Buying a Franchise? Go or No Go?

At our firm, we have recently worked with two clients who invested in early-stage franchises and encountered serious challenges: there was little support from the franchisor, the product mix was limited, and the brand was not yet established with customers. In each case, our clients found themselves paying franchise fees and royalties for many of the benefits an established brand would provide, without actually receiving them. It is worth noting that not all franchises are created equal. Long-established franchises like McDonald’s, Subway, and 7-Eleven have spent decades refining their systems, building brand recognition, and developing robust support networks for their franchisees, whereas early-stage franchises can be a far riskier proposition.

The good: The classic franchise advantages

Buying a franchise is often touted as an easy way to launch a business quickly. The advantages of a franchise are that there is less experience required to own and operate a franchise, tried and tested product lines, and an established customer base that is familiar with an already established brand and support from the franchisor. While, on paper, this makes buying into an existing franchise appear to be an easy path to business ownership, there are some serious downsides that we believe make this a worse option than creating a new business.

Buying a franchise is often touted as an easy way to launch a business quickly. The advantages of a franchise are that there is less experience required to own and operate a franchise, tried and tested product lines, and an established customer base that is familiar with an already established brand and support from the franchisor. While, on paper, this makes buying into an existing franchise appear to be an easy path to business ownership, there are some serious downsides that we believe make this a worse option than creating a new business.

The bad: The cost of doing business

Before a franchise owner even encounters the potential pitfalls of franchise ownership, there are the relatively high startup costs associated with buying in. A typical franchise fee, which allows you the rights to the franchise name and model, can cost anywhere from $20,000-$50,000. This does not include additional startup costs that most business owners have such as inventory, hiring, legal fees, and more. Legal fees in particular could be higher as a simple formation is a straightforward process in most cases, whereas the fees associated with reviewing the legal documents in a franchise agreement may be more unpredictable.

Beyond the franchise-specific startup costs, there are also franchise-specific operating costs. Almost all franchises will have a built-in franchise royalty fee, which is typically represented as a percentage of gross sales. This eats in to overall profitability, and reduces

the potential working capital that could be used for other things. Additionally, many franchises require their owners to dedicate a set portion of their budget towards marketing and advertising. This further reduces the overall profits of the business, and the franchisee often has no ability to reduce the amount required.

The ugly: a lack of freedom

The biggest reason that we discourage our clients from buying into a franchise is the lack of freedom over business decisions that a franchisee has. Ultimately, a franchise owner is answerable to the company that owns the franchise itself. This has the very real possibility of creating friction between franchisee and franchiser. If you dislike a certain product or business direction that the franchiser has decided on, there is practically no means of deviating from their desires.

Looking at this from a big picture perspective, the business is never fully yours. While you do have the ability to make some operating decisions regarding your respective location, a franchise owner is not completely in control. Some franchisers can be very restrictive in what they allow, and this can create a very suffocating environment. The relationship between franchisee and franchiser is complex, and could be its own article, but the essence of it is that a franchise is not always a path that allows you to truly build a company according to your vision and desires.

Bottom Line

Franchises can offer real advantages to those looking to become entrepreneurs, and well-established brands with proven systems and strong franchisor support can be a sound path to business ownership. Our caution is aimed at early-stage franchises, where, as our clients experienced, you may pay franchise fees and royalties for the benefits of an established brand without actually receiving them. Too often, someone buys into an unproven franchise only to find that the idea of easy business ownership they were sold by the franchiser doesn’t quite match reality. If you are considering a franchise, do your due diligence on the franchisor’s track record, support, and systems - and remember that building a business from the ground up, while it has its share of difficulties, can in the long run be a better way to bring your entrepreneurial vision to life.

Are you interested in starting a business? You can contact us at 915.815.8482 or email sseck@seckassociates.com.

When to Use a Texas Shoot-Out: Resolving Partner Deadlock

Business partnerships are hard. What if you and your business partners couldn’t get along? Or, what if you and your business partners couldn’t agree on a major business decision resulting in deadlock? How do you move past such a roadblock? A company’s well written operating agreement or buy-sell agreement should address these concerns. One possible solution to these potential issues is the “shotgun clause”, also referred to as a deadlock provision or a “Texas shoot-out”.

Although varying methods can break up a deadlock, a common method is a Texas shoot-out provision which states that an owner has the option to either (1) buy out the other owner or (2) be bought out and exit the business. A shotgun clause essentially operates as an “I cut, you choose” method. In this scenario, two individuals can agree to share a piece of cake by having one cut the cake and the other choose his piece. Likewise, in a deadlock situation, one owner sets the price for the company and “cuts the cake”, while the other owner “picks the piece of cake” and decides whether to buy or sell his ownership in the company. Specifically, the owner being presented with the offer has the option of either accepting the offer and selling his interest or purchasing the other owner’s interest at the same price.

In theory, the Texas shoot-out is an easy way to settle disputes and offer clarity during an impossible situation. In reality, it could lead to abuse by the owner with the most money. For example, if one owner was cash poor or otherwise did not have easy access to capital, the owner with more capital could simply set an offer price that the cash poor owner could not meet. The outcome could force an owner, who wants to remain with the company, to sell his interest in the company at a value that may or may not be the fair market value. On the flip side, the owner who wants to stay may receive a large payout to move onto his next venture.

One way to combat this possible abuse is to designate a valuation method for the company. You could either (1) choose a valuation equation to be used, or (2) elect to use a third party appraisal (or an average of several appraisals). Another way to limit abuse is to only use the Texas shoot-out to be invoked for certain key matters. The advantage being that a buyout could not be forced unless a true deadlock situation had occurred.

In addition to a pre-determined method to establishing purchase price, the owners should consider pre-determined terms of payment. This includes how long an owner has to make a decision once presented with a deadlock clause and how the payment will be made. For example, will the purchase price be payable immediately or will the purchase price be paid over time through a promissory note? If a promissory note can be used, then you should also determine the basic terms of the promissory note, such as the term, interest rate, and consequences of default.  

The shotgun concept can be applied to a company with more than two owners, although this process is a bit more complicated. Each owner is offered the opportunity to purchase his pro rata share from a selling owner. If any owner chooses not to purchase his pro rata share, then the remaining owners have the opportunity to increase their percentage ownership interests by purchasing the remaining unpurchased interests. Several combinations of this method could be used as long as an owner is entirely bought out.

Aside from the Texas shoot-out, the owners could consider appointing a third or independent party to handle disputes, such as a trusted advisor, or the owners could divide the business in a split-off arrangement where each owner takes a piece of the business. The moral of the story is that you have options in the event of a deadlock. While you can’t have your cake and eat it too, you may be able to pick the piece.

The Series LLC: Is a Series LLC right for your business?

The series limited liability company ("LLC") is a relatively new way to organize business ownership. The series LLC has all of the benefits of a traditional LLC, such as flexibility and limited liability, with some added benefits that may appeal to your business such as the potential for a reduction in administrative costs and the further isolation of liabilities.

The series LLC is a group of mini LLCs all under one master LLC. This is a very similar concept to a parent corporation with many subsidiaries. Each mini LLC is independent from the other mini LLCs because each mini LLC has its own members, is only liable for its own debts and obligations, and can hold its own assets. The master LLC acts like an umbrella LLC or a holding company that controls all of the mini LLCs in the series. The series LLC started in Delaware and eventually became recognized as an entity type in Kansas and Missouri.

 A series LLC is ideal for someone who wants to form multiple LLCs within one large conglomerate without changing the function or business operations of each individual LLC. This is common for real estate investors or property management companies with multiple properties. A series LLC could also be used for a business with several different divisions or product lines. Each division could be its own mini LLC, thereby separating or limiting the liability to each division. Because each mini LLC is its own legal entity, each mini LLC must maintain separate corporate formalities such as a separate corporate book and its own financial accounts.

Not all states recognize the series LLC and formation procedures vary among the states that do. To form a series LLC in Kansas, the members must file Articles of Organization for the master LLC and then obtain a Series Limited Liability Company Certificate of Designation for each of the mini LLCs. The master LLC’s operating agreement must be carefully drafted to ensure that (i) a series LLC is specifically permitted and (ii) each mini LLC has limited liability (i.e. only liable for liaiblities within the mini LLC).

 To form a series LLC in Missouri, the members must file Articles of Organization for the master LLC and then file Form LLC 1A for each mini LLC. Similar to Kansas, the master LLC’s operating agreement must be carefully drafted to ensure that (i) a series LLC is specifically permitted; (ii) each mini LLC has limited liability (i.e. only liable for liaiblities within the mini LLC); (iii) each mini LLC must keep separate records, and (iv) the assets of each mini LLC must be accounted for separately.

Aside from isolating liabilities, a series LLC has other benefits such as potential reduced startup and administration costs. In Kansas, the filing fee for forming a stand-alone LLC is $160, whereas the filing fee for a master LLC is $250 and each mini LLC $100. Thus, filing for one master LLC and two mini LLCs in a series would be $450 compared to  filing three separate stand-alone LLCs which would cost $480. Additionally, Kansas requires ongoing administrative filing requirements for each LLC. However, a series LLC only needs to file one annual report for the master LLC and mini LLC, rather than separate reports for each LLC.

 Because Kansas only authorized the series LLC in July 2012 and Missouri only authorized the series LLC in August 2013, Missouri and Kansas have not clarified whether series LLC owners can file one consolidated tax return or whether each LLC must file a separate tax return.  Anyone contemplating forming a series LLC should consult their tax advisor about the tax implications applicable to their business. For more information on the series LLC or to see if it is right for your business contact Sheila Seck at 913-815-8485 or sseck@seckassociates.com.