To defer, or not to defer, that is the question. A blog on state registration financial assurance options.

As most franchisors know, there are 14 states that require a registration of the Franchise Disclosure Document (“FDD”). Of these 14, nine states will review the franchisor’s financial statements and impose financial assurance requirements if the franchisor’s financial health is not up to their standards. These financial reviewing states are:

California, Hawaii, Illinois, Maryland, Minnesota, North Dakota, South Dakota, Virginia and Washington.
(*New York reviews the financial statements, if they are concerned about the financial condition of the franchisor, they require a risk factor to be listed on the state cover page instead of financial assurances.)

Virginia is the only state of the nine to provide clear guidance on when financial assurances are required (when the franchisor’s liabilities exceed their assets). For the rest of the states, there is no bright line requirement and it will depend on examiner discretion. Generally, a state examiner looks at the franchisor’s equity position, working capital, debt levels, and profits. If a franchisor doesn’t satisfy a state’s criteria, it will be required to provide a financial assurance.

There are generally five ways to satisfy a state’s financial assurance requirement: (1) escrow initial franchise fees, (2) defer initial franchise fees, (3) purchase a surety bond, (4) infuse additional capital, or (5) obtain a guarantee of performance.

Because most franchisors are usually unable to infuse additional capital (which comes with strict requirements about how long the money must remain in the account) or obtain a guarantee from a parent or affiliate (which requires audited financials from the parent or affiliate), we will discuss the three common choices (escrow, defer or bond).

1. Escrow initial franchise fees:
All registration states allow franchisors to set up an escrow account where initial franchise fees are deposited. Initial franchise fees include any fee that would be collected prior to opening, and includes the cost of required purchases of products and services from the franchisor. Franchisors are often required to use a financial institution from the state in which the fees will be collected, and the franchisor must execute an escrow agreement using forms provided by each state. Funds can’t be distributed until the franchisor has fulfilled its pre-opening obligations—like training and site selection assistance—and the franchise is open for business. The state must also provide written authorization to the financial institution before funds are disbursed.

2. Defer initial franchise fees:
This is the most popular option (also the only free option). Registration states may allow franchisors to defer collection of all initial franchise fees until pre-opening obligations are fulfilled and the franchise is open for business.

3. Surety bond:
The last alternative is to post a surety bond that covers or exceeds the initial franchise fees that will be collected in the state during the upcoming 12 months. Some states require an amount equal to the initial franchise fees multiplied by the estimated number of franchises to be sold in the state during the next 12 months, while others require a flat amount (e.g. $100k). In either case, the total dollar amount of the initial fees collected must not exceed the amount of the surety bond (you may have to increase the bond if you sell enough franchises). Many states provide form surety bond agreements. Surety bonds may be expensive and often require a personal guarantee from the franchisor.

Below is a summary of the advantages and disadvantages of each financial assurance option:

Form of Financial Assurance

Advantages

Disadvantages

Escrow Initial Fees

The franchisee has “skin in the game” by paying out the initial franchise fees

Payment is assured as long as franchisee opens and franchisor’s pre-opening obligations are met

Less expensive than a surety bond

Involves ongoing administrative burden (you have to submit paperwork signed by the bank, the franchisee and franchisor to the state to get approval to release the funds- which may take days or weeks)

Often difficult to find in-state banks that will provide the service

Can be expensive (legal and banking fees)

Funds cannot be accessed until franchisor’s pre-opening obligations are met and franchise is open for business

Defer Initial Fees

The only option that is “free” and involves no forms or agreements

Very low administrative burden

Doesn’t rely on or involve affiliate’s or parent’s financial condition

Initial franchise fees cannot be collected until franchisor’s pre-opening obligations are met and franchise is open for business

Franchisee gets trained and gains access to confidential information without paying any initial franchise fees up front

The franchisee does not has “skin in the game” by paying out the initial franchise fees

You will have to sue to get the fees if the franchisee fails to open

Surety Bond

Initial franchise fees may be collected and used immediately upon signing

Lower administrative burden than escrow

May be very expensive

May require personal guarantee

Involves greater administrative burden than fee deferral or guarantee

Bond may need to be increased throughout the year