1. Baker & Hostetler LLP All About Franchising FALL 2009 ENTREPRENEURSHIP AND SMALL BUSINESS SERIES - HUDSON LIBRARY & HISTORICAL SOCIETY October 14, 2009

2. Baker Hostetler 2 Counsel to Market Leaders Introduction Amy M. Shepherd Partner with Baker & Hostetler, working in the Columbus office Practice in the general corporate and business area, with an emphasis on securities matters

3. Baker Hostetler 3 Counsel to Market Leaders Introduction A.What is franchising? B.What are the pros and cons of franchising? C.How is franchising regulated? D.How do I get started? E.Complying with regulations of offers and sales. F.Common issues between franchisors and franchisees. G.Terminating franchise relationships. H.Questions and General Discussion.

4. Baker Hostetler 4 Counsel to Market Leaders What is franchising? History of Franchising Trace back to mid-19 th century Singer sewing machines sold through franchised outlets Viable alternative for capital raising beginning in the 1960s Franchising Statistics (from various franchise consultants): –Approximately 1 out of every 12 businesses in the U.S. is a franchised business –Believed to be more than 750,000 franchise businesses in the U.S. –A new franchised business is opened every 8 minutes of every business day

5. Baker Hostetler 5 Counsel to Market Leaders What is franchising? Franchising is a method of raising capital for expansion of a business and as a means for distributing goods and services. More than 75 different industries use franchising as a means to distribute goods and services: –McDonalds, Wendys, Subway, Quiznos, Dominos, Pizza Hut, Dunkin Donuts, Krispy Kreme, Baskin Robbins –Curves –Liberty Tax Service –AAMCO Transmission, Precision Tune –7-Eleven –Molly Maid, ServiceMaster Clean, Jani-King

6. Baker Hostetler 6 Counsel to Market Leaders What is franchising? Regulated at the federal (Federal Trade Commission) and state levels There are generally two forms of a franchise: –The “traditional” or “product” franchise is a product distribution arrangement, in which the franchisee is to some degree identified with a manufacturer’s supplies. Typical types are automobile and truck dealerships, gasoline service stations and soft drink bottlers. –A “package” or business format franchise, is a business relationship in which the franchisor licenses a fully integrated operation to the franchisee. In this type of franchise, the franchisor provides the franchisee with a plan or system for conducting the franchised business and the franchisee contributes the daily management and operation of the business. Typical types are fast food restaurants.

7. Baker Hostetler 7 Counsel to Market Leaders What is franchising? FTC definition of “franchise” – the three elements: Distribution of goods or services associated with the franchisor’s trademark, servicemark, trade name, advertising or other commercial symbol (essentially any relationship in which a franchisee attempts to gain the benefit of the franchisor’s reputation will satisfy this element) Exercise of significant control over, or the giving of significant assistance to, the franchisee by the franchisor (the requisite level of control or assistance may be found upon a rather modest showing) Payment by the franchisee to the franchisor of at least $500 before the expiration of the first six months of operation of the franchised business

8. Baker Hostetler 8 Counsel to Market Leaders What is franchising? There are exemptions and exclusions from the FTC requirements, including: Fractional franchises – an established distributor adds a franchised product or service line to its existing line of goods or services (two conditions must be met) Leased departments – an independent retailer leases space from a larger retailer to sell his or her goods or services in the larger retailer’s store Oral agreements – the franchise relationship must be purely oral, and there can be no written evidence (even if unsigned) of any material term or aspect of the relationship “Sophisticated Investors” (added in 2007)

9. Baker Hostetler 9 Counsel to Market Leaders What is franchising? “Sophisticated Investors” exemptions include: “large franchise investment” exemption which exempts franchise sales where the initial investment is at least $1 million “large franchisee” exemption which exempts franchise sales to ongoing entities with at least $5 million net worth and 5 years of prior business experience “insiders” exemption which exempts franchise sales to owners, directors, and managers of an entity if such individual was associated with the company within 60 days of the sale and was involved with the company for at least 2 years

10. Baker Hostetler 10 Counsel to Market Leaders What are the pros and cons of franchising? Pros (Franchisor): Expansion (financing mechanism for franchisor) Brand Exposure (and appreciation in the monetary value of the mark) Franchising revenues (cash flow for the franchisor) Incentive to run the franchised operation at peak efficiency because owner-manager has an equity interest in the franchise Risk spreading

11. Baker Hostetler 11 Counsel to Market Leaders What are the pros and cons of franchising? Cons (Franchisor): Loss of control Compliance with regulatory requirements Cost to administer and provide on-going assistance

12. Baker Hostetler 12 Counsel to Market Leaders What are the pros and cons of franchising? Pros (Franchisee): Ability to open own business with proven concept Access to training and assistance from Franchisor Brand recognition and advertising Research and development

13. Baker Hostetler 13 Counsel to Market Leaders What are the pros and cons of franchising? Cons (Franchisee): Significant controls on operation of business, including sourcing of supplies, design or appearance standards, goods or services you may sell, method of operation, and sales area Costs such as initial franchise fee, on-going royalty fees and advertising fee Restraints post-termination Restraints on succession Limits on expansion

14. Baker Hostetler 14 Counsel to Market Leaders How is franchising regulated? Federal and state disclosure requirements and state registration requirements Servicemark/Trademark Matters State relationship statutes Other – Antitrust

15. Baker Hostetler 15 Counsel to Market Leaders How do I get started? A franchisee expects that he/she will be furnished a proven concept, a well- recognized trademark, initial training, ongoing supervision, marketing support, new product development and bulk purchasing power. Is your business a good candidate for franchising?

16. Baker Hostetler 16 Counsel to Market Leaders How do I get started? To be a successful franchise system, your business should have the following characteristics: Your business should have a proven track-record with experienced management. –Does your company have experienced management? A track-record over time? Is the concept proven? Your business should be unique. –Is your business adequately differentiated from its competitors? Is it marketable as a business opportunity? Does it have a sustainable competitive advantage? Your business must be “teachable.” –Are the systems in place? Are operating procedures documented? Could someone learn to operate your business in three months or less? The business needs to provide an adequate return. –The business must be able to generate a significant return on investment after deducting the franchise fee/royalty.

17. Baker Hostetler 17 Counsel to Market Leaders How do I get started? Franchisor: –Trademark/Servicemark protection –Operations and Training Manuals (to replicate business) –Franchise Agreement (structure of franchise system and terms to consider) –Franchise Disclosure Document –State registrations –Personnel and infrastructure to support franchisees

18. Baker Hostetler 18 Counsel to Market Leaders How do I get started? Franchisee: –Consider franchise broker or franchise tradeshows to help you consider alternatives –Consider how much you are able to invest (and lose), your abilities and your goals –In selecting a franchise, consider demand for the franchisor’s product or service, competition in your area, your ability to operate the business, the name recognition of the franchise, training and support services offered by the franchisor and the franchisor’s experience with operating similar businesses and managing a franchise system –Review disclosure documents –Consider terms of franchise contract –Develop business plan –Access necessary capital

19. Baker Hostetler 19 Counsel to Market Leaders How do I get started? Choose a franchise that closely matches your skills, personality traits, budget constraints and risk tolerance – not the current “hot” franchise. [Joel Libava, Cleveland, Ohio franchise consultant and marketer, December 9, 2008]

20. Baker Hostetler 20 Counsel to Market Leaders Complying with regulations of offers and sales. Federal and state disclosure requirements – FDD has 23 separate items of information, including:  Franchisor’s Background – how long franchisor has been in business; likely competition; regulation of the particular industry  Business Background – experience of franchisor’s executives  Litigation – prior litigation involving franchisor and its executives  Bankruptcy  Initial and On-Going Costs –costs involved in starting and operating the franchise  Restrictions – restrictions on suppliers, goods and services offered, customers, etc.  Terminations – when the franchise can be terminated and post-termination obligations; conditions with respect to renewals, sales and transfers  Training – franchisor’s training and assistance  Advertising – advertising fund and how advertising dollars are spent  Current and Former Franchisees  Earnings Information  Financial Statements

21. Baker Hostetler 21 Counsel to Market Leaders Complying with regulations of offers and sales. Some states require a franchisor to register (file registration and disclosure documents and receive approval from states before offering or selling a franchise in that state): CaliforniaMichigan (notice only)Rhode Island HawaiiMinnesotaSouth Dakota IllinoisNew YorkVirginia IndianaNorth DakotaWashington MarylandOregon (no registration)Wisconsin

22. Baker Hostetler 22 Counsel to Market Leaders Complying with regulations of offers and sales. The offer and sale may be subject to state Business Opportunity statutes Some states (requiring registration) may require a new franchisor to escrow the initial franchise fee for some period of time

23. Baker Hostetler 23 Counsel to Market Leaders Complying with regulations of offers and sales. Timing for offers and sales: –The Franchisor must provide the franchise disclosure document at least 14 calendar days before execution of the franchise agreement or accepting payment for franchise –If the franchisor unilaterally and materially changes the terms of the franchise agreement attached to the disclosure document, then an additional 7 calendar days must pass before the revised agreement is signed

24. Baker Hostetler 24 Counsel to Market Leaders Complying with regulations of offers and sales. Advertising regulations Advertising is considered an offer – so care should be taken with respect to registration states Some states also require that all advertising be filed with state franchise regulators at least three business days before they are first used for review by the regulator

25. Baker Hostetler 25 Counsel to Market Leaders Complying with regulations of offers and sales. Franchise brokers: Washington and New York require registration of franchise brokers Franchise brokers must provide the disclosure required of franchisors

26. Baker Hostetler 26 Counsel to Market Leaders Complying with regulations of offers and sales. Options for territory or franchise An option to develop a franchise location(s) is an offer of the franchise – so comply with registration and disclosure requirements

27. Baker Hostetler 27 Counsel to Market Leaders Common issues between franchisors and franchisees. Encroachment Advertising Product Development Assistance Fees, Fees, Fees Termination Events

28. Baker Hostetler 28 Counsel to Market Leaders Terminating franchise relationships. Contractual provisions may be superseded by state relationship laws Many states have laws that bar termination by the franchisor prior to expiration of its stated term, except for “good cause” (after notice and time to cure) Some states apply this “good cause” standard also to franchisor’s refusal to renew the franchise Many states require a franchisor to repurchase franchisee’s inventory, supplies, equipment and/or furnishings on “good cause” termination by franchisor Some state relationship laws limit the right of a franchisor to control transfers of franchises

29. Baker Hostetler 29 Counsel to Market Leaders Questions and General Discussion. Questions? Discussion?

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