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Franchising and Licensing Two Powerful Ways to Grow Your Business in Any Economy_9

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  1. F R A N C H I S I N G A S A G R O W T H S T R AT E G Y 228 Colombia At the present, Colombia has the third largest number of franchises in South America and is open to this kind of investment. It has several dangerous disadvantages, however, which include a high poverty rate (40 percent), the threat of guerilla and drug violence, and a small local market. Western Europe Franchising in Western Europe continues to grow at a steady rate. The United Kingdom is a common entry point into Europe for many U.S. and Canadian franchisors and has no pre-contract disclosure laws or really any specific franchisee legislation whatsoever. Franchisee systems in France, Germany, and Italy continue to flourish, both home-grown and foreign franchise sys- tems. Spain is emerging as a powerful force in European franchising; the number of franchisors operating in Spain has grown 150 percent over the past five years. Statistics recently released by the Spanish Franchise Associa- tion demonstrate that franchising sales now make up over 6 percent of total retail sales and employ over 8 percent of the nation’s workforce. Franchising in northern Europe has also grown at a slow but steady rate, particularly in Denmark, Belgium, and Switzerland, whose early-stage homegrown fran- chise systems are starting to expand into other parts of Europe and have their long-term eye on the North American market. Eastern Europe Eastern Europe continues to navigate through challenging economic times and has not been an attractive market for franchising in the past, but this may be changing. The region’s economy is stabilizing, governments are gradually lifting regulatory restrictions, disposable income is increasing, and the pub- lic is attracted to Western goods. It is apparent that the region will at some point be an excellent place for international franchisors, but the challenge is deciding when to enter this market, particularly now, when competition is limited. At the present, a barrier is that local entrepreneurs generally do not have access to the needed capital or experience to develop franchises; they understand their limitations and this leads them to be afraid of taking such an opportunity. Industries that are expected to succeed in this region are cleaning services, fast food, book and music retailing, professional training, hotels, and motels. The two countries in Europe that are most attractive are Russia and Poland. Hungary, the Czech Republic, Yugoslavia, and Bulgaria also promise to be attractive franchising markets in the future. Russia Russia boasts a very large consumer market with a population of 150 million. It has many negatives, however, that must be overcome. The economy is
  2. TAK IN G Y OU R F RA NC HI SE PR OG RA M O VE RS E A S 229 tainted by high crime rates, political problems, bribery, and poverty. Further- more, many Russian entrepreneurs and consumers are unfamiliar with and unconvinced of the advantages of franchising. This is further complicated by access to capital issues, which are very limited, and entrepreneurs are afraid to put their own money on the line for such a venture. Finally, government regulation has been unkind to franchisors and places many restrictions on them. Poland Poland is far more attractive. It is the second largest country in Eastern Eu- rope (population 40 million) and it welcomes franchising as a step toward its economic development. Locals are educated and are receptive to Western business and customs. There are some obstacles concerning land rights, tight investment loans, and high rental rates, but these can be overcome. Some of the emerging post-USSR nations are developing stable economies and a growing middle class, and may lend themselves to successful franchising in the not-too-distant future. Some U.S. franchise systems have already been established in the Ukraine, Azerbaijan, and Kazakhstan, including Yum! Brands systems such as KFC and Pizza Hut as well as Subway and Baskin- Robbins. Other types of franchise systems such as automotive care, home services, and business services franchise systems may flourish as these econ- omies stabilize. Regional Trade Agreements NAFTA On January 1, 1994, the North American Free Trade Agreement (NAFTA) among Canada, Mexico, and the United States began to take effect. NAFTA mandates the eventual elimination of all tariff and nontariff barriers to trade between Mexico and the United States over 15 years. Between 1993 and 1997, combined real U.S. manufactured exports to its NAFTA partners rose by 40 percent, with 34 percent and 54 percent increases to Canada and Mex- ico, respectively. MERCOSUR The MERCOSUR was created in March 1991 with the signing of the Treaty of Asuncion. MERCOSUR is, since January 1, 1995, a Customs Union, whereby the Member States (Argentina, Paraguay, Uruguay, and Brazil) have eliminated all tariff and nontariff barriers to reciprocal trade and adopted a common external tariff for third-party countries. In 1996, association agree- ments were signed with Chile and Bolivia establishing free trade areas with these countries on the basis of a ‘‘4 1’’ formula. This regime is not, at present, fully in effect. The Member States of MERCOSUR negotiated what has come to be called an ‘‘Adaptation Regime,’’ by which some products
  3. F R A N C H I S I N G A S A G R O W T H S T R AT E G Y 230 traded among the four countries will, for a time, continue to pay duties. Lists of exceptions to the common external tariff for a group of specific products also exist. The Customs Union will be in full effect on January 1, 2006. MER- COSUR as an international commitment is today something between NAFTA and the European Union. European Union (EU) The EU was set up after the Second World War. The process of European integration was launched on May 9, 1950, when France officially proposed to create ‘‘the first concrete foundation of a European federation.’’ Six countries (Belgium, Germany, France, Italy, Luxembourg, and the Netherlands) joined from the very beginning. Today, after four waves of accessions (1973: Den- mark, Ireland, and the United Kingdom; 1981: Greece; 1986: Spain and Por- tugal; 1995: Austria, Finland, and Sweden), the EU has 15 member states and is preparing for the accession of 13 eastern and southern European countries. The European Union, which has its origins in the 1957 Treaty of Rome, has traveled a long road of conciliation and negotiation in order to form today one single market, and is striving to adopt common policies inside and out- side Europe. ‘‘Single market’’ includes free movement of goods, free move- ment of workers, right of establishment, and freedom to provide services and free movement of capital. As of January 1, 2002, the EU launched the euro as its single currency goal, which has helped fuel the growth of franchising systems across Europe.
  4. PART 3 F INANCIAL S TRATEGIES
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  6. C 12 HAPTER Business and Strategic Planning for the Growing Franchisor Owners and managers of growing franchisors have come to understand that meaningful and effective business planning is critical to the long-term suc- cess and viability of its underlying business and to its ability to raise capital. Before you read about the various methods of financing available to the grow- ing franchisor in Chapter 13, you must understand the key elements of a business plan. The Strategic Business Plan Regardless of the financing method or the type of capital to be raised, virtu- ally any lender, underwriter, venture capitalist, or private investor will expect to be presented with a meaningful business plan. A well-prepared business plan demonstrates the ability of the franchisor’s management team to focus on long-term achievable goals, provides a guide to effectively imple- ment the articulated goals once the capital has been committed, and consti- tutes a yardstick by which actual performance can be evaluated. Business plans should be used by newly formed franchisors as well as established franchisors. The following is a broad outline of the fundamental topics to be included in a typical franchisor’s business plan. Executive Summary This introductory section of the plan should explain the nature of the busi- ness and highlight the important features and opportunities offered by an investment in the company. The executive summary should be no longer than one to three pages and include (1) the company’s history and perform- ance to date, (2) distinguishing and unique features of the products and ser- vices offered to both consumers and franchisees, (3) an overview of the market, (4) a summary of the backgrounds of the leadership team, and (5) the amount of money sought and for what specific purposes. 233
  7. F IN AN CI AL ST RATE GI ES 234 History and Operations of the Franchisor In this first full section, the history of the franchisor should be discussed in greater detail: its management team (with resumes included as an exhibit); the specific program, opportunity, or project being funded by the proceeds; the prototype; an overview of the franchisor’s industry, with a specific em- phasis on recent trends affecting the market demand for the franchises; as well as the products and services offered by the franchisee. Figure 12-1 pro- vides a list of questions to be addressed in this section. Many of these issues will be described in greater detail in later sections of the plan. Therefore, each topic should be covered summarily in two or three paragraphs. Marketing Research and Analysis This section must present to the reader all relevant and current information regarding the size and strength of the market for both franchisees and con- sumers, trends in the industry, marketing and sales strategies and tech- niques, assessments of the competition (direct and indirect), estimated market share and projected sales, pricing policies, advertising and public relations, strategies, and a description of sales personnel. The following is- sues should also be addressed: ❒ Describe the typical consumer. How and why is the consumer attracted to patronize the franchisee’s facility? What relevant market trends affect the consumer’s decision to purchase products and services from the fran- chisee’s facility? ❒ Describe the typical franchisee. How and why is the prospective fran- chisee attracted to the franchisor’s business format? What factors have influenced the prospect’s decision to purchase the franchise? What steps are being taken to attract additional candidates that meet these criteria? Figure 12-1. Questions to address in Section 1. 1. When and how was the prototype facility first developed? How has it performed? Will this be typical when the franchise system is built? 2. Why has the company decided to expand its market share through franchising? What other alterna- tives have been considered and why did the company select franchising? 3. What are the company’s greatest strengths and proprietary advantages with respect to its franchisees? Consumers? Employees? Shareholders? Competitors? 4. What are the nature, current status, and future prospects in the franchisor’s industry? 5. Has an economic model and pro forma been built to demonstrate the viability of the franchise system to both franchisor and franchisee? 6. Has the company selected its professional advisory system?
  8. B US IN ES S A ND ST RATE GI C P LA NN IN G F OR TH E G RO WI NG FR AN CH IS OR 235 ❒ Describe the market. What is the approximate size of the total market for the services offered by the franchisee? The approximate market for fran- chisees? ❒ Describe the strategy. What marketing strategies and techniques have been adopted to attract franchisees and consumers? Where do referrals for pro- spective franchisees come from? Do existing franchisees make referrals? Why or why not? (Include sample promotional materials as an exhibit.) ❒ Describe the performance of the typical franchisee. Are current stores profitable? Why or why not? What factors influence their performance? Rationale for Franchising This section should explain the underlying rationale for selecting franchis- ing in lieu of the other growth and distribution strategies that may be avail- able. Discuss whether a dual distribution strategy will be pursued. Under what circumstances will company-owned units be established? Explain to the reader which method(s) of franchising will be selected: single units only? sales representatives? area developers? subfranchisees? Special risks and legal issues, which are triggered by the decision to franchise, should also be discussed. The Franchising Program This section should provide an overview of the franchising program with respect to key aspects of the franchise agreement, a description of the typical site, an overview of the proprietary business format and trade identity, the training program, operations manual, support services to franchisees, tar- geted markets and registration strategies, the offering of regional and area development agreements, and arrangements with vendors. A detailed analy- sis of sales and earnings estimates and personnel needed for a typical facility should be included. Discuss marketing strategies relevant to franchising such as trade shows, industry publications, and sales techniques. Explain the typi- cal length of time between the first meeting with a prospect through grand opening and beyond. What are the various steps and costs during this time period (from the perspective of both the franchisor and the franchisee)? Dis- cuss strategies for the growth and development of the franchising program over the next five to ten years. Corporate and Financial Matters This section should briefly describe the current officers, directors, and share- holders of the corporation. An overview of the capital contributed to the company thus far should be provided, along with an explanation of how these funds have been allocated. Discuss the anticipated monthly operating costs to be incurred by the corporation, both current and projected, not only
  9. F IN AN CI AL ST RATE GI ES 236 for operating and managing the prototype facility but also for the administra- tive expenses incurred in setting up a franchise sales and services office. Discuss the pricing of the franchise fee, royalties, and promotional fund con- tributions. Discuss the payment histories of the franchisees thus far. Are they complying with their obligations under the franchise agreement? Why or why not? What portion of these fees collected from the franchisee will be net profit? Discuss the amount of capital that will be required for the corporation to meet its short-term goals and objectives. How much, if any, additional capital will be required to meet long-term objectives? What alternative struc- tures and methods are available for raising these funds? How will these funds be allocated? Provide a breakdown of expenses for personnel, advertising and marketing, acquisition of equipment or real estate, administration, pro- fessional fees, and travel. To what extent are these expenses fixed and to what extent will they vary depending on the actual growth of the company? Operations and Management Provide the current and projected organizational and management structure. Identify each position by title with a description of duties and responsibili- ties and compensation. Describe the current management team and antici- pated hiring requirements over the next three to five years. What strategies will be adopted to attract and retain qualified franchise professionals? Pro- vide a description of the company’s external management team (attorney, accountant, etc.). Exhibits Include exhibits in the presentation copies of the franchisor’s trademarks, marketing brochures, and press coverage, as well as in sample franchise agreements and area development agreements. The Ongoing Strategic Planning Process In a franchisor’s early stages, the emphasis is on the business plan—how do we properly launch the franchising program to attract qualified candidates and what resources will we need to sustain the program are all among the key concerns. But what happens later? Once a franchisor reaches 50 to 100 units or more, the focus shifts away from mere business planning and on to strategic planning. In the context of franchising, strategic planning is an on- going process that seeks to build and improve the following key areas: 1. The quality and performance of the franchisees 2. The quality and sophistication of the technology used by the franchisor to support the franchisees
  10. B US IN ES S A ND ST RATE GI C P LA NN IN G F OR TH E G RO WI NG FR AN CH IS OR 237 3. The quality and sophistication of the training and support systems 4. The value and recognition of the franchisor’s brand from a customer awareness perspective 5. The development and communication of the franchise system’s ‘‘best practices’’ throughout the system as well as general ‘‘best practices’’ in franchising overall 6. The exploration of new domestic and international markets 7. The organization of franchisee advisory councils, supplier councils, co- branding alliances, and other key strategic relationships 8. The development of strategies for multi-unit franchising, alternative sites, and related new market penetration strategies 9. The development of advanced branding and intellectual property pro- tection strategies Figure 12-2. Key strategic planning issues. • What are the common characteristics of our top 20 percent franchisees? • What can we do to attract more people like this in the recruitment and selection process? • What are the common characteristics of our bottom 20 percent franchisees? • How do we screen these out? What can we do to improve their performance? • What are the five greatest strengths of our system? • What is being done to build on these strengths? • What are the five biggest problems in our system? • What are we doing to resolve these problems? The strategic planning process should manifest itself in periodic meetings among the franchisor’s leadership, periodic strategic planning retreats, and a written strategic plan that should be updated annually. Some of the issues to be addressed are included in Figure 12-2. The strategic planning meetings and retreats could be focused on a specific theme, such as brand building and leveraging, rebuilding trust and value with the franchisees, litigation prevention and compliance, international opportunities in the global village, leadership and productivity issues, financial management and per-unit per- formance issues, the improved recruitment of women and minorities, tech- nology improvement and communications systems, alternative site and nontraditional location analysis, co-branding and brand-extension licensing, or building systems for improving internal communication. Any or all of these topics are appropriate for one meeting or for discussion on a continuing basis. The strategic planning meeting could be led by an outside facilitator, such as an industry expert, or by the franchisor’s senior management team. A model agenda for a general strategic planning retreat is set forth below. Model Strategic Planning Meeting Agenda I. Evaluating Our Strategic Assets and Relationships 1. Overview
  11. F IN AN CI AL ST RATE GI ES 238 ❒ Goals and objectives of the meeting ❒ Key trends in domestic and international franchising 2. Assessing the Strengths of Our Franchise Relations ❒ Franchising state of the union ❒ Common critical success factors by and among our franchisees 3. Evaluating Our Team ❒ Code of values–reality and practice ❒ Motivating and rewarding employees ❒ Protecting the knowledge worker ❒ Providing genuine leadership 4. Our Strategic Partners ❒ What do we expect from our vendors and professional advisors ❒ What can we do to enhance the efficiency and productivity of these relationships ❒ Building the national accounts program ❒ Do all of our strategic relationships truly provide mutual reward 5. Our Targeted Customers ❒ Identifying and dealing with the competition ❒ Customer perceptions of quality and value ❒ Franchisor-customer communications ❒ Customer satisfaction surveys ❒ Exploring two-tier marketing strategies II. Asset-Building Strategies 1. Building and Leveraging Brand Awareness ❒ Building overall brand awareness ❒ Brand leveraging strategies ❒ Building an arsenal of intangible assets 2. Co-Branding and Strategic Alliances ❒ Identifying goals and objectives ❒ Targeting and selecting partners ❒ Structuring the deal 3. Shared Goals and Values ❒ Enhancing intra-company communications ❒ Building trust and respect 4. Role and Value of Technology ❒ How technology is changing the way we work and consume prod- ucts/services ❒ The impact of technology on recruiting, training, and supporting franchises ❒ The impact of technology on how our franchisees will market their products/services to targeted customers 5. Development of Branded Products and Services to Strengthen Reve- nue Base ❒ Business training and assistance resources for clients ❒ Home cleaning and refinishing products ❒ Co-branded products and services (e.g., securities sales, financial planning, home improvement and remodeling, etc.) ❒ Affinity/group purchasing programs
  12. B US IN ES S A ND ST RATE GI C P LA NN IN G F OR TH E G RO WI NG FR AN CH IS OR 239 The strategic planning process should develop, foster, and communicate a series of good habits and best practices that the franchisor’s management team follows as part of its daily, weekly, and monthly routine. Some of these good habits are listed in Figure 12-3. Figure 12-3. The seven habits of highly successful franchisors. 1. An ability to adapt to challenges and changes in the marketplace • How do we react to inevitable and constant changes in the environment? • How well do we plan in advance, anticipate change, and face the reality of what’s really happening in the trenches? • Do we really listen to our franchisees? 2. A genuine commitment to the success of each and every franchisee • A chain is only as strong as its weakest link. • How is this commitment demonstrated? • Is this how our franchisees truly perceive our commitment? 3. A culture committed to overcoming complacency • Are we committed to research and development? • What steps are in place to constantly improve and expand our systems and capabilities? • How quickly do we abandon a failing franchisee? 4. A team ready to break old paradigms • Are we committed to thinking outside the box? • What recent examples do we have where creative thinking solved a problem or created a new opportunity? • Are we using computer and communications technologies such as email, intranets, interactive computer training, and private satellite networks to help us support and communicate with our franchisees? 5. A total devotion to excellent customer service • What systems do we have in place to ensure excellence in our interactions with targeted home and business customers? • Do we have a procedure for gathering feedback and reacting to problems in the field? • When is the last time we spoke directly with our franchisees’ customers? • What are we doing to educate our targeted customers on quality and product/service differentiation issues? How can we achieve ‘‘Good Housekeeping Seal of Approval’’—type status with our custom- ers (e.g., known as setting the standards for quality)? What can we do at the community/grassroots level to promote and enhance this image (e.g., controlling and enhancing the customer’s buying experience)? • Do we treat our franchisees as our customers? 6. A commitment to taking the time to truly understand and analyze the economics of the core business (by all key players in the organization, not just the CFO!) • Does the current franchise fee and royalty structure make sense? Is it fair? • How often are royalty and other financial reports truly reviewed and analyzed? Are key observations and trends shared in the field? 7. A bona fide understanding of the key factors that make our franchisees successful • What are the common characteristics of our top 20 percent franchisees in each division? • What can we learn from these common characteristics? • What can we do to recruit more candidates with these same characteristics and skill sets?
  13. F IN AN CI AL ST RATE GI ES 240 The end result of an effective strategic planning meeting is to develop a list of specific action items. Some action items may be able to be imple- mented right away and some may take some time. Here is a list of specific action items that may result: 1. Consider the entry into new domestic and international markets. You can start with our neighbors to the North and South. Many of you as franchisors are currently exploring opportunities in markets such as Canada, Mexico, and South America due to the close geographic proxim- ity to the United States. 2. Reexamine your vertical pricing structures and strategies in light of the recent Supreme Court case, State Oil Co. v. Khan,* which changed the ground rules for suggested retail pricing by applying a ‘‘rule of reason’’ test to vertical price restraints. The Supreme Court ruled that a manufac- turer or supplier does not necessarily violate federal antitrust law by placing a ceiling on the retail price a dealer can charge for its products. It remains illegal, however, for manufacturers to impose minimum prices on dealers. 3. Consider implementing various types of multi-unit development strate- gies. 4. Consider alternative territorial penetration strategies such as kiosks, sat- ellites, carts, mini-units, seasonal units, limited service units, in-store units, resorts units, military base units, and related alternative site selec- tion strategies. 5. Consider joint ventures with other franchisors or nonfranchisors and complementary but noncompeting markets. This could include joint site developments, such as in the coffee and muffin industries, or automobile mini-malls and other related operational joint ventures. Many food- related franchisors are actively developing co-branding programs as a vehicle for growth and new market penetration. 6. Be aggressive and proactive in commercial leasing strategies. Consider subleasing and turnkey development strategies, stricter site selection cri- teria to improve failure rate, and the financial performance of each fran- chisee. 7. Take a hard look at your financial management practices to avoid the possibility of liability under the Meineke case.† Make sure that advertis- * State Oil Co. v. Khan et al., No. 96-871 (S. Ct. Nov. 4, 1997). † In Broussard v. Meineke Discount Muffler Shops, Inc., 2 Bus Franchise Guide (CCH) 11,125 (DC N.C. 1996), a federal judge in Charlotte, North Carolina, awarded franchisees $601 million in damages—the largest award ever in a franchisor-franchisee dispute. In this class action, the franchisees accused the franchisor of taking more than $31 million from advertising funds dating back to 1986. The franchisees contended that the fran- chisor took additional fees and commissions from the advertising account and negotiated volume discounts for advertising, but took the discounts for itself. The franchisees also alleged that the franchisor violated North Carolina’s unfair and deceptive trade practices act, committed fraud, and breached its fiduciary duty to franchisees by, among other things, using advertising funds for improper purposes such as settling a lawsuit, paying the franchisor’s business expenses, and advertising for prospective franchisees. After a
  14. B US IN ES S A ND ST RATE GI C P LA NN IN G F OR TH E G RO WI NG FR AN CH IS OR 241 ing contributions have been segregated to avoid potential claims by fran- chisees and other financially related ligitation techniques. 8. Reevaluate your internal and external management team. Get rid of inter- nal deadwood and don’t be afraid to demand more and better from your outside advisors. Continue to evaluate your management team for any individuals who may be engaged in a course of action that is unproduc- tive, hostile, or harassing to your current or prospective franchisees. Ask your outside advisors, ‘‘What are you doing to help us grow and do you truly care about the future direction of our company?’’ 9. Cleanse the baseless rabble rousers and nonperformers from your fran- chise system. These negative influencers spread like wildfire. Put these fires out while there is still a spark and not a flame. It is important to separate the good constructive criticism and proactive franchisee from the just plain ‘‘whiners’’ whom you will never satisfy. 10. Build up your arsenal of protectable and registered intellectual property (e.g., trademarks, copyrights, trade dress, etc.). 11. Be proactive in creating franchisee advisory councils and other methods in improving franchisor/franchisee communications to maximize fran- chise relationships. Bear in mind that happy franchisees keep litigation costs down and new franchise sales up. 12. Search for new markets and methods to find new franchisees. Be creative and untraditional. Try new venues and places where the other fran- chisors are not targeting. 13. Venture into the world of being a product and service provider to your network of franchisees. These activities should be subject to applicable anti-trust laws. It could be quite lucrative, provided that you are within legal boundaries, you are not too greedy, and properly structure the eco- nomic relationships. These products and service provider relationships can be done directly or through joint ventures with third-party suppliers. New cases such as Queen City, 1997 WL 526213 (3d Cir. August 27, 1997), discussed in Chapter 4, may open up a new door for you in this area. 14. Get active in industry groups and lobbying efforts that may affect the operations or profitability of your franchisees’ businesses. 15. Use current and developing computer and communications technologies to enhance franchise sales and support, to gather demographics, to pro- vide training, and to facilitate communication by and among fran- chisees. A franchisor’s failure to take advantage of these developments along the information superhighway could be detrimental. These tech- seven-week trial, the jury found the franchisor and other defendants (including three corporate affiliates and three individual principals of the companies) liable to the class of over 900 franchisees and awarded $197 million in compensatory damages. The judge trebled the damage award and added $10.1 million in interest, bringing the total award to $601 million. The parent company, GKN Plc of Britain, said although it plans to appeal the federal court’s ruling, it had already amended its 1996 earnings report by making provisions for $435 million in exceptional charges.
  15. F IN AN CI AL ST RATE GI ES 242 nologies include significantly faster microprocessors, robotics, smart cards, voice-activated and wearable hardware, Intranets and electronic mail, video-conferencing, private satellite networks, virtual reality on- demand publishing, enhanced electronic commerce, and integrated digi- tal communications, which will all permanently change the way we in- teract with our franchisees and the manner in which our franchisees interact with their customers. 16. Develop an internally generated strategic growth plan. This plan should have clear and attainable objectives. Then really use it. Do not let the growth plan sit around and collect dust. Understand the common finan- cial management pitfalls that hinder the performance of many early- stage and rapidly growing franchisors. 17. Explore alternatives to franchising in certain situations where licensing, distributorships, joint ventures, dual distribution, or some other contrac- tual distribution channel may be more appropriate. 18. Motivate your internal team with stock option plans, bonus formulas, and other equity incentive programs. These programs will help enhance customer service and franchisee relations. 19. Reread your UFOC tomorrow as if you were a prospective franchisee. Do the documents convey your company’s philosophies? Do the documents adequately tell your company’s story? Do they convey a sense of trust, fairness, and reasonableness? Are the documents user-friendly to the reader and to the advisors of the franchisee? Would you buy this fran- chise? You will be able to discover a lot about your UFOC and your abil- ity to use the document as a marketing tool if you reread the document as if you were buying the franchise. 20. Develop a good data-gathering system on the financial performance of your franchisees. Use this data to compile sample profit and loss state- ments and balance sheets of some of the strong, medium, and weak fran- chisees in the system. Circulate these documents, subject of course to confidentiality and earning claims regulations, among your existing fran- chisees to increase their performance and to point out flaws in their fi- nancial management. In sum, the strategic planning process is a commitment to strive for the con- tinuous improvement of the franchise system. The process is designed to ensure that maximum value is being delivered, day in and day out, to the franchisor’s executive team, employees, shareholders, vendors and suppli- ers, and of course, its franchisees. It is about not being afraid to ask: Where are we? Where do we want to be? What do we need to do to get there? What is currently standing in our way of achieving these objectives? It is about making sure that the company takes the time to develop a mission statement and define a collective vision and then develops a series of plans to achieve these goals. Executives must stay focused on these objectives and provide leadership to both the balance of the franchisor’s team and to the franchisees as to how these objectives will be achieved. The focus must be on brand equity, franchisee value, customer loyalty, and shareholder profitability. The guidelines and protocols for internal communications must encourage hon- esty and openness, without fear of retaliation or politics.
  16. C 13 HAPTER Capital Formation Strategies One of the most difficult tasks faced by the management team of a growing franchisor is the development and maintenance of an optimal capital struc- ture for the organization. Access to affordable debt and equity capital contin- ues to be a problem for the growing franchisor even though franchising has matured as a viable method of business growth. Only recently have the investment banking private equity venture capi- tal and commercial lending communities given franchising the recognition it deserves. There are finally enough franchisors whose balance sheets have become more respectable, who have participated in successful public offer- ings, who have played (and won) in the merger and acquisition game, and who have demonstrated consistent financial appreciation and profitability. These developments have played a role in providing young franchisors ac- cess to affordable capital in recent years. Nevertheless, a growing franchisor must be prepared to educate the source of capital as to the unique aspects of financing a franchise company. And there are differences. Franchisors have different balance sheets (heavily laden with intangible assets), different allo- cations of capital (primarily as expenditures for ‘‘soft costs’’), different man- agement teams, different sources of revenues, and different strategies for growth. The amount of capital potentially available, as well as the sources willing to consider financing a given transaction, depends largely on the franchisor’s current and projected financial strength, as well as the experi- ence of its management team and a host of other factors, such as trademarks and its franchise sales history. The Initial and Ongoing Costs of Franchising Before examining the capital formation strategies that may be available, you should understand the specific nature of the capital requirements of the early-stage and emerging franchisor. Although franchising is less capital- intensive than is internal expansion, franchisors still require a solid capital structure. Grossly undercapitalized franchisors are on a path to disaster be- 243
  17. F IN AN CI AL ST RATE GI ES 244 cause they will be unable to develop effective marketing programs, attract qualified staff, or provide the high-quality ongoing support and assistance that franchisees need to grow and prosper. Bootstrap franchising has been tried by many companies, but very few have been successful. In a bootstrap franchising program, the franchisor uses the initial franchise fees paid by the franchisee as its capital for growth and expansion. There is a bit of a catch-22, however, if the franchisor has not properly developed its operations, training program, and materials prior to the offer and sale of a franchise. Such a strategy could subject the franchisor to claims of fraud and misrepresentation because the franchisee has good reason to expect that the business format franchise is complete and not still ‘‘under construction.’’ A second legal problem with undercapitalization is that many examiners in the registration states will either completely bar a franchisor from offers and sales in their jurisdiction until the financial condi- tion improves, or impose restrictive bonding and escrow provisions in order to protect the fees paid by the franchisee. A third possible legal problem is that if the franchisor is using the franchise offering circular to raise growth capital, then the entire scheme could be viewed as a securities offering, which triggers compliance with federal and state securities laws, as dis- cussed in this chapter. The start-up franchisor must initially put together a budget for the de- velopmental costs of building the franchise system. This budget should be incorporated into the business plan, the key elements of which are discussed in Chapter 12. The start-up costs include the development of operations manuals, training programs, sales and marketing materials, personnel re- cruitment, accounting and legal fees, research and development, testing and operation of the prototype unit, outside consulting fees, and travel costs for trade shows and sales presentations. Naturally, there are a number of vari- ables influencing the amount that must be budgeted for development costs, including: ❒ The extent to which outside consultants are required to develop opera- tions and training materials ❒ The franchisor’s location and geographic proximity to targeted fran- chisees ❒ The complexity of the franchise program and trends within the fran- chisor’s industry ❒ The quality, experience, and fee structure of the legal and accounting firms selected to prepare the offering documents and agreements ❒ The extent to which products or equipment will be sold directly to fran- chisees, which may require warehousing and shipping capabilities ❒ The extent to which personnel placement firms will be used to recruit the franchisor’s management team ❒ The use of a celebrity or industry expert to ‘‘endorse’’ the franchisor’s products, services, and franchise program ❒ The difficulty encountered at the United States Patent and Trademark Office in registering the franchisor’s trademarks
  18. C A P I T A L F O R M AT I O N S T R AT E G I E S 245 ❒ The extent to which direct financing will be offered to the franchisees for initial opening and/or expansion ❒ The compensation structure for the franchisor’s sales staff ❒ The difficulty encountered by franchise counsel in the registration states ❒ The extent to which the franchisor gets embroiled in legal disputes with the franchisees at an early stage ❒ The quality of the franchisor’s marketing materials ❒ The type of media and marketing strategy selected to reach targeted franchisees ❒ The number of company-owned units the franchisor plans to develop ❒ The length and complexity of the franchisor’s training program ❒ The rate at which the franchisor will be in a position to repay the capital (or provide a return on investment), which will influence the cost of the capital Private Placements as a Capital Formation Strategy Smaller and medium-sized franchisors often initially turn to the private capi- tal markets to fuel their growth and expansion. The most common method selected is the sale of a company’s (or its subsidiary) securities through a private placement. In general terms, a private placement may be used as a vehicle for capital formation any time a particular security or transaction is exempt from federal registration requirements under the Securities Act of 1933 as described below. The private placement generally offers reduced transactional and ongoing costs because of its exemption from many of the extensive registration and reporting requirements imposed by federal and state securities laws. The private placement usually also offers the ability to structure a more complex and confidential transaction, since the offeree will typically be a small number of sophisticated investors. In addition, a private placement permits a more rapid penetration into the capital markets than would a public offering of securities requiring registration with the Securi- ties and Exchange Commission (SEC). In order to determine whether a pri- vate placement is a sensible strategy for raising capital, it is imperative that franchisors: (1) have a fundamental understanding of the federal and state securities laws affecting private placements; (2) be familiar with the basic procedural steps that must be taken before such an alternative is pursued; and (3) have a team of qualified legal and accounting professionals who are familiar with the securities laws to assist in the offering. An Overview of Regulation D The most common exemptions from registration that are relied upon by fran- chisors in connection with a private placement are contained in the Se- curities and Exchange Commission’s Regulation D. The SEC promulgated
  19. F IN AN CI AL ST RATE GI ES 246 Regulation D in 1982 in order to facilitate capital formation by smaller com- panies. Since its inception, Regulation D has been an extremely successful vehicle for raising capital, with billions of dollars being raised each year by small and growing businesses. Regulation D offers a menu of three transac- tion exemptions, which are discussed below. 1. Rule 504 under Regulation D permits offers and sales of not more than $1,000,000 during any 12-month period by any issuer that is not subject to the reporting requirements of the Securities Exchange Act of 1934 (the ‘‘Exchange Act’’) and that is not an investment company. Rule 504 places virtually no limit on the number or the nature of the investors that partici- pate in the offering. But even if accreditation is not required, it is strongly recommended that certain baseline criteria be developed and disclosed in order to avoid unqualified or unsophisticated investors. Even though no formal disclosure document (also known as a prospectus) needs to be registered and delivered to offerees under Rule 504, there are many proce- dures that still must be understood and followed and a disclosure docu- ment is nevertheless strongly recommended. An offering under Rule 504 is still subject to the general antifraud provisions of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; thus, every document or other information that is actually provided to the prospective investor must be accurate and not misleading by virtue of its content or its omissions in any material respect. The SEC also requires that its Form D be filed for all offerings under Regulation D within 15 days of the first sale. Finally, a growing franchisor seeking to raise capital under Rule 504 should exam- ine applicable state laws very carefully because although many states have adopted overall securities laws similar to Regulation D, many of these laws do not include an exemption similar to 504 and as a result, a formal memorandum (which is discussed later in this chapter) may need to be prepared. 2. Rule 505 under Regulation D is selected over Rule 504 (by many compa- nies) as a result of its requirements being consistent with many state secu- rities laws. Rule 505 allows for the sale of up to $5,000,000 of the issuer’s securities in a 12-month period to an unlimited number of ‘‘accredited investors’’ and up to 35 nonaccredited investors (regardless of their net worth, income, or sophistication). An ‘‘accredited investor’’ is any person who qualifies for (and must fall within one of) one or more of the eight categories set out in Rule 501(a) of Regulation D. Included in these catego- ries are officers and directors of the franchisor who have ‘‘policymaking’’ functions as well as outside investors who meet certain income or net worth criteria. Rule 505 has many of the same filing requirements and restrictions imposed by Rule 504 (such as the need to file a Form D), in addition to an absolute prohibition on advertising and general solicitation for offerings and restrictions on which companies may be an issuer. Any company that is subject to the ‘‘bad boy’’ provisions of Regulation A is disqualified from being a 505 offeror and applies to persons who have been subject to certain disciplinary, administrative, civil or criminal pro- ceedings, or sanctions that involve the franchisor or its predecessors.
  20. C A P I T A L F O R M AT I O N S T R AT E G I E S 247 3. Rule 506 under Regulation D, although similar to Rule 505; however, the issuer may sell its securities to an unlimited number of accredited inves- tors and up to 35 nonaccredited investors. For those requiring large amounts of capital, this exemption is the most attractive because it has no maximum dollar limitation. The key difference under Rule 506 is that any nonaccredited investor must be ‘‘sophisticated.’’ A ‘‘sophisticated inves- tor’’ (in this context) is one who does not fall within any of the eight categories specified by Rule 501(a), but is believed by the issuer to ‘‘have knowledge and experience in financial and business matters that render him capable of evaluating the merits and understanding the risks posed by the transaction (either acting alone or in conjunction with his ‘‘pur- chaser representative’’). The best way to remove any uncertainty over the sophistication or accreditation of a prospective investor is to request that a comprehensive Confidential Offeree Questionnaire be completed before the securities are sold. Rule 506 does eliminate the need to prepare and deliver disclosure documents in any specified format, if exclusively ac- credited investors participate in the transaction. As with Rule 505, an absolute prohibition on advertising and general solicitation exists. The Relationship Between Regulation D and State Securities Laws Full compliance with the federal securities laws is only one level of regula- tion that must be taken into account when a franchisor is developing plans and strategies to raise capital through an offering of securities. Whether or not the offering is exempt under federal laws, registration may still be re- quired in the states where the securities are to be sold under applicable ‘‘blue sky’’ laws. This often creates expensive and timely compliance burdens for growing franchisors and their counsel who must contend with this bifur- cated scheme of regulation. Generally speaking, there are a wide variety of standards of review among the states, ranging from very tough ‘‘merit’’ re- views (designed to ensure that all offerings of securities are fair and equita- ble) to very lenient ‘‘notice only’’ filings (designed primarily to promote full disclosure). The securities laws of each state where an offer or sale will be made should be checked very carefully prior to the distribution of the offer- ing documents. Subscription Materials A private offering under Regulation D also requires the preparation of certain subscription documents. The two principal documents are the subscription agreement and the offeree questionnaire. The subscription agreement repre- sents the contractual obligation on the part of the investor to buy, and on the part of the issuer to sell, the securities that are the subject of the offering. The subscription agreement should also contain certain representations and warranties by the investor that serve as evidence of the franchisor’s compli- ance with the applicable federal and state securities laws exemptions. The subscription agreement may also contain relevant disclosure issues address-
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