Franchise Your Business

What are the ongoing legal costs to franchise your business?

Ok. You have just spent a decent amount of money to franchise your business (See How much does it cost to Franchise my Business). So, the next question is how much will it cost to keep the franchising ball rolling?  In typical lawyer fashion, the answer is “it depends,” but here we’ll break down some of the ongoing costs that you will have as a franchisor.  These are legal costs and related costs:  fees you will pay to your lawyer; fees that you pay to the states for state filing fees, and fees that you will pay to your auditors to prepare audited financials.

Franchise Disclosure Document (FDD) Annual Update
Under federal law, the FDD must be updated every year no later than 120 days after the franchisor’s fiscal year end.  There are several FDD items that will need to be updated each year, even if there aren’t any changes to your franchise system or if you haven’t sold a franchise.  For example, you will need to include these changes each year: whether you have sued (or were sued by) any franchisees; a description of any marketing funds you collected in the past year and how you spent the marketing funds; a description of how much revenue you collected from any sales you made to franchisees; updates to any financial information you had given in Item 19; updates to the number of franchised and company-owned outlets in the Item 20 tables; updated audited financial statements (see below); and updates to the list of current and former franchisees.  You can also add system updates such as increased or new fees, additional brands or other changes.  The cost for these annual updates generally range from $4,000 to $15,000 (depending on the number of changes). This is paid to your lawyer.

Audited Financials*
You are required to have yearly audited financial statements for the franchisor prepared by an independent CPA.  Audited financial statements generally cost between $2,000 and $10,000. This is paid to your auditor.

For more information on the required financial statements, check out our blog: Required Financials for Your FDD

*while this is not a legal fee, it is required for your FDD, so we have included it here.

FDD Quarterly Updates
In addition to the annual update, federal law requires that you update the FDD within a “reasonable time” after the close of each quarter of the fiscal year to reflect any material changes occurring during the quarter. These types of changes include newly filed material lawsuits, new bankruptcies, changes to senior management, a materially adverse change to the franchisor’s financial condition or the establishment of a new product line requiring a significant increase to a franchisee’s initial investment.   As with the annual update, the cost will depend on the number of updates and changes and can generally range from $2,000 to $10,000.  This is paid to your lawyer.

State Renewals/New Registrations
Remember all those registration states that you registered in when you began your franchise journey?  Well I have a good news/bad news situation for you.  Bad news first: you have to renew your registration each year.  Now the good news: the renewal filing fees are generally cheaper than the registration fees (sometimes by as much as $400).  You will have to renew your registration in any of the registration states in which you want to keep offering franchises.  You may want to add a state or two as well.

To refresh, here are the 14 franchise registration states:

California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, South Dakota, Rhode Island, Virginia, Washington, and Wisconsin.  Registration State Process (link)

Your state renewal costs will depend on where you want to register and can range from $0 (no state registrations) to $15,000 (all states).  These fees include legal fees paid to your lawyer and filing fees paid to the registration states.

Registration State Amendments
Did you have a quarterly update for your FDD?  Did you have to update your FDD because of a material change (e.g. litigation, franchise closures) or an update to your franchise system (e.g. new fees) (see FDD Quarterly Updates above for pricing)?  12 of the 14 registration states will require that you file an amended FDD (Michigan and South Dakota do not require amendments).   The process is similar to the annual renewal filing.  Amendment filings can range from $0 to $7,500.  These fees include legal fees paid to your lawyer and filing fees paid to the registration states.

Negotiated Deals
Are you giving away the farm to make franchise sales? If so, it may cost you.  How much do you want to negotiate?  When you negotiate terms that are different than your usual terms, you will do so in an “Addendum to the Franchise Agreement.” An addendum is a separate document that is written up that changes or amends certain parts of the franchise agreement.  Franchisors make these changes in addenda and not in the franchise agreement itself so that they can keep track of these negotiated terms over the years.  Most franchisors use an attorney to have addenda drafted and negotiated because even a small change to the franchise agreement can have a big effect on the franchised system. These addenda can also drive up your legal fees.  You may need a one-page addendum for simple negotiations (such as changing a fee amount, or term length), or you might have extensive changes that will require a 10-page addendum (granting rights of first refusal or numerous small changes).  The legal fees for negotiated deals generally range from $500 to $2,500 each deal. This is paid to your lawyer.

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To default or not to default, that is the question.  When your franchisee does not follow the franchise agreement, you will need to decide how to handle it.  You have different options, some of which are described in the franchise agreement.  Calling your lawyer is a good starting point to understanding what your choices are and how your choices may affect the franchised system and the other franchisees. One option many franchisors choose is to send a default notice.

Most franchise agreements have a provision that the franchisees will be responsible for any legal fees that you incur as a result of a breach of their franchise agreement.  So, in theory, if you have legal expenses because a franchisee is in default, you can bill the franchisee for your costs.  The costs generally range from $500 to $1,000 for a simple default notice (unpaid royalties and/or unfiled reports) up to $2,000+ for more complex defaults and consultation (e.g. selling unauthorized services or operating a competing business).  This is paid to your lawyer.

Like most breakups, these can become quite expensive.  Mutual breakups are best (it’s not you, it’s me) to avoid expensive litigation.  Several states have laws that can impact your ability to terminate a franchisee.  If you or your franchisee are located in any of these states, your options are more limited.  For example, New Jersey requires a special 60-day notice for certain termination grounds and California requires that you repurchase inventory from the franchisee for certain terminations. Mutual terminations are normally much less expensive ($500 to $1,000) than one-sided terminations and normally come with the benefit of a release of claims by the franchisee so you avoid ending up in court later.  Contentious terminations are common and can range anywhere from $3,000 to $100k or more in legal fees if the matter ends up in litigation or arbitration. This is paid to your lawyer.

Sales Compliance
Pop quiz for you.  A resident of New York, who is currently vacationing in California, calls you and wants to buy a franchised business to be operated in Rhode Island.  Where do you have to register?  What if you have offered a franchise in a state in which you weren’t registered? What do you do now?

Navigating franchise sales laws can be difficult and mistakes can be costly.  Sales compliance is one area where an ounce of prevention is worth a pound of cure.   You should budget between $1,000 and $5,000 each year to handle franchise compliance issues. This is paid to your lawyer.

When a franchisee sells their franchised business (this is a “transfer” to a new franchisee), or when a franchisee renews their franchise, you will need to document this change.

In the case of a transfer, your primary role is to approve the transferee (the person buying the franchise) and the transfer documents.   You are not involved in the deal terms between the buyer and seller, but are checking the transfer documents to make sure there are no issues that would affect the ongoing operation of the franchise.  The documents will usually include an approval of transfer agreement as well as some attached documents (like a release from the seller and a guaranty from the buyer).  You may also decide that you want the buyer (who will be the new franchisee) to sign a new, current form of franchise agreement.   Franchisors generally charge a transfer fee of 25% to 50% of the initial franchise fee.  The legal costs for these reviews range from $500 to $1,500.  This is paid to your lawyer.  The seller will pay you a transfer fee that should cover this cost as well as the cost for training of the new franchisee.

For renewals, you may choose to negotiate some of the terms of the new franchise agreement (see negotiated deals above).  A negotiated renewal addendum can generally range from $500 to $2,500.  This is paid to your lawyer.  The seller will pay you a renewal fee that should cover this cost.