Franchise Lawyer Blog

This brief blog entry comes in the form of a question.

First, some background: Our firm has drafted many franchise agreements. For quite a while each agreement included an arbitration clause similar in intention to the type of clause invariably seen in franchise agreements nationwide. My partner, Michael Einbinder, is a litigator with extensive experience in the franchising field. He has, over time, become of the opinion that arbitration does not offer the advantages for which it is praised: it is not necessarily cheaper or more expeditious. Moreover, the fact that arbitration findings are unappealable has proven to be, on occasion, a major drawback. We have accordingly begun to draft franchise agreements that do not have an arbitration clause.

The question is: what do you think? In your experience, is arbitration a preferred method of dispute resolution, demonstrably better than litigation? Or have you, like us, begun to develop doubts in that area? Any thoughts would be welcome.

We recently wrote in this blog on the development of "fair franchising acts" in a number of states, statutory alterations of franchise law that could dramatically rearrange how the franchisor-franchisee relationship has historically worked. We ran across a piece by our colleague David Kaufman in the  April 24 New York Law Journal which concerned a recently introduced bill in California known as "The Level Playing Field for Small Business Act of 2012." The article is worth a look, as it highlights many of the concerns we raised in our blog entry. The law looks to reinvent many of the fundamental aspects of the franchisor-franchisee relationship and should be of interest to franchisees and of concern to any franchisor.

Many entrepreneurs are shying away from a return to corporate America after a round of layoffs catalyzed by the recent economic downturn. Instead, these pioneering businessmen and women are choosing ownership in a franchise.

This opportunity may initially appeal as a relatively inexpensive way to begin a business, but those looking into buying a franchise need to be wary of possible hidden costs.

Differentiating Between Fees and Real Start-Up Costs

It may be fairly economical to buy a franchise, but does the purchase price cover everything needed to open the business? More often than not, the answer is no. In addition to the initial fee, funds are needed for:

• Working capital reserves
• Real estate costs
• Permit and license fees
• Equipment rental or purchase costs

Working capital reserves are funds set aside to cover the first few months of operation. Generally, businesses do not make much of a profit during the first few months and use these funds to cover initial fees like rent, utilities and other operating expenses.

The franchisee may also need to obtain permits and licenses ranging from pollution control and sign permits to a liquor license. Those required will vary depending on the business. In addition, the franchise will often require particular operating equipment, a fee also covered by the franchisee if not specifically covered within the initial franchise agreement.

The initial franchise agreement can be negotiated to include some of these costs. As a result, it is wise to seek the counsel of an experienced franchise lawyer to review the rights and obligations contained within franchise contracts and ensure your rights are protected.

Source: NuWire Investor, "Cheap Franchises Can Cost Big Bucks," March 16, 2012.

A number of states are attempting to level the playing field between franchisors and franchisees by passing so-called "fair franchising" acts.

Rhode Island enacted three years ago; California, Vermont and Massachusetts are all poised to act on their version during their current legislative session.

In essence, the acts aim to solve a perceived problem of a few bad apples spoiling the entire barrel. Although most franchisors operate fairly, a few have engaged in deceptive or unscrupulous practices that have caused franchisees to unwittingly lose significant amounts of money. Legislators have focused on this issue as one that needs fixing. 

Many of the lawmakers' concerns are rooted in the perception that franchise agreements have, over the last twenty years, become more complicated and skewed toward the interest of franchisors. Some franchisors have been accused of repeatedly subjecting franchisees to unfair terminations and non-renewals.

Many franchisees are welcoming the acts with open arms. After all, franchisees rely on their businesses to earn a living. Many have their entire life savings wrapped up in the franchise. If it fails, they face the real possibility of financial ruin.

California's version of the bill includes the following protections for franchisees:

• Sixty days - instead of the current five - to settle overdue fees
• Automatic renewal of franchise agreements under the current terms, unless the franchisee has materially breached the contract
• Protections against new franchise locations opening up in the franchisee's territory
• A requirement that both parties deal in good faith
• A requirement that the franchisor recognize an independent association of its franchisees

In addition, under the proposed law, all franchisors would owe a duty of competence to their franchisees.

Considering how fast this issue is taking off, it would not be surprising to see a similar bill introduced in New York in the near future.

Source: NuWire Investor, "California Legislates Fair Franchising," March 16, 2012.

As we have mentioned before, we live in a country obssessed with lists (I just read about the Top Ten Cupcakes in the World) and the franchising world is no different. Entrepeneur Magazine has just released two lists:(i) a list of the top 50 new franchise opportunities for 2012; and (ii) a list of the top ten franchises for 2012.

Of course, all lists of this nature are subjective, but the assemblage of franchises mentioned in each list offer some interesting highlights into what may be going on in the economy in general and franchising in particular. The top 50 list offers a dizzying array of businesses, but certain trends emerge. Two of the top 10 are frozen yogurt shops and four others on the list offer frozen yogurt or smoothies, which suggests a healthy trend. On the other hand, four of the the 50 franchises sell burgers. So there's a countertrend. Seven concepts relate to personal appearance or physical conditioning. Six relate to home improvement and four are in the health care industry. One even sells cupcakes. 

It seems that if you were to try and detect the trends in what we are focused on as a society at any given time, you may be able develop a successful franchise concept on one of those notions. But you have to be nimble and move fast, because as a nation we have a notoriously short attention span and not all of our trends of the moment stand the test of time. Some of these ideas ring particularly true for this writer, who has children and aging parents: HappyFeet Legends promotes soccer programs for kids. Acti-Kare provides non-medical in-home senior care. Other ideas seem more of a stretch: RimTyme provides rent-to-own custom wheels and tires. I wouldn't have thought of that, but there they are at #17, so what do I know? 

The top 10 list consists of business models and franchise systems that have stood the test of time: hospitality (Hampton Hotels and Days Inn); fast food (Subway, McDonalds, Denny's, Pizza Hut and Dunkin' Donuts); 7-Eleven, H&R Block and ServPro (damage restoration). The story with each of these ten is that they have continued to grow and improve, despite appearing to approach saturation in their respective markets. How they found room for improvement varied in each concept, but there was always a strong focus on some vital aspect of the business. Hampton improved service. Subway and McDonald's expanded their offerings. Denny's and Pizza Hut went international. Dunkin Donuts and 7-Eleven grew into new domestic markets and expanded their brands. ServPro and Block expanded their service offerings.

What is the takeaway? (To use the latest addition to corporatespeak). Find a niche in a segment of the market that is currently popular or, better yet, which is about to become popular. Jump in with both feet. Don't try to be too much to too many people. Know your business and your clientele and remain focused. And then stay nimble, always improving, always watching, to stay ahead of the next shift in public perception.

Michael Einbinder of this firm recently argued an appeal in the United States Court of Appeals for the Second Circuit for a matter involving the enforcement of a non-competition covenant by our clients, Singas Famous Pizza Brand Corp. and Singas Famous Pizza & Restaurant Corp., which operate or franchise Singas Famous Pizza restaurants. The United States District Court for the Southern District of New York originally held that the defendants, a former franchisee and its principals, were enjoined from operating similar pizza restaurants from the location of the franchised business and from a Queens location that was located within ten miles of the franchised business. The defendants appealed the District Court's decision as to the Queens location only, arguing that the ten-mile geographic scope of the non-competition covenant was unreasonably broad. The United States Court of Appeals for the Second Circuit affirmed the decision.

The holding of this case is of interest to the franchise community. The Court of Appeals found that defendants expressly agreed in the Franchise Agreement that the ten-mile geographic restriction was fair, reasonable and necessary for the protection of the franchisor's proprietary interest and that a breach of the non-competition covenant would cause substantial and irreparable harm to the franchisor. The Court of Appeals noted that the defendants' agreement to such contractual provisions could be viewed as an admission.

The Court of Appeals referred to the legitimate interest of the franchisor in preventing a former franchisee from using knowledge that it gained from the franchisor to serve former customers and in preventing customer confusion and damage to the franchisor's goodwill. The Court of Appeals found that defendants' operation of a pizza restaurant in the Queens location posed a danger to Singas Famous Pizza's institutional know-how, reputation and goodwill, especially because the defendants used a virtually identical menu, adopted certain practices distinctive to the Singas Famous Pizza system, employed personnel from its former Singas Famous Pizza franchised restaurant and used custom made equipment from that former franchised restaurant.

As a practice advisory, this decision serves as a lesson to draftsmen to make sure that their franchise agreements and non-competition agreements contain express statements and admissions that establish the fairness and reasonableness of the restrictive covenants.

By: Richard Bayer

Franchisors, franchisees, area developers, multi-unit developers and any other operator in the franchising space invariably operate in the form of a company, a business entity. The currently preferred entity for conducting business is the limited liability company, which offers its owners, known as members, a shield from liability while at the same time avoiding the double taxation that can be the bane of corporate existence. It is possible to avoid double taxation in the corporate form by electing to treat one's corporation as an "S" Corp., but there are restrictions on the use of S Corps (S Corps may only have individual owners and a limited number of them, for example) that make them not quite as useful as the LLC. LLC's are also more flexible in terms of ownership and management.

LLC's are governed by operating agreements. When we sit down with clients to discuss how to structure their operating agreement, without some firm guidance the conversation can go spinning off in innumerable different directions. People who decide to go into business together typically do not think about exactly how they are going to manage that business, nor what they are going to do down the road if someone wants to quit or retire, sell their interest, or in the unfortunate event someone is disabled or dies.

One of the hurdles to giving good advice is how to obtain the information you need to do so in an efficient manner. We have found that clients like to respond to questionnaires. They can me made to be brief, to the point, with simple questions. We have a limited liability company questionnaire that enables a layperson to walk through a series of questions that will both focus him or her on the issues that the agreement is concerned with and hopefully extracts from that person the information necessary for us to draft an operating agreement for their enterprise. It looks like this at the start:

Limited Liability Company

Operating Agreement Questionnaire

Below is a list of questions that would help us prepare an operating agreement for your Limited Liability Company ("LLC"). Do your best to fill out the questionnaire with as much information as you can. If you do not understand any of the questions or are unsure as to how to answer the question, do not hesitate to contact us to discuss that question in more detail.

1. a) Name of the Limited Liability Company:

    b) State of Formation:

2. Does the LLC intend on doing business under an assumed name? If so, please state the intended assume name:

3. LLC's Address:

4. List the LLC's Members and their addresses:

5. State each Member's initial ownership percentage (total must equal 100%):

The questions become somewhat more involved, asking abiout management, succession of control, sale of interests, additional capital contributions, termination and a host of other issues. But by breaking down the discussion point by point, we are able to obtain what we need to provide people with a comprehensive document.

Some have concluded that franchising growth is based upon macroeconomic trends that cannot be expected to rebound to the same levels that existed prior to the last bust. A recent piece by Garth Snider of FranchiseOpoortunities Network warned of the dangers of wishing for yet another liquidity fueled bubble driving growth in the franchising space at a rate of 4 or 5%, which would prove to be as unsustanable as prior to the Recession that has supposedly ended. Mr, Snider was referring to the IFA's perennially sunny global outlook, recently tempered somewhat, when he cautioned that franchising needs leadership that does not push for growth for growth's sake, but rather plans for growth on an achievable model of more carefully applied liquidity. He also dismisses the oft-heard chestnut that "franchising does better in a recession." the IFA's rvised growth fuigures do not appear to support that premise.

Meanwhile, the Wall Street Journal's Small business section recently pointed out that tighter times in the franchising world are highlighting tensions between franchisees and management. The piece task about multi-franhcisee claims against Cold Stone Creamery, Burger King and Edible Arrangements, the inference throughout being that more are sure to follow.

As always, a closer analysis reveals a more complicated picture. Yes, some segments of the franchising world are suffering, but others have hit theor stride in these particularly dificult time. the question may not be whether or not to get into franchiing and instead, which area to get into.A recent piece in the Oregon Business News charted franchise growth by sectors. Health care and fitness centers showed strong growth, while real estate services, financial services and video rentals lagged badly.

On an individual level, then, perhaps the best advice is to be neither frightened away from nor too strongly drawn to, franchising. Rather, take a look at the business opportuniyt, the secotr in which it operates, the location and your own capabilities when evaluating whether a franchise is the right investment/opportunity for you.