Franchising into the U.S. From Abroad: Quantifying the Cost of Regulatory Compliance

Before selling franchises in the U.S., franchisors will need to accomplish a number of legal items including franchise agreements and disclosure documents that comply with U.S. laws. It should be understood that legal compliance is a cost of doing business. 

By Carl E. Zwisler

If you are a franchisor operating outside the U.S., you may have avoided expanding to the U.S. because you fear the complexity and cost of complying with U.S. federal and state franchise sales laws. Ironically, while experienced foreign franchisors have remained on the sidelines for decades, approximately 250 U.S.-based small businesses begin franchising here each year. They understand that franchise legal compliance is a cost of doing business, and they retain experienced U.S. franchise lawyers to help them to deal with the process.

Founders and executives of U.S. companies who are considering becoming franchisors almost universally ask two questions about franchise law compliance:

1. How much will compliance cost?
2. How long will it take me to come into compliance?

Those questions are equally relevant to franchisors considering the U.S. market.  Before answering those questions, a brief overview of U.S. franchise sales regulations is in order. 

With both a federal franchise disclosure requirement and franchise registration requirements administered by 13 (of 50) states (Franchise Registration States), one might think that compliance with U.S. franchise sales laws is horribly complicated. For bonafide franchise lawyers, it is not. Here is what is involved:

Federal law requires that all offers of franchises for locations within the U.S. (that are not subject to an exemption) must be made using the Franchise Disclosure Document form the Federal Trade Commission has prescribed. FDDs must be delivered to prospective franchisees at least 14 days before they make a payment for the franchise or sign an agreement related to a franchise purchase. Final copies of franchise agreements must be delivered to prospective franchisees at least seven days before they sign a franchise agreement. State franchise registration laws require use of the same FDD that the FTC requires, but add some additional requirements. Most franchisors add a one or two page state addendum to their FDDs for each Franchise Registration State in which they offer franchises to address these differences.

Franchise Registration States 

In Franchise Registration States, franchisors must file their FDDs, their standard form franchise agreements and audited financial statements with a state administrative agency before offering franchises there. In non-registration states, franchisors may offer and sell franchises without any review of their FDDs. State franchise examiners review the documents submitted to determine if all information required to be disclosed appears to have been submitted, and if it violates any of the state’s franchise laws.  

Financial statements are reviewed to determine whether they satisfy audit requirements and to evaluate whether the franchisor is likely to be able to fulfill its obligations to new franchisees. If the financial condition of a franchisor is questionable, an examiner may require a franchisor to escrow initial franchise fees or to defer collection of the fees until the franchisors initial obligations to help the franchisee open its business have been fulfilled. Or, a franchisor may opt to obtain a surety bond in an amount the examiner prescribes.

Franchise registrations are generally effective until 120 days after the franchisor’s fiscal year end. FDDs and registrations must be amended whenever a material change occurs in anything that is required to be disclosed.

What determines the time and cost of franchise law compliance?

The answer depends upon several variables, including:

The franchising format selected (master franchise, area development franchise, area representative franchise, unit franchise, joint venture, etc.). Unit franchises require a single franchise agreement and FDD, but other franchise formats require more documentation and negotiation. JVs are not form agreements and involve considerable negotiation;

1. The state(s) where the first franchises will be offered or where the first franchised business will be located. If a state has a franchise registration law, compliance with state franchise registration laws is required;
2. Whether the prospective franchisee or the nature of the transaction qualifies for an exemption from franchise and business opportunity laws. Investments of greater than $1,084,900 million and franchisees with a net worth of more than $5,424,500 million are among the bases for exemptions from the FTC rule;
3. Whether the franchisor may “phase in” to the audited financial statements requirements. Franchisors must include financial statements in the FDDs that they must provide to prospective franchisees. Financial statements must be audited and prepared using U.S. Generally Accepted Accounting Principles. However, franchisors lacking a previous audit may often “phase in” to the audit requirement;
4. The time of year when the franchise is offered. Because more than 90 percent of franchisors file annual reports with state regulators in March and April, new registration applications may receive delayed attention during that time; and,
5. The experience and competence of your franchise lawyer. Lawyers lacking experience in preparing franchise agreements and FDDs and with franchise registrations are likely to encounter many more problems and delays when seeking franchise regulations then experienced franchise lawyers.

How do those factors affect cost and time?

If a franchisor is exempt from the FTC Franchise Rule and if it either does not grant a franchise in a Franchise Registration State or qualifies for an exemption from state registration, and grants a unit franchise, legal fees for franchise documents could be as low as $12,000-$15,000. But if a franchisor uses a master franchising strategy and must register its franchise in one or more Franchise Registration States, legal and filing fees could be as high as $40,000-$60,000. These amounts do not include audit fees or trademark registration expenses. (See the sidebar for an explanation of how franchising strategies affect legal costs.)

The time required to prepare documents and begin offering franchises in non-registration states can range from 30 days to six months. Franchise registrations can take 30 days to six months depending upon the state and when applications are filed.

Franchisors hoping to exhibit at the International Franchise Expo should begin consulting with U.S. franchise counsel at least six months before the event if they hope to be able to sell franchises to prospects they meet at the Expo. Although an IFE Exemption from registration is available, franchise sales may not be concluded in New York until after a franchise registration is effective.

How much can a franchisee make?

The most unusual requirement of U.S. franchise sales laws is a restriction on franchisors’ making any statements about historical or projected sales, income or profits of franchised or affiliated locations unless those statements are included within an FDD.  Financial Performance Representations or must have a reasonable basis at the time they are made, and franchisors must possess substantiation of their claims at the time they are made and provide the substantiation to prospects upon receipt of a reasonable request. The FDD Guidelines prescribe the format in which FPRs may be made.

Franchisors are not required to provide FPRs. In fact, only within the last decade have the majority of franchisors used FPRs in their FDDs; a substantial minority of franchisors still do not use FPRs to sell franchises. Rather, they refer prospects to other franchisees, and emphasize that no one can realistically tell a prospective franchisee what he would earn as a franchisee. Implemented on a national basis in 1978, restrictions on FPRs do not seem to have had any adverse effect on the growth of franchising in the U.S., and the rules may have actually led to fewer claims of misrepresentation.

To recap, before selling franchises in the U.S., franchisors will need: to prepare franchise agreements and FDDs that comply with U.S. laws; to obtain franchise registrations or exemptions if they offer franchises in states with franchise registration laws; to provide FDDs to prospects before accepting payment or signing agreements;  to update FDDs and registrations when material changes occur; and to prepare and file annual reports and to make revisions to FDDs annually. 

Carl E. Zwisler practices franchise law in the Washington, D.C. office of Gray Plant Mooty.