THE FRANCHISEE PERSPECTIVE: BE ON THE LOOKOUT

I often receive calls from people who are looking to start their “own” business and have been talking to franchisors about buying into the franchisor’s system. They have a franchise agreement in front of them, and want an attorney to make a quick review, and explain one or two matters to them, so they can proceed to sign on the dotted line by some unfathomable deadline. In answer to my question as to whether or not they have reviewed the franchise disclosure document (FDD) provided by the franchisor, too often I am advised sheepishly that they have only made a cursory review of the FDD. Taking the time to read that 60 to 100 page document because it’s “too technical”, “too boring”, “not understandable”, “unnecessary”, etc., often seems too daunting a task.

It’s at this point that I give my caller some cautionary advice. It is a waste of your time and money to see me for a consult on the franchise until you have done some minimal homework. It takes hours to go through an entire FDD, and it is unreasonable to expect any meaningful advice in a one or two hour consult unless they have done at least three (3) things:

1. Read the FDD and all attachments, including the franchise agreement, in their entirety;
2. Marked the FDD and attachments, flagging items they do not understand or on which they need further clarification (preferably making a written list of all these matters); and
3. Call and talk to least three (3) of each of the listed current and terminated franchisees disclosed in the FDD for their impressions of the franchise and the franchisor.

Here are just a few of the things they will learn by doing their homework:

1. Who the franchisor is, what experience he has in the business, just what the business is, and the past or current problems the franchisor is experiencing;
2. Upfront costs to start up and open the business, and what you will be paying on a weekly, monthly and/or annual basis to stay in business;
3. The type of restrictions the franchisor is placing on the “approved” location, the products and services you can offer, and what other “profit centers” the franchisor has built into his system;
4. Your obligations to the franchisor, both in-term and post-term, and your financial exposure if you fail to live up to those obligations;
5. The obligations of the franchisor to provide initial and on-going assistance in the operation of the business, and to protect you from competition from both the franchisor’s own outlets and other franchisees’ outlets;
6. The financial condition of the franchisor and whether the franchisor has the where-with-all to meet its continuing obligations.

Obviously, there is much more to the franchise relationship that needs to be considered, and you should take the time to understand what you are getting into. Doing the homework will increase the practical value of the consult, and you will be able to make a more reasoned decision as to whether to pursue the opportunity or to keep looking for one that better meets your expectations and objectives.

Is franchising the best way to expand my business?

Before taking the leap into franchising your business, let’s look at some of the various alternatives to franchising. Franchising is an expensive undertaking, so a different expansion strategy might be a possible route to consider. We will very briefly look at 5 other business expansion vehicles compared to franchising:

o Company-owned expansion
o Joint Ventures and Partnerships
o Independent Sales Representatives
o Licensing
o Distributorships/Dealerships
o Franchising

1. Company-owned expansion
Advantages: Basically, branch offices with control over all aspects of the business.
Disadvantages: Heavy capital outlay, management and employee issues, local state regulations, and ownership liability to third parties, direct financial impact of failures.

2. Joint Ventures/Partnerships
Advantages: Fewer regulatory requirements, greater control and flexibility, synergies of combined business skills.
Disadvantages: Moderate capital outlays, joint and several liability, no up-front payments, direct financial impact of failures, local state regulations.

3. Independent Sales Representatives
Advantages: Independent agent, not an employee, fewer local state regulations, no direct impact for representative’s failure to make sales (hire other salespersons as needed).
Disadvantages: Agency liability, potential tax treatment as an employee, non-exclusive relationship with product.

4. Licensing
Advantages: Lower capital outlay, fewer local state regulations, licensing and royalty fees, minimal oversight and staffing, minimal direct financial impact for failures.
Disadvantages: Minimal controls, teetering on the franchise vs. license ledge (the inadvertent franchise), monitoring issues, “at-will” relationship.

5. Distributorships/Dealerships
Advantages: Lower capital outlay, fewer local state regulations, increased market penetration, potential sharing of some advertising costs, minimal direct financial impact for failures.
Disadvantages: Minimal controls, teetering on the franchise/employee ledge (the inadvertent franchise/employer), monitoring issues, potential termination and renewal, local state regulations, no fees or royalties per se, potential non-exclusive relationship with product.

6. Franchising
Advantages: Greater control of quality and uniformity of brand, franchise fees and royalties, lower capital outlay, motivated operators, enhanced trademark value, no employee burdens, no direct financial impact for failures, increased market penetration.
Disadvantages: Initial costs of setting up system and annual updating costs, significant state and federal regulatory requirements, audit expenses, employing a franchise staff, monitoring of quality and uniformity, greater local state regulations.

The foregoing is not intended to be exhaustive analysis of advantages and disadvantages. You should consult your business attorney or consultant for an in-depth discussion of each business format. However, you should consider whether you and your product might be better suited for an alternative to franchising. In fact, you might look at one or two of these alternatives as stepping stones to ultimately franchising.

Please call me at 407-701-7530 for a free telephone interview.
B.F. "Biff" Godfrey, Esq.
B.F. GODFREY, P.A.
2601 Technology Dr.
Orlando, FL 32804
(407) 701-7530 (off)
(407) 578-2347 (fax)
biff@godfreylegal.com
www.godfreylegal.com

What is the best type of legal entity for my new business in Florida?

Determining the kind of legal structure you select to conduct business will affect, among other things, the kinds of taxes you will pay, individual verses business liability, and what state and IRS forms to file. There are four basic formats to select from, with each having a number of variations too detailed to discuss here:

1. Sole Proprietorship: A sole proprietorship is easy to set up and easy to dissolve. Profits are taxed at the owner’s individual federal tax rate, with the amount reported on Schedule C or Schedule C-EZ. Sole proprietorships do not pay Florida state corporate taxes and are not required to file state corporate income tax returns; however, the owner is personally liable for all the debts of the business.

2. Partnership: Partnerships can be formed as easily as sole proprietorships. These unincorporated businesses allow two or more people to share liability and provide capital. Business income is reported on partners’ individual tax returns, with the partners being individually and jointly liable for all of the debts of the business. (Limited partnerships are a slightly different form of partnership and must file with the Florida Department of State, Division of Corporations, but only the general partner is liable for all of the debts for the limited partnership.)

3. Limited Liability Company: Limited liability companies (LLCs) are a hybrid form of business that combines elements of partnerships and corporations. In Florida, LLCs may elect whether to be taxed as partnerships or corporations. On the federal level, LLCs with more than one member file a partnership return with the IRS, unless they elect to be classified as a corporation for tax purposes. LLCs, like corporations and limited partnerships, must also file with the Florida Department of State, Division of Corporations. An LLC shares many of the same advantages as an S-Corp., but there are significant differences that affect taxation and share-ownership. When properly organized and run, the owners of an LLC are protected from personal liability for the debts of the business.

4. Corporation: Corporations are separate legal entities that must be incorporated with the Florida Department of State, Division of Corporations. The two types of corporations are the C-Corporation (C-Corp.) and the S-Corporation (S-Corp.). With a C-Corp., the corporation, rather than individual share-holders, pays taxes and assumes liabilities. But a C-Corp’s shareholders pay separate taxes on dividends as they are paid out. An S-Corp. allows a limited number of shareholders to share income and expenses and to report them on their individual income tax returns. However, there are certain additional restrictions on share–ownership and taxation that must be taken into consideration as well. When properly organized and run, the owners of a C-Corp. or an S-Corp. are protected from personal liability for the debts of the business.

Conclusion: Determining which type of entity to select could make differences that may be minor for some, and major for others. In some cases the differences may not even matter if some other overriding factors cause you to choose one entity over another. The important consideration is that before you select the form of the entity, you make the choice based on specific circumstances related to your business or business plan. Consult both your accountant and an attorney to get the best advice. Every business is different, and you should carefully examine the particular facts and circumstances of your business plans and needs before deciding which entity to choose.

How do you determine the worth of a business?

Any estimate of a business’s value is more art than science. There is no magic formula that will simply tell you with any degree of certainty the value of your business.
Generally, a business’s value is set by negotiations between a willing buyer and a willing seller who have no particular compulsion to buy or sell, with both parties having reasonable knowledge of the relevant facts concerning the business. For the buyer, it’s determined and confirmed through due diligence before and during the negotiation process. That value would be the price, in cash or cash equivalents, which a buyer would reasonably be expected to pay, and a seller would reasonably be expected to accept.

But if you haven’t had someone offer to buy your business or are just considering the purchase of a business, a good range of potential values is not hard to calculate. While working on some buy-out terms of a syndication a number of years back, I was introduced to a fairly simple and quick method to determine, at least in general terms, the value of a business. Look at the last two to three years' income statements. If sales and profits have been relatively stable, compute the average over that period for your net profits before tax, then add back depreciation and amortization charges and the annual interest paid on interest-bearing loans. (If sales and profits have increased significantly over that period, then use the most recent year without an average. If there has been a decline, then look at other factors.)

The result of that calculation is your average EBITDA over the two to three year period or for your last and best year. That's an acronym for Earnings Before Interest, Taxes, Depreciation, and Amortization. That is the cash flow that is generated with the depreciation and amortization charges added back, and independent of the amount and extent of the company's financing and its tax status.

Now, multiply the EBITDA by a factor that is usually between 3.0 and 7.0. If the business is in a very competitive industry with lots of competition and low levels of proprietary elements, the multiplier would be on the low side. If the business has less competition and holds proprietary elements that tend to reduce competition, the multiplier would be on the higher side.
After deciding on that critical multiplier for your business and applying it to your EBITDA, then subtract all of your company's interest-bearing debts. The assumed debts are as much a part of the purchase price as the cash being paid on the purchase price.

The business is worth is also heavily influenced by more than the competitive nature of your market and the proprietary elements or intellectual property held by the business. The structure of the transaction will also have an influence on the price. For an all cash purchase, the price will be lower than one for which the seller will provide a significant part of the financing by holding a purchase money note issued by the buyer.

Also, most buyers prefer to purchase assets and assume certain of the recorded liabilities. Such an asset purchase transaction usually has a higher price than a stock purchase. In the asset transaction, the buyer has the tax advantages of writing up the value of the acquired assets to their fair market value on the closing date, then depreciating them from that higher cost basis. In addition, the asset purchase offers the buyer more protection than a stock purchase against unknown or unrecorded liabilities.

In a stock purchase transaction, the buyer is buying the entire balance sheet of the business and cannot write up the value of the acquired assets. The buyer can also be subjected to contingent liabilities which accrue to the acquired company that maintains its existence and obligations, both recorded and unknown, after the closing.

Choosing an asset or stock purchase will have significant tax consequences for the seller and, therefore, have an impact on the seller's after-tax proceeds. In a stock purchase, the seller is taxed at capital gains rates for the difference between the selling price and cost basis in the stock. In an asset purchase, other than for a company taxed as an S Corp., the corporation selling its assets will be taxed on that sale and the subsequent distribution by the business to its shareholders of the proceeds from the sale is again taxed at the individual’s tax level.

None of the above-mentioned formulas are magic, but providing this information to a qualified lawyer or accountant will assist them in helping you determine the worth of the business you want to buy or sell, and the most advantageous way to structure the sale or purchase of a business to mitigate significant tax consequences based on your needs and desires.