8 Legal Mistakes to Avoid When Buying a Franchise

December 7, 2021by Brian Walsh

The cost to buy a franchise is significant. In 2020, the average franchise fee was around $34,000, with an additional royalty of 3%-6% of annual sales. In many cases, franchisees must contribute an extra percentage of sales to an advertising fund. Adding the cost of a physical location and necessary equipment can easily add $250,000 or more to the out-of-pocket expenses. Popular franchises – McDonald, KFC, Buffalo Wild Wings – can easily exceed several million dollars to open. Deciding to acquire a franchise is one of the more complicated legal and business decisions you can make.

Despite the stakes, many prospective franchisees, blinded by the promise of slick brochures and glib sales pitches, willingly agree to stipulations and conditions contrary to their interests. People purchase automobiles with more care and investigation than is expended on a franchise agreement. The unforced errors invariably come back with a high cost. Avoiding the following eight mistakes when buying a franchise will improve the likelihood of a profitable outcome.

1. Proceeding without a franchise attorney

The relationship between a franchisor and a franchisee is defined exclusively in the franchise agreement, a multi-page compendium of boilerplate, legalese, and franchise jargon. The format and language often confuse laypersons since its purpose is to establish specific legal principles and defenses for its maker. Potential franchisees often rely on slick sales pitches and exaggerations, overlooking contract language that controls the future relationship between franchisor and franchisee.

Disagreements between franchisors and franchisees frequently wind up in court. To the franchisee’s surprise, they learn that “most modern franchisee agreements promise very few required services and little support from the franchisor.” [i] The services of a qualified franchise attorney during the investigation of a franchise purchase can give potential buyers peace of mind and possibly save thousands of dollars in future disputes.

2. Relying on verbal promises and interpretations

Potential franchisees need to be aware of “vague” statements and effusive adjectives – great, awesome, fantastic – sales documents or by franchisor representatives when describing the franchise opportunity. Franchise contracts typically include an “entire agreement clause,” often in a boilerplate provision overlooked in the fine print. The purpose of the language is to prevent the parties of a contract from relying on any preceding discussions, negotiations, or agreements not expressly detailed in the signed contract between the parties. Generally, the law favors strict interpretations of contract language unless the suing party can prove fraud or fraudulent intent.

In 1979, the Federal Trade Commission initiated its “Franchise Rule” applicable to the offering and sale of business franchises within the United States. The rule requires a franchisor to provide potential franchisees with a disclosure document (the “FDD”) covering 23 specific items of information about the franchise, its officers, and other franchisees. When the potential franchisee has access to the FDD (regardless of if it is read and understood), the legal burden of proof falls upon the party claiming misleading or false oral representations.

3. Failing to read the fine print

The focus of the Federal franchise regulations is accurate disclosure by the franchisor to the franchisee. It does not require nor approve specific contractual terms contained therein. The sole purpose of the FDD is to allow potential franchisees to make an informed decision. If the franchisor discloses the details of its practices, the practices are enforceable.

According to the AAFD, a modern-day franchisee is merely a license to operate the business on behalf of the franchisor for the franchise term. Some franchises specifically state that the franchisee owns no equity in the business and that the business effectively belongs to the franchisor. Moreover, most modern franchise agreements promise very few essential services and little support from the franchisor.

The only sure way to understand the details governing the relationship between franchisor and franchisee is a careful line-by-line, word-by-word reading and understanding of the contract. The advice – Better to be safe than sorry – always applies to contracts, even when the process is tedious and time-consuming.

4. Limiting the Due Diligence Process

Due diligence refers to the process of carefully assessing and validating the presumed benefits and risks of a transaction before legally agreeing to a contract. Buoyed by the excitement of the new business, too many franchisees fail to complete or adequately implement a due diligence process. Franchise veterans recommend a three-part approach, with some activities coinciding:

  1. Careful review of the franchise agreement. Areas of specific interest are the assumed financial obligations, rights of exclusivity, details of franchisor support and assistance, and conflict resolution. Having experienced legal counsel is recommended during the review.
  2. Interviews with existing franchisees. Existing franchisees that have completed the franchise honeymoon period are the best sources of the probable results of a franchise. They know what works and what doesn’t; they have experienced the reality of working with the franchisor. Experts recommend at least ten interviews with existing franchisees, including some not recommended by the franchisor. Franchisees seeking to sell their businesses are excellent sources of information.
  3. Meetings with franchisor principals. There is no substitute for a headquarters visit and face-to-face discussions with the franchisor’s staff. Evaluate the physical appearance and work culture with your expectations and seek explanations where differences arise.

Most franchisors will appreciate the due diligence process. Having an unsatisfied or angry franchisee is a costly burden for them. A successful due diligence process reduces the likelihood of future disagreements.

5. Assuming terms are non-negotiable

Few business contracts are non-negotiable. Popular franchisors with a queue of potential investors may be less likely to negotiate terms and conditions. However, each circumstance is different and depends on the issue and its importance to a successful agreement.

A potential franchisee who cannot get a needed concession from a franchisor should think carefully before pursuing that franchise. If interests do not coincide before the agreement, the likelihood that they will mesh after a contract is signed is questionable. Furthermore, nothing is lost when pursuing better terms; the worst outcome is the status quo.

6. Considering the downside risk.

All new businesses face the possibility of failure. Franchises are no different, despite the myth that the failure rate is less than independently owned businesses (No reliable statistics support a conclusion). Even so, hundreds of franchisees fail every year across a broad spectrum of business models and variety of causes of funding, poor business concept, inferior franchise model, inadequate training, and bad management.

Opening a franchise is a significant financial risk, even for the wealthier. The hazards include events outside the franchisees’ control or ability to manage. The criminal conviction of Jared Fogle, Subway’s spokesperson, in 2015 caused a drop in sales nationally, contributing to the closing of more than 1,000 locations. Papa John’s pizza chain suffered 11% sales drop in 2019 when its founder used a racial slur during a conference call.

7. Not establishing a proper legal structure

The choice of a business structure affects the personal liability of the franchisee and the taxes that will be due on income earned. Most franchisees elect to incorporate or form a Limited Liability Company (LLC) for their advantage. Consulting with an attorney in the state where the business will be domiciled is recommended.

Establishing the optimum legal structure should occur before signing any legal documents, including the franchise agreement, leases, debt obligations, or other legal agreements. Replacing an established legal structure is often expensive, administratively burdensome, and confusing to customers, vendors, and suppliers. For these reasons, initially selecting the optimum business structure is best.

8. Providing unnecessary personal guarantees

New business owners, including franchisees, frequently agree to sign personal guarantees (or induce others to sign them) as additional security to franchisors, lenders, or vendors. In many cases, the guarantees are not necessary or limited. Franchisors and lenders typically seek personal liability to reduce risk, even when the added protection is unjustified.

Personal guarantees effectively void the liability protection of a corporation or LLC structure. When written assurances are essential to a transaction, the guarantor should

  • negotiate limits to the maximum exposure (amount and duration),
  • define specific circumstances leading to a call on the guarantee,
  • specify future events to reduce the signer’s liability, and
  • identify a final date nullifying the contract.

A personal guarantee is a contract between the signer and the body receiving the guarantee. It requires the same scrutiny and consideration as the franchise agreement, i.e., seeking legal advice before signing.

Final Thoughts

Whether buying a security or opening a franchise, the outcome of a business decision generally correlates with the research and preparation before commitment. It is always better to be over-prepared than under-prepared. The imagined benefits of the future do not so blind successful people that they forget the possible potholes and obstacles along the way.

A wise investor knows his strengths and limitations, seeking counsel when necessary. It is always better to avoid problems than fix them later. Understanding the fine print of a contract or the liabilities of a personal guarantee before a signature is common sense and the reason to seek legal advice.

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