Bringing a Franchise Brand to the U.S.

Bringing a Franchise Brand to the U.S. LeClairRyan Thomas M. Pitegoff 885 Third Avenue Sixteenth Floor New York, New York 10022 Phone: 212.634.5032 tom.pitegoff@leclairryan.com WWW.LECLAIRRYAN.COM

BRINGING A FRANCHISE BRAND TO THE U.S. Testing the market with a wholly-owned subsidiary A growing franchise company based anywhere in the world may view the U.S. as an attractive prospective market. But the factors that make the brand a success in one country may not translate easily to the U.S. market. For this reason among others, it makes sense to start small in the U.S. When a company considers expanding abroad, the first question is whether there is a market for that company s products or services in the destination market. Will the business concept appeal to the U.S. market given U.S. tastes and the competitive landscape in the U.S.? The best way to know is to test the concept on a small scale in the U.S. before expanding either through franchising or a larger company-owned operation. Testing the market not only allows the brand owner to see whether the concept will be accepted in the U.S. It also allows the brand owner to make modifications in its products and services and their pricing, to find reasonablypriced supplies, to hire the right talent and to differentiate the brand from the competition. All of these things will improve the likelihood that the brand will succeed when it expands. A test might be done in any of a number of ways. The simplest approach is to form a wholly-owned U.S. subsidiary company that will do the testing. This approach is often preferred for several reasons: The brand owner has full control. No other entity has an ownership interest. Having a subsidiary limits the brand owner s liability to the amount of money invested in the entity. The U.S. entity (and not the offshore brand owner) will be taxed in the U.S. and the entity s activities will not cause the brand owner to have a permanent establishment in the U.S. for tax purposes. Managing the test through a wholly-owned U.S. subsidiary has additional advantages for a franchise company. For one thing, it defers the need to comply as a franchisor with U.S. franchise laws. In addition, it can shield the offshore brand owner from liability under the U.S. franchise laws. Using a wholly-owned subsidiary to do the testing avoids the franchise laws altogether, at least during the test phase. The U.S. subsidiary can learn from direct experience during the test what works and what does not work in the U.S. market before taking any steps to expand. If the company decides to expand through franchising, it can then offer a proven concept. Also, it will have built an organization that can manage the training and support of franchisees and the marketing of the franchise system in the U.S. Why master franchising may not work When expanding a franchise brand into another country generally, many franchisors use the master franchise approach. The franchisor grants the right to one company in the destination country, called the master franchisee, to develop the brand in that country. The master franchisee sells franchises in the destination country and manages the brand within the country. Master franchising is usually not the best way to sell franchises in the U.S. The reason is that the U.S. franchise laws make this approach difficult. First, the grant of master franchise rights might require disclosure under U.S. federal law. The Federal Trade Commission s trade regulation rule on franchising (the FTC Rule ) requires franchisors to prepare a detailed disclosure document and deliver it to prospective franchisees. It is awkward to prepare such a document for a transaction that is likely to be highly negotiated and entered into only once. The FTC Rule has a number of exemptions and exclusions. An exemption may apply, but some risk may remain. 1

Second, a number of states also regulate the sale of franchises. These states require franchisors to use essentially the same detailed disclosure document required by the FTC Rule. But several states also require franchise offerings to be registered with the state before the franchisor can sell franchises in the state. Some of these states might view the grant of rights to a master franchisee to sell in their state (as part of a multi-state territory) to be the grant of a franchise in the state, even if the master franchisee has its offices in another state. If the grant of the master franchise is not exempt under either federal or state law, then the master franchisee s franchise disclosure document must include disclosures about both the brand owner (as the franchisor) and the master franchisee (or subfranchisor). Both the franchisor and the master franchisee would be jointly and severally liable for each other s violations. Both would be obligated to comply with the franchise laws. This is especially difficult when the brand owner is a non-u.s. company because both the brand owner and the master franchisee would be required to disclose audited financial statements prepared in accordance with U.S. generally accepted accounting principles. The financial statements must be audited by an independent certified public accountant using generally accepted U.S. auditing standards. Legal entity of the U.S. subsidiary A foreign company entering the U.S. commonly forms a wholly-owned corporation as its U.S. subsidiary. The alternative of a limited liability company usually is not appropriate in an international context. Limited liability companies are commonly used as pass-through entities from a tax point of view. An off-shore company will not want a pass-through entity. Instead, it will typically want to shield itself from tax liability in the U.S. A corporation serves this purpose. In which state should the brand owner incorporate its U.S. subsidiary? Corporations are established in the U.S. under the laws of any one of the fifty states. Delaware is a popular state for businesses that expect to raise funds from outside investors and possibly to go public. The Delaware advantages for some companies usually do not apply to wholly-owned subsidiaries. Most off-shore companies form their U.S. subsidiary corporation in the state in which they will locate their U.S. headquarters. Once the subsidiary entity is formed, regardless of the state in which it is formed, the corporation can operate anywhere in the U.S. But if the corporation intends to establish offices or warehouse facilities in a state other than the state in which it was incorporated, it may be necessary to seek formal authority to do business in that state. One key advantage of operating a business through a legal entity like a corporation is the ability to limit liability. In order to enjoy this advantage and to protect the parent and affiliate companies from legal challenges based on the acts of the subsidiary corporation, it is important to observe certain corporate formalities. These include preparing a minute book and keeping accurate accounts of the corporation s finances. A corporation keeps its official records in the minute book. In a privately held company like a wholly-owned subsidiary, most of these records are not public. It is up to the company to maintain them. The only public documents are those filed with the state. These include the certificate of incorporation or an application for authority to do business in the state and very little more. A corporation has a board of directors and officers. The directors are elected by the shareholders. They act at meetings or by written consent. Individual directors cannot act alone on behalf of a corporation. The directors appoint the officers. Officers hold titles such as president, treasurer or secretary. Their roles are described in the corporate bylaws. The rights, obligations and liabilities of the officers, directors and shareholders are further defined in the laws of the state in which the corporation is formed. Neither the officers nor the directors need to reside in the U.S. However, it is helpful to have at least the president or vice president and the secretary in the U.S. in order to sign documents as necessary. 2

Franchising entity Before selling the first franchise, it is often a good idea to form a new business entity that will be the franchisor, separate from the operating company. The franchise entity might be a wholly-owned subsidiary of the initial company that the offshore brand owner forms in the U.S. That new franchise entity will be the company that prepares the required franchise disclosure document, registers the franchise offering with the relevant states and enters into franchise agreements and manages the franchise system. This structure shields the operating company from the liabilities of the franchise business. In most cases, it also avoids the necessity of disclosing financial information about the company-owned outlets and the financials of a parent company or an affiliated company. A newly-formed franchise company can prepare an opening balance sheet for its first franchise offering. In New York, the opening balance sheet of even a new franchisor must be audited. So if the company plans to franchise in New York within the first few years, it is a good idea to start with audited financials in the very first year. All franchise companies need to have audited financial statements within three years of launch in any event. Franchise agreement and disclosure document Before the franchisor entity can sell even one franchise, the company must prepare a form of franchise agreement and a detailed franchise disclosure document. The agreement is the contractual basis for the ongoing relationship between the franchisor and the franchisee. The franchise disclosure document, or FDD, describes the franchise offering in plain language. It includes the franchise agreement, disclosures relating to the management of the company, its litigation, its audited financial statements and much more. It is intended to protect the prospective franchisee by providing detailed information about the franchisor and the franchise system in a format that is readable and allows prospective franchise buyers to make easy comparisons of one franchise to another. Franchise agreements and offering documents prepared for use in countries other than the U.S. typically must be substantially rewritten to meet U.S. legal requirements and market expectations. The FTC Rule requires the franchisor to deliver the FDD to each prospective franchisee anywhere in the U.S. at least 14 days before the prospective franchisee signs an agreement or makes any payment to the franchisor. There is no federal filing or registration requirement just a requirement to make disclosures to prospective franchisees in a timely manner. Under the laws of several states, the franchisor must register its franchise offering with the appropriate state authority before the franchisor can offer or sell franchises in the state. These states include California, Illinois, Maryland, New York, Virginia and others. The franchise registration must be renewed in each state from year to year and amended whenever there is a material change in the franchise offering. The process of preparing to offer franchises in the U.S. is likely to take at least two months and probably longer, especially in those states that require franchise registration. U.S. geography What is the best place in the U.S. to test the concept? This will depend on various factors. Are supplies and equipment easily available? Is the target market urban or rural? Will the brand appeal to a particular income or age group? Are the costs of real estate and labor an important factor? Are local regulatory restrictions a potential issue? Does the company or its management already have a connection with a particular city or area? Many U.S. franchise systems exist only in a small portion of the U.S. A foreign franchisor might use a similar approach, at least at the outset. It makes sense to enter the U.S. market in one geographic area (or a small number of areas) and to expand gradually as the brand becomes successful. 3

A more aggressive approach that might work would be to appoint multi-unit area developers in different parts of the U.S., but not to allow them to subfranchise. How large a territory should a developer have? Generally, it is good to start small and grow a territory as the developer shows success. The development agreement should include a development schedule requiring the developer to open a stated number of units over a defined period of time. If the developer falls behind, the development rights can terminate. If the developer stays on schedule, the parties can always agree to expand the territory. How many company-owned outlets must a company have before it can or should begin to franchise in the U.S.? There is no legal requirement to have any outlets at all, let alone any particular number of outlets, before a company offers franchises. However, U.S. companies commonly do not begin to franchise until they have some experience with at least a few company-owned outlets. Presumably, the U.S. subsidiary company that tests the brand will own at least one outlet and possibly more. Federal trademark registration One important initial step that any brand owner should take when entering the U.S. is to apply for trademark registration. The application for federal trademark registration in the U.S. should precede any test and certainly should precede investing in advertising and marketing. The process of obtaining federal trademark registration in the U.S. commonly takes a year or longer. From a marketing point of view, will the trademark work in the U.S.? If so, is the mark or a similar mark already being used in the U.S. by a company in the same or a related type of business? Is the mark descriptive of the goods or services that the company intends to sell? Descriptiveness can be a basis for denying trademark registration in the U.S. In some cases, it may be necessary or advisable to use a different trademark in the U.S. than the brand owner uses outside the U.S. Should the mark be owned by the owner of the brand abroad? Or should the U.S. entity own the mark in the U.S.? A safe approach from a franchise law point of view is for a U.S. entity to be the brand owner in the U.S. Otherwise, the license from the trademark owner to the franchising company in the U.S. might possibly be viewed as a franchise agreement itself. Federal trademark registration is especially important for franchisors. The status of trademark registrations must be disclosed in the franchise disclosure document. Having a trademark registration is not a requirement in order to franchise, but the absence of a trademark registration would be obvious and would detract from the company s ability to sell franchises. Also, trademark registration allows a franchise company to be exempt from some of the state business opportunity laws. Half of the states have business opportunity laws. What is a business opportunity? The definition varies widely from one state to the next. In most cases, representations made in the course of the sales process determine whether the sale falls within the scope of a business opportunities law. The seller of a package of equipment or inventory may represent that it will find customers for the buyer s products or services, or that the seller will purchase the products made using the equipment sold to the buyer, or that the seller guarantees that the buyer will derive income from the opportunity. Like the franchise laws, the business opportunity laws contain disclosure requirements and sometimes require a filing. Unlike the franchise disclosure requirements, which are largely uniform throughout the U.S., the business opportunity law disclosure requirements vary from state to state. The business opportunity laws generally contain exceptions or exemptions for franchise offerings made in compliance with the FTC Rule, and many of these laws exempt offerings that include rights relating to a federally registered trademark. Even so, a few states require franchisors to make simple exemption filings under their business opportunity laws. 4

Conclusion Taking the first step The U.S. market is huge and diverse. Even a small percentage of the market may reap large dividends. For many companies, the opportunities of the U.S. market far outweigh the obstacles. But success in any venture is most likely when you know the obstacles and plan accordingly. This introduction does not cover all possible legal issues. For franchisors, though, the federal and state franchise laws are a central consideration. About the author Tom Pitegoff is counsel at national law firm LeClairRyan, where he focuses his legal practice on franchise law, business transactions, licensing and international business. For franchisors, Tom drafts franchise agreements and disclosure documents, obtains state franchise registrations and provides ongoing franchise compliance counseling services. He also counsels businesses on the scope of franchise laws and he represents entrepreneurs in the purchase and sale of franchises and area development rights. In his international work, he represents foreign franchisors in their U.S. business and U.S. franchisors expanding abroad. Tom was recognized by Best Lawyers in America as the 2015 Franchise Law "Lawyer of the Year" for New York, New York. Follow Tom as he covers the gamut of issues in franchise law for the firm's blog, Franchise Alchemy. For questions or comments, he can be reached directly by phone at 212.634.5032 or by email at tom.pitegoff@leclairryan.com. 5