are also better heeled and are more likely toorganize themselves into associations and take action if they are not receiv-ing the required levels of support and assistance They are also more likely

to suggest valuable improvements to the system, which should be carefullyconsidered and taken seriously by the franchisor As we will discuss inChapter 10, those franchisors who fail to mold their sales and support sys-tems around the characteristics of these new franchisees and continue toconduct business ‘‘the old-fashioned way’’ are headed on the road to disasterand litigation

A Commitment to Being (and Staying) Creative and Competitive

Today’s franchisor must have an initial and ongoing commitment to beingcreative and competitive Market conditions and technology that affect fran-chising are changing constantly and the franchisee of the next millenniumexpects you to change at the same pace For example, the ability to adoptyour franchising system to allow for growth and market penetration into al-ternative and nontraditional venues is critical The more creative and aggres-sive franchisors in the retail and hospitality industries are always searchingfor new locations where captive markets may be present, such as airports,hotels, hospitals, highway roadside travel plazas, universities, sports arenas,

or military bases where trends toward outsourcing, the demand for brandedproducts and services, and the desire to enhance the captive customer’s ex-perience have all opened up new doors and opportunities for franchising.Franchisors such as TCBY, based in Little Rock, Arkansas, have nearly 50percent of their 3,000 frozen yogurt stores worldwide in these alternativevenues In other cases, franchisors have pursued co-branding strategies topenetrate these new markets, again taking advantage of the trend toward con-venience stores, grocery store chains, and gas stations all wanting to providetheir patrons with an enhanced customer experience and offer a more com-prehensive and integrated solution to their consuming needs And again,

a trend toward branding and the ability to share costs, positioning towarddifferentiation, and penetrate new market segments at a relative low costhave opened up many doors for the creative and aggressive franchisor who

is committed to capturing more market share and serving more and morecustomers

Developing the Operations and

of the relationship and on an ongoing basis

The documentation required to properly administer the franchise tem includes:

sys-❒ Statement of corporate philosophy, policies, and general rules of tions

opera-❒ Confidential operations and procedures manual

❒ Local sales, marketing, and public relations kit

❒ Site selection, architectural, interior design, signage, equipment, and ventory specifications

in-❒ Guidelines for financial record keeping and reporting

❒ Quality control and inspection reports

❒ Special manuals for subfranchisors and area developers (where cable)

appli-Depending on the nature of the franchisor’s business, many of the requireditems listed above may be combined into a single confidential operationsmanual (‘‘the manual’’) The manual is the heart and soul of the franchisingprogram, designed to be a resource for the franchisee when the franchisorcan’t be there Despite the importance of the manual to the long-term success

of the franchising program, many early-stage franchisors experience greatdifficulty in their attempts to prepare a proper manual Yet a franchisor un-able to properly document and communicate the critical steps of success-fully operating the business (often in painstaking detail) is doomed for

21

failure and really has no business getting into franchising in the first place.Franchisors should also take steps to use available computer and communi-cations technologies to support the franchisees For example, a growingnumber of franchisors are making their manuals available to franchisees on

a password-encrypted Intranet system and sending manual updates and tem bulletins via email Sophisticated franchisees are demanding access tokey operational data using this technology

sys-Guidelines for Preparation of the Manual

Before sitting down to prepare your operations manual, keep in mind thefollowing basic principles and guidelines:

1 The operations manual is a living, breathing document Its contents willdevelop and change as your franchise system develops and changes Besure to reserve this level of flexibility in your franchise agreement

2 Because it is inevitable that your franchise system will evolve, prepare themanual in a format that is user-friendly and easy to update For example, aseries of three-ring notebooks with tabs for each major heading will makesection or page replacements and additions quick and easy, if these up-dates are not made available electronically

3 Assume nothing about the skills and experience of your typical franchise.The text of the manual should be written at a high school reading level ofcomprehension and should anticipate that your franchisee is likely to be

a complete novice in your industry Dry, technical, and difficult-to-usemanuals will be ignored by franchisees, and this will cause a breakdown

of quality control throughout the system Be creative in your use of chartsand diagrams that may be effective teaching tools and help avoid qualitycontrol breakdowns The more user-friendly, the more the manual willactually be used

4 No detail should remain unaddressed in the manual Do not leave anyoperating discretion in the hands of the franchisee Everything rangingfrom preopening procedures to preparation of products to employee dis-cipline must be included Remember that comprehensiveness in thepreparation of your manual provides a certain level of legal protection.Franchisees will not be able to claim, ‘‘They never told me how to

’’ in any subsequent litigation if all details are addressed

5 The manual must be comprehensive (yet generic) enough to be followed

by all franchisees that must run their businesses in a range of differentmarkets and operating conditions For example, if procedures are differ-ent for long stand-alone facilities (as opposed to kiosks within a regionalmall), then these expected differences must be included and discussed Ifadvertising strategies are different for rural areas (as opposed to inner-citylocations), then these differences must be anticipated and included in themanual

6 The manual should anticipate and answer some of the questions mostcommonly asked by your franchisees The more often they need to callyou for assistance, the larger the administrative staff (and thus overhead)you need to maintain.

7 Remember that the manual is confidential and proprietary As such, itshould be treated as a trade secret under the law of intellectual property.Procedures must be developed for protection and care of the manual byeach franchisee and its employees Access should be restricted to those

on a ‘‘need to know’’ basis Remember that the manual is licensed, notsold to a franchisee It remains the property of the franchisor at all times.Special receipts should be developed for providing the manual to fran-chisees and special forms prepared for ordering replacement manuals

8 The manual should at all times be consistent with the representationsmade in the Uniform Franchise Offering Circular (UFOC), the disclosuredocument that must be delivered to prospective franchisees under federaland state law, as well as with the specific obligations contained in thefranchise agreement One easy way to find yourself in litigation with yourfranchisees is through inconsistencies between promises made in the FOCand actual obligations contained in the manual

9 Avoid the temptation to turn your operations manual into a strategic ness plan Naturally, there should be a section that addresses the fran-chisor’s overall goals, mission, and values; however, the bulk of themanual should teach the franchisee how to perform key tasks, not just be

busi-a strbusi-ategy dissertbusi-ation

The Relationshipbetween the Franchise Offering Circular and the Manual

It is the modern practice of many franchise lawyers to be rather vague

in the preparation of franchise offering circulars and franchise ments, with common references to information contained in themanual The rationale here is that amending a manual is far less com-plicated than amending a registered disclosure document or bindinglegal agreement Although I generally advocate this practice, be careful

agree-If the document is too vague, then it will be challenged by the ers in the registration states Similarly, if the franchisor attempts to in-troduce a significant new program, operating procedure, or policy, thismay trigger a ‘‘material change’’ that will require amendment of theoffering circular and perhaps even the franchise agreement itself SeeChapter 6 for a more detailed discussion of the ‘‘material change’’ regu-lations

examin-Suggested Outline for the Operations Manual of a Franchisor

An operations manual should encompass virtually every aspect of the ness to be operated by the franchisee, from prior to grand opening to the

busi-ongoing day-to-day operating procedures and techniques The following is

an outline that has been designed for a typical franchisor in the servicesbusiness:

Section A: Introduction

1 Foreword/Notice of Proprietary and Confidential Information

2 Acknowledgment

3 History of the Franchisor

4 The Franchisor’s Management Team

5 The Franchisor’s Obligations to the Franchisees (an overview)

6 The Franchisee’s Obligations to the Franchisor and the System (anoverview)

Section B: Timetables for Opening the Franchised Office

A comprehensive timetable that the franchisee is to follow, beginning thedate that the franchise agreement is signed to the first date that business will

be conducted and beyond

Section C: Preopening Obligations and Procedures

1 Architectural, Engineering, Interior Design, and Site ConstructionSpecifications

2 Minimum Requirements for Utilities, Ventilation, etc

3 Signage

a General Information

b Description and Explanation of Signs to Be Used, Interior and

Exterior

c Dimensions, Specifications, etc

4 Ordering and Receiving Fixtures, Supplies, Equipment, and Inventory

5 Building the Management Team: Managers, Employees, and ProfessionalAdvisors

6 Application for Licenses, Permits, Utilities, Insurance, and Bonding

7 Lease Review and Negotiations

8 Community Involvement, Trade Groups, Charities, Chambers of

Commerce, etc (pre- and postopening)

9 Recommended Reference Books on Small Business Management

Section D: Office Policies

1 Image, Decor, and Theme

2 Quality Standards of Services

3 Pricing Policies and Fee Structure

4 Service and Courtesy to Clients

5 Handling Typical Complaints and Problems

6 Employee Appearance (uniforms) and Hygiene

7 Hours of Operation

Section E: Office Operation and Maintenance

1 General Housekeeping

2 Basic Duties of Personnel: Office Manager, Sales Staff, Employees, etc

3 Daily Office: Opening Procedure, Checklists

4 Daily Office: Closing Procedure

5 Daily, Weekly, and Monthly Reports

6 Self-Inspection

7 Health and Safety Standards

8 Rest Rooms

9 Pest Control

10 Parking Lot Care and Management (Where Applicable)

11 Alarms, Locks, and Keys

12 Emergency Procedures

Section F: Equipment, Computer System, Inventory, and Supplies

1 Equipment, Inventory, and Supply List for a Typical Franchised Office

a Specifications

b Approved Vendors

c Repair and Maintenance (Equipment Only)

2 Operation and Management of the Franchisor’s Proprietary Database

3 Approved Vendors for Equipment, Inventory, and Supplies

Section G: Administration

1 Personnel: job chart, position descriptions, hiring, qualifications andinterviewing, application form; checking references, hours, shifts,timekeeping, vacancies, sick pay, time off, training, payroll taxes, lawconcerning employees, rules of conduct for employees, bulletin boards,and required notices

2 Record Keeping and Accounting

3 Collections and Accounts Receivable Management

4 Managing Accounts Payable

5 Recruitment and Training

6 Quality Control

7 Group Insurance Policies

Section H: Sales Promotion

1 Grand-Opening Promotion Plans (With Timetable)

2 General Ongoing Promotion: Newspaper, Radio, Direct Mail,

Advertising Cooperatives, Community Groups

3 Special Promotions: Franchisee Referral Programs, Customer ReferralPremiums, etc.

4 Public Relations

5 Use of Public Figures

6 Use of Coupons and Direct-Marketing Mailers

7 Group Discounts and Promotions

8 Maintaining High Visibility in the Community

9 Understanding and Analyzing Local Demographic Statistics and Trends

Section I: Protection of Trademarks and Trade Secrets

1 Trademark Usage and Guidelines

2 Examples of Trademark Misuse

3 Care and Protection of Trade Secrets

4 Use and Care of the Operations Manual

5 Key Employee Nondisclosure Agreements

6 Protection of Proprietary Computer Software and Manuals

Section J: Preparation of Reports to the Franchisor

1 Guidelines and Requirements

2 Examples of Forms

Section K: Guidelines for Transfer of a Franchise

1 Requirements

2 Sample Forms and Notices

Section L: Financing and Corporate Structure

1 Required Corporate Structure

2 The Franchisor and Franchisee as Independent Parties

3 Financing and Loan Applications

4 Financing Alternatives

Drafting the Operations Manual: Selected Topics

The preparation of a comprehensive operations manual is truly an art Nolevel of attention or detail may be ignored For example, most franchisorsmight (and for good reason) assume that a typical franchisee would knowhow to prepare a peanut butter and jelly sandwich Yet there are many levels

of details that need to be addressed if the old-fashioned ‘‘PB&J’’ sandwichwere a staple on the franchisor’s menu, such as:

❒ What type of peanut butter? Chunky or smooth? Any particular brand?

❒ What flavor jelly? Grape? Apricot? Strawberry? May a customer choose?

❒ How many ounces of peanut butter per sandwich? Of jelly?

❒ What type of bread should be used? White? Wheat? Rye? May a tomer choose?

cus-❒ The bread served toasted or untoasted? Toasted using what type of oven?How long should the bread be in the oven?

❒ The sandwich served with condiments? Pickles? Potato chips? slaw? How much of each condiment?

Cole-❒ How is the sandwich to be served? What type of packaging?

❒ What are the suggested price ranges for the sandwich? Does the ment selected affect the price? What other products should be recom-mended to the customer when the sandwich is ordered?

condi-Now multiply the answers to these questions by the number of issues thatmust be addressed in order for the franchisee to properly operate the specificfranchised business, and you begin to get a feel for the level of detail re-quired

For example, the operations manual of a temporary services franchisorwill emphasize hiring and recruiting techniques, sales training, interviewingand screening methods, development of referrals, fee structure, use and pro-tection of the proprietary computer system and database, public relations,and administrative management

The specific organization and content of each manual will vary fromfranchisor to franchisor and from industry to industry Naturally, the manual

of a fast-food operation may have a more detailed section on sewage, ing, food preparation, inventory controls, and lavatory facilities than wouldthat of a services-driven business

plumb-Consider the level of detail contained in these sample provisions in ure 3-1 dealing with garbage, refuse, and rodent control for a fast-food fran-chisor

Fig-Complying with each section of the manual makes compliance withother sections much less a task An excellent example of this interrelation-ship is the requirements of this section easing compliance with the followingsections on insect and rodent control (see Figure 3-2) Note some of the spe-cific requirements of these paragraphs:

❒ Storage of garbage and refuse in plastic bags is approved for inside therestaurant building, but not outside

❒ Provide hot water, detergent, or steam for washing containers

❒ Dumpsters or containers must be located on a nonabsorbent slab of crete or blacktop; and preferably, some distance away from the estab-lishment doors so as not to entice vermin into the establishment

con-❒ Indoor garbage and refuse storage rooms must be insect and rodentproof