Individuals who are drawn to entrepreneurial pursuits frequently consider investing in a franchise, for a variety of reasons. Some of these reasons can be compelling: At their best, a franchise business model offers the security of an established company brand and support network for advertising and business growth, while at the same time leaving the unit franchisee (the operator of a specific franchise location) much of autonomy and self-determination in the handling of day-to-day business operations they might enjoy if they opened a fully independent business. As with any business, however, there are a few questions you should ask before investing in a franchise. To gain a more detailed perspective on these questions and how they may impact your ultimate decision regarding whether investing in a franchise is right for you, consider consulting with an experienced Arizona business law attorney from Harrison Law, PLLC. Call (480) 320-2310 today to set up a consultation.
Is It a Good Idea To Invest in a Franchise?
Entrepreneurs can invest in a franchise in two main ways. The first and most common is to secure capital, negotiate a contract with the franchisor, and open a “unit franchise” – an individual franchise location (if the same individual or entity undertakes this process for multiple locations, each separate location is its own unit franchise, and the operating individual or entity is the “unit franchisee” for each one). The second is to provide some of that capital necessary to open a unit franchise, essentially acting as an investor or silent partner to the unit franchisee, without necessarily becoming involved in the everyday administrative tasks or location-specific strategy (some of which may still be set by the franchisor) involved in running the business.
The questions you will want to ask are likely to be broadly similar in either case. However, if you are considering investing as a creditor or silent partner to the unit franchisee, you will want to consider how the unit franchisee’s habits, preferences, and approach are likely to fit with the franchise paradigm and especially with the particulars of the contract offered by the franchisor. If you are thinking of becoming the unit franchisee yourself (or of engaging in a contract to make your business entity the franchisee), then you will also want to consider how the terms of the contract outlining the degree of self-determination enjoyed by local operators and the administrative requirements for communicating and working with the franchisor will fit with your personality, preferences, and entrepreneurial goals. Asking sound questions and carefully considering their answers will be key to making a good business decision.
What Is the Franchise Structure?
Determining the administrative structure through which the franchise functions is important because this structure will determine how the unit franchisee communicates with, pays royalties to, and receives support in startup and sustaining growth. In many cases, the unit franchisee will work directly with the franchisor to establish the unit franchise location, build a successful business, and identify and develop opportunities for business growth. However, in large franchises, and especially in those whose unit locations cover a broad geographic area, it is not unusual for the franchisor to connect with local operations through the services of a third-party “middleman,” who typically assumes responsibility for local recruitment and expansion operations and for providing startup and administrative support to unit franchisees within their contractually-assigned territory.
Third-Party or Multi-Level Franchise Structures
The American Bar Association (ABA) explains that third-party franchise structures come in two basic models: area representative and master franchisee. Individual arrangements of either type are “customizable” to some extent by the terms of the specific contract negotiated by the parties, but these two models differ from other types of franchise arrangements by the presence of a third party, who is neither the franchisor nor the unit franchisee. They also differ from each other in the scope of the third party’s responsibilities and in the contractual relationship of that third party to the unit franchisee: In the master franchisee model, unit franchisees will have contracts with the master franchisee as well as with the franchisor, whereas in the area representative model, the unit franchisee will sign only one contract, with the franchisor.
Master Franchisee
A master franchise agreement (MFA) is a legal agreement between a franchisor and a master franchisee that authorizes the latter to own and operate multiple franchise businesses. Frequently the master franchisee will be responsible for recruiting, and providing support to, subsidiary franchisees, also called “unit” franchisees – that is, operators of individual franchise locations (units).
MFAs can involve a number of complexities, but as first-time franchisees are unlikely to be negotiating for the master franchisee position themselves, the important thing to remember before deciding to open a unit franchise within a master franchisee structure is that it will mean contracting with the third party (the master franchisee), who will likely enjoy extensive authority in overseeing operations within their territory. Consequently first-time unit franchisees will need to subject the business history and practices of the master franchisee and the terms of the contract with this third party to the same kind of scrutiny as those of the franchisor, before determining whether to move forward with the deal.
Area Representative
Unlike master franchisees, area representatives will not have their own contracts with unit franchisees, who will contract directly with the franchisor even though in many cases the bulk of their communication may be with the representative delegated to their region. However, area representatives may still be a unit franchisee’s primary contact with the franchisor and their principal source of support during business startup and upcoming growth phases. For these reasons, it is important to develop a clear understanding of whether the franchise is built on the assumption of any third-party relationships, and how those are handled.
Clarify Key Terms
The terminology used in franchising arrangements and especially in the many organizational structures involving multi-unit franchising by a single franchisee have historically been so inconsistently applied – and therefore confusing to potential franchise investors – that in 2014 the North American Securities Administrators’ Association issued a guidance sheet of definitions in an attempt to achieve standardization across the industry. Change in day-to-day usage takes more time than updates to official documentation, and the American Bar Association (ABA) uses a somewhat different set of definitions for many of the same terms. Consequently it is important not only to become familiar with the various terms used, but to develop a detailed understanding of how the franchisor is applying those terms within their own organization and with regard to prospective new franchisees.
What Are My Options for Growth?
Often, opening one unit franchise is seen as the doorway to opening more. If the franchise location is a commercial success, the unit franchisee will likely be motivated to open additional franchise locations. Understanding at the outset how growth opportunities will be structured and how determinations regarding additional unit franchise locations will be made can help an business-minded individual to decide whether investing in a franchise is the right move for them. A seasoned business law attorney with Harrison Law, PLLC may be able to help you evaluate your franchise options during a personalized consultation.
Area Development
One of the most common structures for facilitating franchise growth is what the NASAA calls “area development.” Also sometimes called “multi-unit franchising,” area development is an arrangement in which a single person operates multiple unit franchises. This organizational structure is distinct from the master franchisee and area representative structures in that the area developer is not responsible for overseeing the operations of other unit franchisees within their territory. The area developer may operate all unit franchises within a predetermined geographic area, but they do so without taking on additional responsibilities beyond managing their own location staff.
Subfranchising
In most cases an area developer will operate under contract directly with the franchisor. If simply expanding the total number of unit franchises in operation is not sufficient, and if the franchise structure allows for the possibility, an ambitious unit franchisee who has attained some experience in building and growing their unit franchise(s) may opt to pursue a subfranchising arrangement. A version of the master franchisee scenario, a subfranchising structure will involve precisely the supervisory activities that are absent from area development, although the full scope of the master franchisee’s authority and responsibility will depend on the terms outlined in the MFA.
Like area development agreements and area representative assignments, MFAs are typically region-specific, meaning a master franchisee will occupy a supervisory role with respect to all the unit franchisees within their assigned territory. The arrangement offers limited support to the subfranchisor, but can afford master franchisees the chance to collect royalties from unit franchisees in their region while limiting their day-to-day investment of both time and capital.
Are There Stock Incentives?
Franchisors do not always offer franchisees the opportunity to purchase stock options at an attractive price, but such options are a very common form of compensation in franchising agreements. Subfranchisors may also be able to extend this incentive to their subfranchisees. In addition to providing, from the franchisor’s perspective, a strong incentive for the franchisees to support the franchisor’s brand and ultimate goals, stock options – and the ability to sell as well as purchase additional company stock – when utilized strategically and at scale can enhance a franchisee’s “voice” within the organizational structure. The availability of stock options, and their relative concentration or dilution, vary widely from one franchise to another, so determining up-front whether a franchisor offers stock to franchisees as an incentive is an important step in evaluating whether to invest in a specific franchise.
Thinking of Investing in a Franchise?
Individuals considering investing in a franchise business may have a number of questions. Many of the most important require detailed investigation to ensure a thorough understanding of the factors in play. Before deciding whether to invest in a franchise business, consider scheduling a conversation with an experienced Arizona business law attorney with Harrison Law, PLLC. Call (480) 320-2310 today to set up a time.
