By Steven B. Feirman
Nixon Peabody LLP
We are frequently asked – “Can I promote my brand to potential franchisees in the United States,
before I have completed a Franchise Disclosure Document (FDD)?
Yes. UK and European franchisors can advertise and market their franchises on websites, social media, franchise directories, business publications, and wherever interested franchise buyers may be located!
However, such advertisements and marketing generally may not include information about past or projected sales or profits of the franchised businesses, until that information is included in an FDD.
Ultimately, an FDD will be required in order to sell any franchises in the US. And, in certain states, an FDD is necessary in order to enter into discussions or negotiations with prospective franchisees.
Franchising internationally can present many opportunities for growth and expansion. The United States, in particular, is a tempting market for European franchisors because of the size of the United States economy and the affection of consumers for European brands. There are about 2,500 franchise systems in the United States, and they operate over 800,000 franchised establishments in 300 different industries. The annual sales of the goods and services provided by franchised establishments in the Unites States are $1.2 trillion, and the franchise sector is growing more quickly than the rest of the Unites States economy.
A decision to begin franchising in the United States should not be taken lightly. Such a decision should be strategic, as it will require a significant commitment of resources by the franchisor. This paper discusses some of the business and legal considerations that must be analysed before a European franchisor decides to take the plunge into the United States market.
1. Establish the Franchise System at Home
It is important for a franchisor to become established in its home country before launching an international franchise program. This will ensure that the franchisor has experience in the business of being a franchisor, as opposed only to being an experienced operator of restaurants, fitness clubs, or whatever the underlying line of business might be. Franchisors must become adept at the dual functions of franchise development and franchise operations, and there is no better place to refine those skills than in the franchisor’s home market. While there are examples of franchisors that go international sooner rather than later, franchisors who are more patient tend to have greater success when they begin an international franchise program.
In addition, it is advisable for franchisors to begin expanding internationally by taking baby steps; they should first export their franchise to a nearby country, or to a country that is familiar to the franchisor. For example, many United States franchisors test the waters of international franchising by first expanding into Canada.
Once a franchisor has overcome the obstacles and costs of expanding its system to a neighbouring or familiar market, it can then consider its expansion strategy for the United States.
2. Conduct A Cost/Benefit Analysis
The potential rewards of entering the United States market are substantial, but so are the costs. A franchisor should understand its likely costs so that it can determine whether expanding its franchise operations to the Unites States is likely to be a profitable endeavour. While a franchisor may be able to shift some of the additional costs to its franchisees, the franchisor must be careful to ensure that the franchise costs are not so high that its franchisees are not profitable. The added costs arise in a number of areas.
A. Legal Expenses
There will be significant legal expenses associated with entering the United States market. The franchisor will have to register and protect its trademarks in the United States, and conform its franchise agreement as necessary to account for local laws, language, and currency. There is also a requirement under the Federal Trade Commission (FTC) Franchise Rule to provide pre-contractual disclosures to a prospective franchisee by providing a Franchise Disclosure Document (FDD). A franchisor also should seek tax advice to determine whether any special taxes will affect the financial terms of the franchise relationship. Such advice may require specialized expertise and additional expense. If a franchisor is entering into a multi-unit agreement or master franchise arrangement, the other party is likely to be a sophisticated purchaser, and the terms of the final franchise agreement may be highly negotiated. Any such negotiations may increase the legal expenses associated with franchising in a new country.
B. Travel Expenses
Inevitably, a franchisor’s personnel will need to travel to the United States to identify franchise prospects, train personnel, inspect proposed sites, provide operational assistance, and monitor franchisees operations to ensure that they are operating in accordance with system requirements. The travel costs, including flights, visas, and daily travel expenses, can add up. The methodical franchisor should seek to budget for these expenses, and structure both its initial and ongoing fees accordingly.
C. International Support/Assistance
The cost of providing support and assistance in the United States is likely to be higher than in one’s own country. This is due to a variety of factors, such as the need for greater training and assistance; introduction of a new concept in a foreign market; and adaptation of the franchised concept to the United States market.
D. Regulatory Expenses
A franchisor will have to incur a variety of compliance costs in the United States. Twenty-two countries, including the United States, directly regulate the sale of franchises in some form, and a number of states have separate franchise registration requirements. There will be added costs to generate disclosure and registration documents and to make the required filings. There are also expenses associated with seeking and maintaining intellectual property protection.
3. Register the Primary Trademarks in the United States
Neither the FTC Franchise Rule nor any of the state franchise sales laws requires that the franchisor have a federally registered trademark to use with its United States franchise program. Nevertheless, there are practical and legal reasons why a federally registered trademark is desirable.
If a mark is not registered, there is a risk that another party could use a similar or identical mark and obtain a common law right in the mark in a specified area of prior use. That would mean that the franchisor would not be able to grant a franchise using the mark in that area of prior use. In addition, the franchisor would have to disclose in its FDD if it knows of either superior prior rights or infringing uses that could materially affect the franchisee’s use of the principal marks in the state where the franchise will be located. Moreover, the infringing party may seek to register its own mark. The risk to the franchisor if it uses an unregistered mark is that the franchisor may have to modify its trademarks or discontinue using a trademark, which then raises the practical issue of which party would bear the cost of modifying the marks used by the franchisees. Brand identity is critical to a successful franchise program, and having to change or modify a mark could have a negative impact on the franchise system.
4. Determine the Optimal Structure for the Franchise System in the United States
When expanding a franchise system to the United States, the franchisor has to choose the method for expansion. Establishing a subsidiary and beginning direct unit franchising provides the franchisor with maximum control but is very expensive and time consuming. For this reason, direct unit franchising tends to be disfavored in international franchising transactions.
Many franchisors prefer to contract with a local party in the United States, someone who is familiar with the business environment, the cultural environment, and the legal environment, and who can focus on expansion in the United States as its primary function. For this sort of contractual arrangement, the choice may be between a master franchise and an area development agreement.
In master franchising (also known as sub-franchising), the franchisor will grant the master franchisee the right not only to establish and operate outlets owned by the master franchisee but also to sub-franchise outlets to independent sub-franchisees. The master franchisee will have to act as local franchisor and take on all obligations and perform all services for the sub-franchisees. The franchisor has to train the master franchisee not only in the operation of the franchise system but also in the training of sub-franchisees. As the master franchisee creates another layer in the structure, it is necessary that the training of sub-franchisees be identical to the training that the franchisor gives its local franchisees.
In area development agreements, the area developer will be granted the right to establish and operate a number of outlets during a certain period of time. The area developer will not be allowed to sublicense its right to others; it has to establish all outlets by itself. The area developer usually handles the obligations of a franchisor for the territory it has been granted.
An area development agreement is often preferred over a master franchise agreement: the franchisor will get the expansion it wants but without the middle man seen in the master franchise structure.
5. The Franchisor Should Adjust its Franchise Agreement
When entering the United States, it is usually necessary to modify the franchisor’s existing agreements. This is especially true when a franchisor from a civil law country (such as Germany) enters a common law country (such as the United States).
In an area development structure, the development agreement can include both the development grant and the grant to operate units with all the details concerning the operations. The development agreement can also be a two-fold system with a separate agreement for the development grant and an agreement for the operation of each unit. The latter agreement may be very much like a direct franchise agreement. In both scenarios, the franchisor will be one of the parties to the agreements and will want to have its law as the governing law. If the franchisor originates in a civil law country, it will most likely use its civil law agreement. However, there are clauses that need to be adjusted to protect the intellectual property and to enable the franchisor to seek injunctions in the United States.
If the arrangement is based on master franchising, there are two layers of agreements: the master franchise agreement and the sub-franchise agreement. The master franchise agreement will be concluded between the franchisor and the master franchisee. Just like the development
agreement, the franchisor will most likely demand that the governing law be the law of its home country, similar to most licensing agreements. If the franchisor originates in a civil law country, it will most likely use its civil law agreement. But, like the development agreement, it needs to be amended to enable the franchisor to protect certain right in the United States. The second
layer of agreement the sub-franchise agreement will be concluded between the master franchisee and the sub-franchisees. Both these parties are established and operate in the United States and must use a franchise agreement that recognizes common law principles.
6. Cultural Differences May Require Adjustments to the Franchise System
Franchisors from outside the United States used to spend a considerable amount of time trying to determine how best to Americanize their concepts for the United States market. Now, the need to change any franchised concept to conform to what might have been considered Americanâ tastes and preferences has been significantly diminished. A franchise concept developed in Europe may be much more successful in the United States if it remains authentic, instead of trying to turn itself into something more American. European franchisors will want to minimize any changes to its concept that could sacrifice the integrity of the brand.
Some successful foreign concepts also target the market of emigrants in the United States who are from the country where the concept was developed. In those cases, the franchisor wants to capitalize on its authenticity and heritage and successfully bring the home country feel of the brand to consumers in the United States who are already familiar with the concept. Of course, for each particular system, relevant cultural differences should be studied and taken into account as the foreign franchisor considers entering the United States market. For restaurant concepts, portion sizes may need to be altered. In the hotel industry, American business travellers expect that each room will have internet access, as well as an iron and ironing board. Given the number of overweight Americans, furniture sizes for restaurants and hotels may also need to be reviewed. Every aspect of the brand will have to be carefully considered prior to determining the exact offering for the United States.
If the franchisor’s home country and the countries where it has already expanded utilize the metric system or the Imperial system, the franchisor must include in the budget for its United States expansion the costs to convert all its measurements (recipes for both proprietary and non-proprietary food and beverage items) and architectural and interior designs for plans and specifications to the United States system of measurement.
7. Adjustments May Have to Be Made Due to Different Laws
The extent to which the franchisor will have to adjust its business model will depend on many factors, but most particularly on how the franchisor has set up its model in its home country and the level of any applicable disclosure requirements with which it is already complying. For example, in Germany there is limited pre-contractual disclosure because there is no statutory requirement for such disclosure; the limited obligation to disclosure arises from German case law and the German Franchise Association code of ethics. On the other hand, in the United States, the FTC Franchise Rule requires an FDD containing twenty-three items of disclosure. A German franchisor that is doing business in France, Italy, or Spain will be familiar with the level of pre-contractual disclosure required in the United States; but a German franchisor that has not previously had to provide detailed disclosures may be in for a surprise.
For example, in the United States, the franchisor must include information about any payments designated suppliers may make to the franchisor from franchisee purchases. If the arrangement with suppliers in the home country includes rebates or other payment benefits for the franchisor related to such purchases and there is no obligation to disclose them, the franchisor may have simply included such payments in its income. This disclosure does not, of course, dictate what the franchisor must do with rebates, but the transparency required regarding the payments may lead a United States franchisor to alter the use of such payments.
8. The Franchise System May Have to Be Modified Due to Supply Chain Differences
One key to a successful launch of a brand in the United States is the development of a secure, high quality supply chain. It will be necessary for the franchisor to determine whether products and supplies must be imported from the home country into the United States, with the added expense of transportation and logistics services and the payment of customs duties; or whether proper suppliers and manufacturers can be located in the United States. The integrity of the brand will be at stake so the franchisor must be assured that local United States suppliers can meet the requirements and provide the same quality of goods and products as the brand does in its home country. If the concept includes proprietary ingredients or technology, for example, the franchisor may be hesitant to permit production of these items by any supplier other than those with which it has a long term relationship. Supply chain analysis should be undertaken very early in the investigation of whether the brand and the business model will be financially attractive for franchisees in the United States, particularly if any goods or inventory must be imported.
The franchisor will also need to undertake careful research to determine if the amount of the advertising contribution required in the home country or other countries where the franchisor has units will be appropriate for the United States market. The franchisor must also decide if it will allow the United States franchisees to undertake advertising on their own, particularly when the brand is just beginning to grow in size.
9. A Franchisor Must Prepare and Register a Franchise Disclosure Document
As noted above, the content of the FDD is mandated by the FTC Franchise Rule. In addition, state franchise regulators have issued Franchise and Registration Disclosure Guidelines to provide further guidance on the disclosure and state registration process. A number of the franchise registration states require that certain additional state specific disclosures be included in the FDD, usually in an addendum.
Counsel in the United States may provide the franchisor with a detailed questionnaire that can be used to gather the information that will be needed to prepare the FDD. Many disclosures in the FDD need to reflect certain provisions in the Franchise Agreement, the Area Development Agreement or Master Franchise Agreement, and other documents used in the franchise sales process. Therefore, it is most efficient to prepare the Franchise Agreement and other agreements before preparing the FDD. Among other requirements, the FDD must contain the franchisorâ€™s audited financial statements and a copy of each agreement to be signed by the franchisee.
Once the FDD is ready, it can immediately be used in about 35 states. However, it will have to be registered in 15 states before a sale or offer of a sale of a franchise can be made that isÂ subject to the laws of those states.
10. A Franchisor May Be Responsible for its Master Franchisee’s Compliance with the
FTC Franchise Rule
Franchisors that enter into master franchise agreements (rather than area development agreements) have additional disclosure obligations. The FTC Franchise Rule defines a franchisor as any person who grants a franchise and participates in the franchise relationship. Unless otherwise indicated, a franchisor also means a master franchisee. As noted above, there are at least two agreements involved in a master franchise relationship the master franchise agreement between the franchisor and the master franchisee, and the franchise agreement between the master franchisee and the sub-franchisee.
These two types of agreements each have their own FDDs: (1) the FDD provided by the franchisor to the master franchisee; and (2) the FDD provided by the master franchisee to the sub-franchisee. The latter FDD must include information about both the master franchisee and the franchisor. The franchisor is responsible for the master franchisee’s representations in the FDD to sub-franchisees. Therefore, the master development agreement should contain detailed provisions about the responsibility for preparing the FDD. Similarly, state franchise laws also require that disclosure be included for franchisors in sub-franchise offerings.
11. The Size of the Franchisee’s Territory Must Be Manageable
The United States market is very large. The franchisor who grants too big a territory to the master franchisee or area developer is likely to be disappointed when the territory is not developed at the pace it expected. If the master franchisee or area developer undertakes to develop a territory that is too big and, as a result, fails to meet the development schedule, it risks losing its development rights. The way to handle the territory and the pace of development is by agreeing on a development schedule that both parties believe is feasible. The franchisor should set realistic goals on how fast it wants the territory to be developed. If the development is state- by-state or area-by-area, it is easy to set goals and thresholds. If the master franchisee or area developer does not meet the goals, the franchiseeâ€™s exclusivity may be terminated, the territory may be decreased, or the whole agreement may be terminated.
Many foreign franchisors expand to the United States with the naive perception that the United States is a single market. Too often have we seen franchisors grant a territory defined as all of USA. This is not the recommended way to expand. Very few franchisors would grant a territory defined as all of Europe. The countries of Europe may, in this example be compared to the states of the United States. Even though the states have the same currency and the same language, the laws and the culture will differ among the states.
12. The Franchisor Must Decide Whether to Form a United States Subsidiary
Franchisors generally form a United States subsidiary to license and operate the franchise system in the United States under one or more of three circumstances: (1) if it wants to have a presence in the United States to support the franchise operations or conduct company-owned operations; (2) to comply with the FTC Franchise Rule’s financial statement requirements for the FDD disclosure; and/or (3) to minimize its liability risk exposure.
If the franchisor plans to have its personnel stationed in the United States to support its United States franchise operations or conduct its own operations, it would be prudent to set up a United States subsidiary to conduct those operations. For tax reasons, and perhaps liability reasons, the franchisor may want to avoid having a branch office in the United States. The personnel stationed here would have to obtain the appropriate business visa to allow them to work in the United States, which may be easier to obtain if there is a local subsidiary. Such personnel often obtain a United States green card allowing them to live and work in the United States as a resident alien.
An important part of preparing the FDD required by the FTC is the need to have audited financials prepared in accordance with Generally Accepted Accounting Principles used in the United States. Most foreign franchisors establish a United States subsidiary to license and operate the program, adequately capitalize it, and then obtain an audited opening balance sheet prepared in accordance with Generally Accepted Accounting Principles.
13. The Franchisor Will Have to Provide Training for its United States Franchisees
A franchisor entering the United States should begin with its existing written training programs and materials. If these materials do not already exist in English, they will have to be translated and the costs for such translations can be significant. If they have been previously translated into an English version other than â€œAmerican English, they will likely need to be reviewed and revised in order for Americans to be able to utilize them successfully. Some franchisors entering the United States have chosen to do so through their home country nationals who have emigrated to the United States and who are fluent in the home country language. In that case, written training materials may not have to be translated immediately.
Additionally, if the franchisor expects that the franchised businesses will be operated by a diverse workforce, it will need to contemplate the possibility that certain training materials will not only have to be translated into English, but also into Spanish or another foreign language, depending on the ethnicity of the workforce. The franchisor may be able to minimize costs by having a substantial amount of its training program provided through on-line tools.
14. The Franchisor Must Conduct Inspections and Ensure Quality Control
If the franchisor has determined to create a subsidiary in the United States to provide support for the franchise system, it may determine to hire its own local employees who can undertake inspections of the franchised businesses. Such employees will have to be trained in the culture of the franchisor and likely will have to spend a significant amount of time in the franchisor’s home country to learn about the system and the operation of the units in order to be prepared to conduct inspections of the United States units.
Alternatively, the franchisor may have created an in-house team who inspect the foreign units, both in the home country as well as in other locations where the franchisor has expanded prior to its entry into the United States. Any such non-United States citizens who come to the United States for such inspection work will have to obtain a non-immigrant visa, a process that can be very simple or complicated and time-consuming, depending on the citizenship of such person. Inspections can also be handled by independent third parties who have been provided with the criteria for such review. Mystery shoppers are another tool that some franchisors utilize. Customer satisfaction surveys may also serve as a tool for quality control. All of these methods may be combined, but as the franchisor considers its entry into the United States, it will be necessary to establish a budget for these activities.
15. Tax Implications for the Franchisor May Be Different from its Prior Experience
The United States tax implications of a foreign franchisor entering into the United States market depend upon the ownership structure of the franchise. Foreign franchisors may enter the United States market by either (i) entering into a franchise agreement, area development agreement, or master franchise agreement directly with an unrelated party; or (ii) forming a United States subsidiary to serve as a base of operations in the United States or as a joint venture partner. Each structure will have different tax implications, so it is advisable to seek advice from a qualified accountant or tax lawyer in order to create a tax-efficient structure. In addition, the effect of tax treaties must be considered.
16. United States Franchise Laws Apply to Many Commercial Agreements
A franchise relationship may exist even if it is called a license agreement, a dealership, a distributorship, or a sales agency. For a transaction to be a franchise, three elements of the franchise definition must be present in the relationship. The first element is significant association with the licensor’s trademark or commercial symbol. The second is the payment of a fee. The third element varies, depending on the jurisdiction. Under the FTC Franchise Rule, this element is described as â€œsignificant control over the licensee’s operations or significant assistance in such operations. In a number of states that regulate the offer and sale of franchises, this element is described as a marketing plan that is prescribed in substantial part by the licensor. Some states instead require that there be a â€œcommunity of interest between the licensor and licensee for a franchise to be present. Franchise laws are considered to be remedial laws and, therefore, interpreted broadly. In fact, some states have a broader definition of franchise than the FTC Franchise Rule definition. In New York, a franchise consists of only two definitional elements: the payment of a fee and either a marketing plan or a trademark license.
It does not matter what name or designation is given the arrangement if it includes the definitional elements. Therefore, if a European franchisor wants to enter the United States market as a non-franchised licensor, it will need to eliminate the payment of fees. As a practical matter, this may be possible if the franchisor only sells goods to the franchisee for resale. That structure may qualify as an exception from the fee element if the amount paid is a bona fide wholesale price and if the franchisee is not required to purchase more than a reasonable business person would to maintain an inventory.
European franchisors are increasingly entering the United States market because consumers in the United States are attracted to European brands. In addition, the size of the market and the large middle class in the United States offers many potential benefits to European franchisors looking to expand. However, the decision to bring franchising in the United States requires that European franchisors have a keen understanding of the differences between the European and United States markets