Franchise Article

 

 

There are no formalities required to launch a franchise business and there are no specific legal requirements which relate to franchising.  In other words any business can describe itself as a franchisor and grant franchises.  That is not to say that it is sensible to do so.  It is an essential element of franchising that franchisors, before they recruit franchisees, have evaluated their business and have ensured that it will be a profitable and successful business for its franchisees.  To launch a franchise without having undertaken this research is, at best, unethical.  This chapter deals with the steps that any prospective franchisor should consider taking prior to the launch of a franchise.

 

 

 

2.         Is the Business Franchisable?

 

 

 

In order for a business to be capable of being franchised it has to be capable of being replicated, must be able to last for so long as there are franchisees and the franchisee must be able to operate the franchise profitably.

 

 

 

Whilst it is possible for a franchise to be launched successfully on the basis of simply an “idea” this is not to be recommended and, indeed, would not comply with the BFA’s Code of Ethics (which are a set of rules which all BFA members have to comply with and which is analysed in Chapter 7) and franchisors who launch a franchise without pilot testing, will find it difficult to recruit franchisees, not least because they will not be allowed to exhibit at BFA sponsored franchise exhibitions or to become members of the BFA. 

 

 

 

Essentially all businesses are franchisable except for the following:-

 

 

 

-            creative businesses – those businesses which require particular skills whether of an artistic or creative nature which cannot be easily taught.  In other words it is most unlikely that a design business which requires the flair of a designer could be replicated and franchised.  That having been said there are existing successful networks of franchised hairdressers in the UK under which franchisees are required to recruit stylists, so provided that the franchise does not depend on the franchisee himself being taught skills which, in practice, he is unlikely to have or is unlikely to be able to learn in a relatively short period of time even creative businesses can be franchised.

 

 

 

-            technical businesses – are unlikely to be franchisable because in the great majority of franchises a relatively short period of induction training is provided by the franchisor.  Whilst in some high cost franchises such as McDonald’s very extensive training over a long period of time is provided, this is very much the exception to the rule. If a franchise requires a high level of technical expertise in a highly technical area this is unlikely to be franchisable unless the franchisor takes on franchisees who already have that technical expertise or the technical aspects are referred back to the franchisor so that, in effect, franchisees are salesmen or the interface with the customer.  The BFA may have some doubts as to whether this type of franchise is a genuine business format franchise which would satisfy its criteria. 

 

 

 

-            low margins – there needs to be sufficient margins not only for the franchisor to make a profit but also for the franchisees.  In low margin businesses there may not be sufficient margin to enable this to occur. 

 

 

 

-            fashion products/service – the great majority of UK franchises last for at least five years and give  franchisees the right to renew, usually on two occasions or on one occasion if a ten year term is granted.  In other words the franchise business must be capable of operating for at least fifteen years.  Only those businesses providing goods or services which will continue to have appeal over this period can be franchised. 

 

 

 

-            no advantages – at the risk of stating the obvious there is no point in franchising your business if there are no genuine advantages in doing so. 

 

 

 

 

Whether and how your business should be franchised is an area where considerable expertise is required.  Franchise consultants can provide assistance on this.  Franchise consultants come in varying sizes from sole traders to large groupings.  As with all things it is likely that a consultant that you approach will claim expertise in franchising.  In fact, relatively few consultants have sufficient expertise.  The following steps should be taken before choosing a franchise consultant:-

 

 

 

-            meet the consultant and form a view as to his approach and what he can offer.  The great majority of consultants are prepared to have an initial meeting at no charge.  It is essential that the “chemistry” is right between you and your consultant although bear in mind that a consultant who indicates that he can easily franchise your business and tells you what you want to  hear may not be the ideal consultant.  Consultants should be in a position to criticise what you have done and to stress the difficulties and challenges in franchising your business.

 

 

 

-            talk to franchisors who they have previously assisted to obtain their comments.

 

 

 

-            obtain a clear and unambiguous idea of the cost of the service that they provide and compare it with other consultants. You need to ensure that you are comparing like with like so be clear as to precisely what services are or are not included. 

 

 

 

-            talk to bankers and lawyers who are involved in franchising and obtain their assessment but bear in mind that lawyers and bankers who are referred work by a consultant are likely to feel more favourably disposed towards that consultant than would otherwise be the case!

 

 

 

-            avoid “consultants” who are not affiliated to the BFA, claim that franchising is simple, guarantee success, prepare the franchise agreement themselves or link their fees to the recruitment of franchisees (although in the latter case a number of perfectly respectable franchise consultants offer this).  A number of organisations have sprung up that can tick all of these boxes and they should be avoided like the plague.

 

 

 

Consultants will advise you as to whether your business can be franchised, what changes you need to make and steps you should take.  They may also assist in preparing the information to enable a franchise lawyer to prepare a franchise agreement and prepare the operations manual.

 

 

 

 

 

 

The BFA attaches considerable importance to pilot testing as do banks’ franchise units, prospective franchisees and their advisors.   

 

 

 

Section 2 of the BFA’s Code of Ethics (which is discussed in more detail in Chapter 7) provides as follows:-

 

 

 

             - have operated a business concept with success for a reasonable time and in at least one pilot unit before starting its franchise network;”

 

 

 

Both the expressions of “success” and “reasonable time” are vague, but guidance has been provided on this in the BFA’s “The Ethics of Franchising”.  In the Ethics of Franchising “success” is defined as demonstrating that the level of profitability was sufficient when a business is operated by a franchisee:-

 

 

 

 

The first two elements are crucial.  The third element less so because a franchisor’s ability to operate profitably will be directly linked to the number of franchisees within the system.  Many franchisors with relatively few franchisees cannot operate their franchise business profitably, but the position changes when the number of franchisees increases.  The purpose of a pilot network is not to prove the success of the franchisor’s business but rather to prove the success of the franchisee’s business. 

 

 

 

A further difficulty is that, in practice, the first year’s operation is unlikely to prove very much on the basis that relatively few franchisees will make a profit (or at least a significant profit) in their first year.  All that can be proven with a single pilot operation operating for one year, is that the projected turnover/profitability has been achieved in that first year.  In order to be able to demonstrate profitability of a proposed franchise business it is unlikely that a franchisor should have less than two pilot franchisees who have operated for at least two full accounting years.  In practice, very few franchisors do this and the BFA does not require it. 

 

 

 

A further area of uncertainty is what is meant by a “pilot” unit or operation.  A franchisor does not, in order to operate a pilot unit, have to recruit a pilot franchisee (although many franchisors do this) but can instead operate a pilot unit using its own staff.   The crucial element is that the pilot must be operated as nearly as possible to the way that the franchisor intends to operate its franchise after the pilot stage. The franchisor must ensure that the pilot, whether he is a staff member or a newly recruited franchisee, operates remotely from the franchisor’s business, from an outlet or in an area which is representative of the types of outlets/areas which are to be franchised and operates as if he were an independent franchise.  If an employee is used the employee chosen should not have been actively involved in developing the franchise himself or be a very senior member of the franchise business if that level of seniority does not represent the sort of person that the franchisor is likely to recruit as a franchisee. 

 

 

 

When a franchisor’s employees operate a pilot operation they will be subject to their terms and conditions of employment which may contain confidentiality obligations and may also contain express obligations of confidence and good faith, but such terms and conditions will not contain a clause preventing the employee from being involved in a similar or competing business following termination of that employee’s employment.  Franchisors therefore need to be concerned, if they use employees to operate a pilot, that they may not be able to prevent that employee from using the experience that he has gained for the purposes of setting up or assisting in setting up a similar or competing business based on the pilot operation.

 

 

 

It is essential that franchisors review the terms and conditions of employment of those employees who are to operate a pilot operation to ensure in terms of confidentiality, good faith and post termination non compete obligations, that the contractual provisions go as far as possible to protect the franchisor’s know how and the system.  As an alternative the franchisor may, with the employee’s approval, terminate the employee’s employment and grant the ex-employee the pilot rights although, in practice, employees may be reluctant to give up their employment rights.  If, however, this approach is adopted or if a franchisor uses a third party to develop the pilot operation, contractual protection is required.  In an ideal world the franchisor would prepare its standard franchise agreement prior to granting a third party the right to operate the pilot so that the terms and conditions of the agreement used by the pilot are the same as those that will be used once the franchise is launched.  This is part of the process of ensuring that the pilot operation accurately replicates the proposed franchise.  Some would-be franchisors are reluctant to go to this expense at the pilot operation stage and in such situations franchisors can prepare a pilot franchise agreement which is considerably shorter than a full franchise agreement and would:-

 

 

 

-        Set out obligations of confidentiality;

 

 

 

-        Require the pilot to operate the franchise strictly in accordance with the franchisor’s instructions;

 

 

 

-        Oblige the franchisee to enter into the franchisor’s standard franchise agreement when prepared and when required by the franchisor;

 

 

 

-        Contain post termination non compete obligations;

 

 

 

-        Set out the beneficial terms (if any) which will be offered to the pilot for taking the additional risk of operating as a pilot;

 

 

 

-        Set out precisely what assistance the pilot is required to provide to the franchisor in terms of developing or refining the Franchise System.

 

 

 

The purpose of the pilot franchise is not only to prove the financial viability of the franchise and to enable the franchisor to ensure that it is able to transfer its know how but also to refine the franchise offering itself.  In other words it envisages a two way process for transferring know how and experience between the pilot franchisee and the franchisor.  During this period the franchisor will develop its operations manual.  Operations Manuals are likely to deal with:-

 

 

        1.                      

 

-           Brief summary of the franchise business

 

 

 

-           What the franchisee will have to do

 

 

 

-           What the franchisor will provide

 

 

 

-           Details of the existing franchise network

 

 

 

-           The franchisor’s business philosophy

 

 

 

2.                       System

 

-           A detailed description of the system and each of its elements

 

 

 

3.                      

 

A list of what is required in the business should be set out and should include:-

 

4.                      

 

              All matters relating to the operation of the business should be set out in detail and will include:-

            5.                       Outlet

            6.                       Standard Forms

 

              All standard documentation and forms required to be used in the business should be set out.  This may include:-

 

            7.                       Legal Issues

 

A summary of relevant legislation should be provided.

             8.                       Franchisor's Directory

 

-         Useful telephone numbers and contact details

 Franchise consultants often prepare a franchisor’s operations manual as part of their feasibility exercise but there are also businesses which specialise in writing manuals.  It is good practice for franchisors to be heavily involved in the process of preparing a manual and not simply leave it to a third party because whilst that third party may be an expert in operations manuals, he will certainly not be an expert in the franchisor’s business. 

 

 

 It is a requirement of the Code of Ethics that the franchisor either is “the owner or [has] legal rights to the use of its network’s trade name, trade mark or other distinguishing identification” (Section 2.2).  Accordingly, if the franchisor is not the owner of the trade marks to be used in the franchise business a licence agreement needs to be in place between the owner and the franchisor.  That licence agreement should be exclusive because otherwise franchisees would have to compete with third parties using the same brand/trade marks but not necessarily subject to the same restrictions and the trade mark owner should not be in the position to terminate the licence other than by virtue of the franchisor’s insolvency.  Ideally, the franchisor should be the owner of the relevant trade marks.

 

 

 

It is surprising the number of prospective franchisors who leave obtaining a registered trade mark to the last possible moment.  Trade marks/brands are fundamental to franchising.  Without a well known brand or the prospect of having a well known brand, it is unlikely that a franchisor will be able to retain franchisees.  It is the ability of the brand to attract customers that draws in franchisees.  Without a recognised brand, unless franchisees are able to purchase items for their franchise at a substantial discount through the franchisor, inevitably franchisees will argue that they are obtaining little value from their participation in the franchise. 

 

 

 

It is, of course, not a legal requirement for a franchisor to have a registered trade mark, but relatively few franchisors do not because if they have not registered their trade mark this is likely to put franchisees’ lawyers on notice that there may be difficulties in either using or protecting their brand against infringers.  Whilst it is certainly true that an unregistered trade mark can be protected by bringing a “passing off” action, these actions are complex and expensive and, in practice, few franchisors would wish to go to the expense of proving the five requirements for a passing off action:-

 

 

 

-          a misrepresentation;

 

 

 

-          made by a trader in the course of trade;

 

 

 

-          to prospective customers of his or ultimate consumers of goods or services supplied by him;

 

 

 

-          which is calculated to injure the business or goodwill of another trader (in the sense that this is a reasonably foreseeable consequence); and

 

 

 

-          which causes actual damage to a business or the goodwill of the trader by whom the action is brought.

 

 

 

In passing off actions franchisors would have to undertake surveys to demonstrate that their prospective customers associated their unregistered trade mark and brand with the franchisor and not the infringer. Whilst a franchisor, once established, might be in a position to do this, almost certainly it would not be in a position to prove confusion at the early stage of its development because it simply won’t have the necessary reputation or brand awareness.  Hence the need to obtain a registered trade mark.  This process needs to be started early because it will not take less than six months.

 

 

 

 

Once a registered trade mark has been obtained the franchisor may be encouraged by its lawyers to grant a separate “registered licence” – a short licence agreement which is registered with the Trade Mark Registry - to its franchisees in respect of the registered trade mark.   Many franchise agreements provide for this, although, in practice, very few franchisors actually require their franchisees to enter into a registered licence agreement because there are no benefits to the trade mark owner of recording a licence at the Trade Mark Registry.   In other words don’t bother!

 

 

 

If a trade mark cannot be obtained the reasons for this are either that the trade mark is descriptive or there is an existing similar registered trade mark.  Clearly, if there is an existing registered trade mark this would preclude the franchisor from franchising using that trade mark because its franchisees would have no protection against an infringement action.  If the proposed trade mark is descriptive then the franchisor would need to consider registering the logo – the appearance of the trade mark – rather than the word.  Alternatively, the franchisor could investigate obtaining a registered design.  Design protection does offer certain advantages over trade mark registration.  Design rights protect the design itself and not the article bearing the design and so, unlike trade marks, can prevent the use of the design on any products.  This is an area where specialist advice should be sought. 

 

 

 

At the same time as a prospective franchisor starts the process of obtaining a registered trade mark the franchisor should investigate domain names – it will be a major difficulty for any franchisor if it cannot obtain a domain name incorporating the franchisor’s proposed brand.  Additionally, if any materials such as marketing brochures, or operations manuals or any software is being commissioned the franchisor must ensure that it retains the copyright  in these items.  The copyright should not be owned by the third party business which is commissioned to produce it.  In the UK , unlike, for instance, the United States , copyright simply exists and does not need to be registered.