Which Franchising Structure Fits Your System?

Franchise Development

Franchise systems must consider carefully whether a multiple-unit franchising approach is appropriate for their business.

By Bret Lowell, CFE 

A variety of terms have been used to describe the techniques in franchising known and described below as area development, subfranchising and area representation.  The most common of these terms are “multiple-unit franchising,” “multi-tier franchising,” and “master franchising.” Close analysis of these terms indicates that perhaps the term “multiple-unit franchising” is the most appropriate to describe all of these techniques.

The term “multiple-unit franchising” recognizes the common goal of these techniques to establish relationships which provide for the opening of more than one unit.  The term “multi-tier franchising” appears to provide an inadequate description because it fails to recognize the distinction between ordinary franchisee-franchisor relationships, which are two-tier in nature, and area development relationships (described below), which are also two-tier in nature.  The term “master franchising” could be used to identify the techniques, but may not be the best choice because it describes neither the common goal of the techniques to establish multiple-units, nor the structure of the relationships which are established.  Thus, the term “multiple-unit franchising” will be used to refer to the group of techniques identified above.

The common goals of multiple-unit franchising are to establish many units with speed, to leverage both money and personnel by relying upon another person’s resources, and to obtain a local presence.  These goals recognize the following potential advantages of multiple-unit franchising:

•   Opportunity for extremely rapid development.

•   Use of another person’s financial and human resources.

•   Shared risk with another person.

•   Opportunity to consult with another person who has certain shared interests.

•   Added source of ideas.

•   Potential for rapid cash flow from sale of multiple-unit franchise rights.

•   Increased local credibility.

•   Increased knowledge of local conditions.

•   Added knowledge of local competition and ability to tailor programs to meet such competition.

Multiple-unit franchising also has its disadvantages, including the following: 

•   Loss of control to another potentially-large and powerful–person.

•   Potentially more difficult to manage and lead the other person.

•   “Giving it all away”–a significant portion of the revenue may no longer flow to the franchise system.

•   Vicarious liability for acts by the other person.

•   Potential limitations on the franchise company’s ability to enforce its franchise agreement, especially where the franchise system is not a party to the agreement. •   Complexity of the required agreements and the interrelationship of several required agreements.

•   Complexity regarding the required content of disclosure documents and the procedures for registration.

As a matter of caution, it should be noted that, while multiple-unit franchising is a clear trend and a source of success for many franchise organizations, it is not recommended for all franchise systems.  The reasons for this may relate to one or more of the disadvantages listed above, to corporate goals or philosophies, to business exigencies or to timing.  Multiple-unit franchising may be appropriate for a franchise company at one point in its life cycle, but not at another point.  For most franchise companies, for instance, it is recommended at an early stage of development, to encourage initial growth at a rapid rate.  A mature franchise company that has utilized multiple-unit franchising often regrets having granted rights which the system wishes it had retained.  In such cases, in fact, franchise companies sometimes attempt to repurchase previously granted rights.  Franchise systems often will utilize a combination of techniques, or a multiple-unit franchise technique in some territories, but not in others. To understand which technique is best for a given franchise company, at a given point in time, or in a given territory, it is necessary to understand the structure of each technique.  This analysis is also facilitated by an understanding of the advantages and disadvantages of each technique.

Area Development

Area development is a technique whereby the franchise system grants to an entity (the “area developer”) the right, and the area developer undertakes the obligation, to establish and operate more than one unit within a specified territory.  The area developer may pay a development fee for the right to have territory set aside for its development and, generally, must adhere to a schedule for development.  Individual franchise agreements ordinarily will have to be entered into for each unit to be developed, and a portion of the development fee may be credited toward the initial franchise fee payable under each franchise agreement.

Under this technique, the area developer must have the financial and managerial capability to develop multiple units itself.  Ordinarily, subfranchising, as that term is used below, is not permitted.  The area development arrangement may be structured, however, so that the area developer has the right, for example, to have the individual units owned and financed by limited partnerships in which the area developer is the sole general partner.

Generally, the advantage of an area development arrangement is that it has potential for rapid growth with shared risk.  The pace of growth may not be quite as rapid as the subfranchising and area representation techniques described later, however, and will depend upon the financial and managerial resources of the developer.  If structured properly, area development can increase a franchise company’s revenues through both initial development fees and increased franchise fees and royalties.

Generally, the disadvantage of area development is that it has the potential to create large and powerful counterparts who may demand concessions of both an economic and business nature.  A franchise company also risks “freezing” an area by misjudging the potential number of franchises which can be established in that area.  The required agreements can be complex, and the disclosure implications significant.

Subfranchising

Subfranchising is a technique whereby a franchise system grants to another person (the “subfranchisor”) the right, in a specific territory, to exercise powers normally reserved to the franchise company.  The subfranchisor may be an existing franchisee or, in some systems, a person unrelated to the system.  Some franchise companies will require their subfranchisors to operate at least one unit, while other franchise systems will prohibit the subfranchisor from engaging in such activities.  The subfranchisor ordinarily has the right to offer and sell franchises (sometimes subject to a schedule or quota), to sublicense the use of the franchise system’s trademark, to collect franchise fees, and to provide certain services to franchisees.  Generally, the subfranchisor undertakes services of a regional or local nature, while the franchise company assumes broader responsibilities such as national advertising and annual conventions.

The subfranchisor signs a subfranchise agreement with the franchise company.  The subfranchisor also enters into franchise agreements with franchisees.  The form of franchise agreement is generally provided or approved by the franchise company, although in some cases the subfranchisor has wide latitude as to the form of franchise agreement which is used.  The franchise agreements also may be signed by the franchise system, or the franchisor may be a named third-party beneficiary in such agreements.

Generally, a subfranchise agreement is advantageous because it will delineate the portion of fees which will be retained by the subfranchisor and the portion which will be paid to the franchisor.  In some cases, the subfranchisor may retain a majority of the fees.  Also, in some cases, subfranchisors are granted rights to purchase individual franchises – often at reduced fees.  Subfranchising has the potential for extremely rapid expansion.  It also benefits from most of the general advantages of multiple-unit franchising listed above. 

Generally, the disadvantage of subfranchising is loss of control (primarily due to the insertion of an additional and independent entity between the franchise company and franchisee) and to registration and disclosure complexities.

Area Representation

Recognizing some of the disadvantages of subfranchising, the concept of area representation has developed.  In an area representative arrangement, the so-called “area representative” is given the right to solicit prospective franchisees, and to provide certain services to existing franchisees, in a stated territory.  Unlike the case in subfranchising, however, the area representative has no right to contract with franchisees.  All franchise agreements are entered into directly between the franchise company and the franchisee.  In this fashion, the franchise system assumes all responsibilities to the franchisee, but delegates some of those responsibilities to the area representative.  For example, the area representative, in addition to soliciting for prospective franchisees (which is, ordinarily, subject to a schedule or quota), might have responsibilities for training franchisees, periodic inspections, local or regional advertising and periodic consultation.

As the franchise agreements are entered into directly between the franchise company and the franchisee, the initial franchise fees and royalties are paid directly to the franchise system.  The franchise company might charge the area representative for the right to solicit and service within the territory.  In turn, the franchise company will pay the area representative a portion of the initial franchise fees as compensation for soliciting prospective franchisees, and a portion of the royalties as compensation for servicing franchisees.

Generally, the advantage of the area representative approach is that the franchise company retains direct control over franchisees by contracting directly with them.  While the franchise company retains responsibility for servicing franchisees if the area representative can no longer (for whatever reason) do so, this increased responsibility, when compared to subfranchising, generally is viewed as a small price to pay for increased control.  Another advantage of the area representative approach is that, because the area representative is not contracting directly with franchisees, less disclosure may be required concerning the area representative in the offering circular furnished to prospective franchisees than would be the case with the subfranchise approach discussed above.  Also, depending upon whether the area representative pays for the acquisition of area representative rights, the area representative may or may not be acquiring a “franchise,” as that term is defined under the Federal Trade Commission Rule and state franchise laws, for which registration is necessary and disclosure must be furnished.

Generally, the disadvantages common to the area representative approach include the potential to give away a significant portion of the revenue, vicarious liability concerns, the complexity of agreements, and the complexity of registration/disclosure issues.  Thus, franchisors should not undertake the area representative approach without adequate thought, analysis, and guidance.

Franchise systems must consider carefully whether a multiple-unit franchising approach is appropriate for their business; if so, which approach; and, if an approach is appropriate, in which territories and time periods the approach should be used.  The issues of concern are not limited to choosing the appropriate approach, but also include the many options available with regard to each approach.  

Bret Lowell, CFE, is a partner with the law firm of DLA Piper US LLP in Reston, Va.  He can be reached at bret.lowell@dlapiper.com