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Growing Without Franchising

Looking to grow your biz? Check out some business alternatives outside the franchise structure.

When making a decision to franchise, you should attempt to determine not only if your company is franchisable, but also if franchising is the best expansion strategy for your company to pursue. While I've already written extensively about franchising versus company-owned growth in this column, no examination of strategic growth alternatives is complete without an understanding of the other alternatives available to you.

To gain a more thorough understanding of these alternatives, it's perhaps easiest to use the federal definition of a franchise as a ready point of reference. The federal definition of a franchise includes a business relationship that has three elements:

1. The use of a common trademark;

2. The provision of operational support or assistance, training or the exercise of significant operating control;

3. The payment of a fee of over $500 in the first six months of operation. This definition includes initial fees, royalties, advertising fees, training fees or fees for equipment. In fact, the lone exception is for goods sold to the franchisee at a bona fide wholesale price for resale to their customers.

If a company has those three elements, it's a franchise regardless of what you call it. If it looks like a duck .

So to create a different type of relationship, you'll need to remove one of those three definitional elements.

Business Opportunities or Licensing: The "No Name" Options
Often, we see companies with what they call a "license" program--sometimes something they dreamed up and sometimes the creation of their attorney. But simply calling something a license or a business opportunity does not make it so. It becomes a "license" or, more technically, a business opportunities license (also called a biz opp) when you remove the name element of the definition.

The advantages to the business opportunity route are that, in many cases, you do not have to comply with franchise disclosure regulations promulgated by the FTC--saving money and making the sales process less complex. That said, a biz opp may still have to comply with franchise disclosure laws in some states, and, aside from franchise disclosure laws, will need to comply with the patchwork quilt of biz opp laws that exists in more than two dozen states. So while you may avoid some legal costs if you plan to roll out the offering on a local level and may avoid the "hassle" of disclosure as well, a national rollout may require you to pay more in the way of legal fees and make it only marginally easier to sell.

At the same time, avoiding a common brand identity often puts you at a significant long-term disadvantage over your franchisor brethren. First and foremost, the use of a common brand and a common identity can be a significant benefit to the franchisor. Even a one-unit chain looking to expand through franchising will be likely to double advertising expenditures with the sale of the first franchise, whereas the licensor who sells 100 biz opps will get little, if any, in the way of brand recognition--because each of its operators will do business under their own name.

Moreover, because each biz opp will operate under a different name, you have no legal nexus from which to control how the licensee operates. The legal principle here is simple: If someone is operating under your name, you can control their operations because their operation affects how people perceive your name. But when they operate under their own name, you no longer have a vested interest in their performance, as it isn't your name that's getting dragged through the mud.

For this same reason, the fees charged by biz opps tend to be substantially lower and often don't have any long-term component or royalty--unless it involves ongoing purchases from you. Again, the reason traces back to the name. Without the name, you cannot exercise control. Without control, it's difficult to provide the value provided by a franchisor developing common advertising campaigns, marketing initiatives, merchandising schemes and otherwise finding ways to enhance value and performance at the unit level.

Finally, biz opps will often find themselves competing with one another in ways that franchises generally would not. Because biz opps don't share a common name, consumers may "shop" the different locations to see which offers the better price--encouraging price competition and decreasing each operator's margins. Franchises, on the other hand, rarely get shopped against each other at the consumer level, because even though the franchisee has a good deal of pricing latitude, the consumer will often view the franchise chain as a unified whole with a single price structure.

Trademark Licenses--The "No Support and No Control" Option
The second option available to you, if you're looking to expand without franchising, is the use of a trademark license. A ready example of such a license would be Michael Jordan allowing someone to use his image as part of their advertising or on a piece of clothing. After all, who doesn't still want to be like Mike?

But for those of us with less prominent names, trademark licenses are exceptionally difficult to market--especially if we're branding a business. After all, if someone is going into a business, it is the system of operation--the recipes, the advertising, the operating procedures and the knowledge of how to succeed--that the prospective buyer is looking to obtain, not simply the name.

More important, it's extremely easy to step over the line of providing "significant operating control or significant operating assistance." Among the elements cited by the FTC as being significant are controls over site approval, design specifications, production techniques, promotional campaigns requiring franchisee participation and territory restrictions. And the FTC has stated that training programs, management and personnel advice, site selection assistance and operations manuals are all forms of significant assistance. Moreover, you don't need to provide all these elements in order to trip the support and control element of the definition. One slip in the wrong place, and, oops . you are an inadvertent (and illegal) franchisor.

And even if you were to remain pristine on this issue--not providing any support or exercising any control--wise trademark owners should be asking themselves, "Do I really want to allow someone to use my name on a business, without the ability to control them?" These aren't T-shirts here. The damage that could be done by a single rogue operator could significantly harm the brand equity that took years to build.

The "No Fee" Options
The last alternative for avoiding franchising, of course, involves removing the fee element from the equation. One way of doing this is simply to wait more than six months to collect any fees from your non-franchisee. But while this may work in some cases, variations in state laws make this a treacherous path indeed. For example, in the case of To-Am Equipment v. Mitsubishi Caterpillar Forklift America, Mitsubishi granted a distributorship to To-Am, assuming that since it was not charging To-Am a fee, it was not subject to franchise laws. But over the course of the eight-year relationship, To-Am purchased $1,600 worth of manuals from Mitsubishi, thus triggering Illinois state franchise laws and ultimately costing Mitsubishi about $1.5 million.

Even if you're operating in a state without franchise laws, the other question you should ask is why anyone would want to go the fee-deferral route. You'd need to incur significant marketing and selling costs and then incur significant additional support and training costs, all without compensation for six months--simply to avoid the minor inconvenience of complying with franchise disclosure laws.

Other non-fee options are more rational and often appropriate for certain companies. These include dealerships, distributorships, agencies, independent sales reps and joint ventures.

Dealerships and distributorships, like the Mitsubishi example above, involve the provision of products to a third party at a "bona fide wholesale price" for resale. This is certainly a tried-and-true means of establishing a channel of distribution, but of course, these alternatives are only appropriate for manufacturers and wholesalers. And again, caution must be the byword. Selling equipment, displays and other items that are not intended for resale--even if not sold at a profit--will trigger the fee element of the definition and potentially create problems similar to those cited above.

Moreover, many manufacturers these days are finding that the traditional dealer model is much less efficient and much less profitable than franchising. Because the dealer relationship lacks a fee, support needs to be provided for free--essentially eating into the manufacturer's wholesale margin. And while dealers will clamor for more and more support, they'll often have little loyalty to the manufacturer's brand when a competitor comes calling with a product that provides for increased sales, improved margins or is perhaps just the "flavor of the month"--turning the manufacturer into nothing more than a redheaded stepchild overnight.

Similar issues can be found in agency relationships. In an agency, the salesperson is selling a service on your behalf--so again, this form of relationship is only appropriate for companies in which fulfillment of the contract is provided by corporate, and not by the agent. The easy distinction here (much like that of an independent sales rep) is that all money flows downward (from corporate to the agent) and not upward (from the franchisee to the franchisor). Minimal brand loyalty, high turnover and support-oriented margin erosion typify these types of relationships.

The last type of "no fee" option, of course, is the joint venture. A joint venture partnership is characterized not by fees, but instead by a sharing of equity and profits. And while joint ventures can work very well in isolated cases, they are notoriously difficult to carry out on any significant scale.

The first major issue encountered by the "joint venturer" is defining and tracking profits. How should the operating partner get compensated for their time? When does an expense become a perk? What constitutes overhead, and how does that get allocated? How does the nonoperating partner get compensated for their time? Does the operating partner have the latitude to hire friends and family, and if so, how is this controlled? What controls need to be established to ensure all profits are, in fact, reported?

Even in relationships in which the operator is honest and well meaning, the process of tracking profitability for a single unit can be cumbersome, but across 100 units or more, the accounting involved quickly becomes daunting. And one more cautionary note here: A joint venture that pays fees to the owner of the intellectual property will be deemed to be both a joint venture and a franchise, even if the IP owner is one of the JV Partners.

Lastly, the joint venture relationship itself is extremely difficult to manage. Unlike a franchisee, who is obligated to follow the rules by contract, the joint venture partner is, in fact, a partner--and will often attempt to take greater latitude with the system of operations than would a franchisee. We often liken a joint venture partnership to a marriage. It is an individually negotiated, occasionally contentious partnership of "equals" that often ends in divorce. A franchise relationship, by contrast, is much more like a parent-child relationship. The franchisee starts as a highly dependent infant and will evolve into an increasingly independent, occasionally rebellious adolescent, who will (assuming you are good at parenting) still follow the rules--despite occasional protestations.

Complicating Factors--The States
No discussion of franchise alternatives is complete, of course, without at least a brief word on the complications that arise out of state laws. In some states, such as New York, a business needs only two and not three of the definitional elements of a franchise to qualify as a franchise--either the name or the marketing system, combined with the fee.

Likewise, in a recent Connecticut case (Charts Insurance Associates v. Nationwide Mutual Insurance), a jury awarded more than $2 million for the sale of an insurance agency that triggered the Connecticut Franchise Act. Here again, only two elements were present--the marketing system and the trademark--but there was no fee element.

So, as I've stated before, even if you're trying not to franchise (and perhaps especially if you are trying not to franchise), you must receive the advice of qualified franchise counsel when finalizing on the structure of your relationship so you can comply with the laws triggered by your decisions.

Starting with the End in Mind
All this explanation of the various alternatives is, in some respects, putting the cart before the horse. In making a decision as to how to expand, you should put labels out of your head and instead focus on the structure best suited for expansion. And this examination can, at least at a macro level, be boiled down to several very basic questions:

Do you want to build a common brand?

If so, do you want to control the way in which that brand is represented?

Is it important to provide support and assistance to those that will be operating under your brand?

And, finally, how do you want to be compensated for that support?

The answers to these questions will tell you whether you have a duck or perhaps have something else.

At the end of the day, there is no right answer. And sometimes, multiple strategies can be combined to optimize profitability and shareholder value.

The bottom line: Never start by picking a legal structure and then designing the strategy to fit. While this approach might reduce your legal bills in the short term, if you cannot afford to do things the right way, you probably should not be looking to expand in any event.

Instead, start with a focus on a structure that will optimize your business value. And once you have defined that structure, hold it up to the light of day. Turn it over and examine it closely. Then hire the right professionals to develop the legal and other documentation you need.

Remember, business decisions should drive legal decisions--not the other way around.

Mark Siebert is the CEO of the iFranchise Group, a franchise consulting firm that has worked with 98 of the nation's top 200 franchisors. He can be reached at 708-957-2300 or at info@ifranchise.net.
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