BUSINESS STRUCTURE AND INTELLECTUAL PROPERTY ISSUES
By David Gurnick
I. STRUCTURAL CONSIDERATIONS FOR START-UP AND SEASONED FRANCHISORS
A franchisor, whether new or established, faces many competing priorities. Start-up franchisors must develop and refine their system concept; create a product that will sell, or service the public needs or wants; and develop a brand identity that is memorable to the public and will distinguish the products or services from those of competitors. The franchisor must construct the program with a cost and revenue structure that will generate income for each participant: franchisees, possibly subfranchisors and area development representatives, and the franchisor. A key part of the financial structure is raising capital, whether from the promoter’s own funds, from investors, by borrowing, by a structure in which operating revenues will pay for operation of the franchise program, or a combination of these. A marketing program must be created, to inform the public about the franchise. Recruiting and staffing with capable, enthusiastic personnel are critical, as are recruiting and training quality franchisees.
A seasoned franchisor—one with sufficient operating history and experience, must continuously refine and develop the system concept to stay relevant and interesting to the public. Success in the past does not ensure that the public will continue to buy the system’s products and services.
McDonald’s, as an example, has continually evolved and reinvented itself in product offerings, marketing, and image. In early years, the company focused almost exclusively on selling burgers, fries, and milkshakes. Over time its menus have evolved and expanded, and currently include salads and breakfast foods. Its marketing and slogans have changed. Former jingles emphasized that “McDonald’s Is Your Kind of Place,” “You Deserve a Break Today,” and “We Do It All For You.” More recent slogans have included “Did Somebody Say McDonald’s?” and “I’m Lovin’ It.” Likewise, its iconic arches in the shape of the letter M have kept changing to stay contemporary (see images on next page).
In contrast, Blockbuster Video, and Fotomat are examples of once successful, now-defunct, or highly challenged franchise systems. It is possible that their declines could be attributed to failure to anticipate or adequately respond to changing trends. Blockbuster continued to offer film rentals on video and discs but trailed behind in making its offerings available via online streaming. Fotomat offered convenient, quick film processing at retail kiosks, but may have fallen victim to the emergence of electronic photography. Sizzler restaurants faced challenges due to e-coli health incidents and changing consumer meal preferences. Over time, American consumers have become increasingly thoughtful about the healthfulness of meal choices. Thus, the Kentucky Fried Chicken brand and its owner, Kentucky Fried Chicken Corporation, which were established in the 1950s, began to transition the brand in the 1970s, and eventually the corporate name, to KFC. They did so to direct attention away from the deep-fried nature of the product.
Franchisors in all industries, to survive and prosper, must foresee what their customers will need, and develop new products and services to meet those needs. At the same time, they must create advertising and marketing to connect with customers. They must retain quality personnel, and demonstrate ongoing delivery of value to franchisees. All the while they must anticipate and respond to initiatives of competitors to contend with peer companies in the same industry.
Apart from core issues, franchisors must address numerous significant but seemingly secondary, or collateral, issues. Collateral issues that start-up franchisors face differ in many ways from those confronted by seasoned franchisors. The issues may seem to be secondary, or of merely collateral importance, but they have a significant impact to the success, and even survival of, a franchise system. In truth these issues are no less important to the franchisor; they are merely less immediate in their sense of urgency.
Among the collateral issues that start-up franchisors must address are: establishing credibility; raising capital; maintaining flexibility to be able to pursue opportunities; choosing entity type (corporation, limited liability company [LLC], or other form); deciding which state to organize the entity in and where to locate headquarters; deciding where to establish bank accounts; purchasing insurance; choosing whether or not to join a trade association; reviewing and possibly revising the company’s business plan; and responding to unexpected opportunities and challenges that may arise.
Collateral issues that seasoned franchisors must deal with are even more numerous and varied. The particular issues facing any particular franchisor depend on its particular history and circumstances. Some issues that almost any seasoned franchisor may confront include: deciding whether to maintain existing supplier and vendor relationships or making changes in response to solicitations offering better quality, better service, or better pricing; choosing whether to pursue or pass on new, often unsolicited opportunities and proposals that are received; and deciding whether and when to add new products and services, and/or remove products and services that are in decline. In the case of a seasoned franchisor, a collateral issue may be anything that involves a question or decision that was not intended by the franchisor to be a focal point at the time.
II. COLLATERAL ISSUES FOR THE START-UP FRANCHISOR
Start-up franchisors face the challenge of getting people to believe and recognize that their concept and system will succeed. This is the challenge of credibility. By virtue of being new, the franchisor’s program lacks key elements that establish credibility: a record of revenues and profits, existing locations, satisfied franchisees and customers, prominence, and a history of dealing with and overcoming challenges. To recruit franchisees when there are none and to attract investment capital without an operating history, the start-up franchisor must persuade others that the concept and system will succeed.
New franchisors apply a variety of methods and tools to accomplish this. These start with the development of a compelling business plan. The promoter may create a formal, written business plan. Or the promoter may develop the plan in mind only, and present it orally. In the plan, the promoter of the franchise has identified a need that the franchise program will fulfill. The plan describes the market for the goods or services, including an explanatory description, and some form of measurement of the market. The measurement may be in dollar volume, or a count of potential customers for the product or service. The business plan tells how the envisioned franchise will operate to fill the need the promoter has identified.
The business plan presents an appeal based on logic. The logical connection between the product or service offered, the need it will fulfill, the size of the market, and the revenues to be received when those in the market patronize the business, provides an argument for a venture that is worth participating in.
The business plan also seeks to instill confidence by describing backgrounds and experience of personnel who will manage the franchised business. The logical premise is that if people with previous experience and success apply their talents to the business, then the current business will also succeed.
To obtain investment capital, the business plan may provide financial projections, showing how much revenue the program is expected to generate, and anticipated expenses. The difference between revenues and expenses is the projected profit to investors.
Other tools are also used to instill confidence in the concept. Classic advertising and persuasion strategies may be employed. The “bandwagon” appeal claims the product or service is desirable because it is used by numerous people. The “endorsement” strategy involves participation of a celebrity or prominent person in the venture. Because the famous person is affiliated with the franchise, the public’s respect and affection for the celebrity will transfer to the franchise itself. In a “testimonial” strategy, individuals with established credibility attest that they used and were satisfied with the franchise’s goods or services. A promoter’s own enthusiasm and commitment may also be used to persuade others to participate.
Through these methods, the promoter of the new franchise venture seeks to establish credibility as a method to persuade franchisees to invest and participate.
B. RAISING CAPITAL
The start-up franchisor, like entrepreneurs in any business venture, must provide or obtain money to pay the expenses of establishing the franchise program. This is the challenge of raising capital. The franchisor must either self-fund the venture or persuade others to invest by providing either equity capital or funds in the form of a loan.
Self-financing provides the benefit of being in control of the amount of money to be invested in the business, and how it will be used. Using one’s own funds as investment capital means the investor need not negotiate or make commitments to others to obtain funds. The self-financed venture has freedom to use its money as the owner wants because no commitment has been made to restrict the use of funds.
Self-financing, like obtaining funds from others, can occur in two forms. A self-financed investor can invest money as capital. Typically, the new franchisor will be established as an entity, such as a corporation or LLC. To invest money as capital, funds are given to the entity. In exchange, the entity grants the investor a share of ownership, typically issuing a certificate representing shares of stock if the entity is a corporation, or units of membership if the entity is a LLC. When money is provided as capital, the company has no legal obligation to repay the investment. Alternatively, funds can be provided in the form of a loan, with an obligation by the company to repay the loan. Again, the investor provides the funds to the entity. In exchange, the entity provides the investor with a promissory note, stating the timing when the loan to the company will be repaid, and the interest rate.
When funds will be obtained from third parties, the franchisor becomes an investment promoter, seeking to raise capital. These steps include developing a cogent and compelling business plan, identifying sources that may have an interest or willingness to fund the plan, and taking the legal steps to receive and document their investments properly. The business plan also must include detailed financial data. Generally this begins with a budget, stating how the invested funds will be used.
There are many reasons why a potential investor may be willing to make an investment of money in a start-up franchise concept. The most obvious and common reason is a belief that the concept will succeed and generate profit, which the company will return to the investor; or that success will result in the business being sold, generating a good return on the investment. Friends and family will sometimes invest based partly on emotional connection and desire to support the promoter’s efforts. Others, who operate a business related to the franchise concept, may invest because they believe they will make a profit and because they want to have other business relations with the new venture, such as to become a supplier.
Banks and other lenders comprise another source of capital, typically provided in the form of loans. They, too, must be satisfied that the new venture has a logical business plan that, when implemented, will generate sufficient returns to repay any loan with interest.
C. FLEXIBILITY FOR DIFFERENT KINDS OF DEVELOPMENTS
Another important consideration for the start-up franchisor is being prepared for expected developments, and for the unexpected. Expected developments are set forth in the franchisor’s business plan. The plan may identify the franchisor’s personnel, project the number of locations to be established, and project revenues and other financial performance. But developments may not occur as planned. While the business plan projects where management wishes to direct the company, more often than not, the course of events will deviate in at least some ways from the specific plan. Some of the expected personnel may leave. The franchise sales program may generate more sales than anticipated, or fewer. Revenues may exceed, or fall below expectations.
Countless other developments may occur. Management may discover that the company’s main product, or service, needs to be modified due to changes in consumer interest or improvements in technology. New law or government regulations may hinder the public’s use of a product. An unanticipated cease and desist letter might be received, forcing the company to modify its brand name, or modify the product to work around someone else’s claim of patent rights. Favorable or negative publicity, an unanticipated major expense, litigation, unanticipated interest from a potentially significant investor, or prospective franchisee seeking to establish a large number of units, are examples of events that can occur, though none of these is expected.
D. CHOICE OF ENTITY OR STRUCTURE TO FACILITATE LEGAL COMPLIANCE AND LOGICAL OPERATION
A start-up franchisor has the opportunity to choose the kind of legal structure it will use. This includes the type of entity that will be used to conduct the business. The start-up must consider what structure will best facilitate compliance with the various laws that regulate franchising.
Among the compliance issues that can affect the legal structure are Federal Trade Commission (FTC) and state law franchise registration and presale disclosure requirements. These require the preparation and registration of a disclosure document. The disclosure must include information on predecessors; backgrounds of directors, managers, officers, and others with management responsibilities; historic and pending litigation; and audited financial statements. These requirements often militate toward using a corporate entity (corporation or LLC) because this type of entity lends itself to disclosure.
The various legal organizational structures are the sole proprietorship, general partnership, corporation, LLC, and limited partnership. Each of these alternative structures has different characteristics.