I’M BUYING A FRANCHISE: DO I NEED A BUSINESS ENTITY?
Business Entities In Franchising, And Their Limitations
By Brian A. Loffredo, Esq.
The answer is yes. If you plan to buy a franchise, you should strongly consider setting up a business entity from which to operate your business. Business entities serve an important role in the business world because they offer their owners protection. However, in the franchise world, business entities have some weak spots that franchisees should keep in mind.
One of the most common reasons business owners form business entities is to protect personal assets. Because business entities maintain a separate legal existence, business owners can use their entities to transact business, instead of obligating themselves personally. An entity can enter into contracts, incur debts, sue and be sued. It can take out loans, open bank accounts, own property, enter into leases, and engage in a wide variety of other business-related activities. The business entity conducts the activities of the business, and the owners therefore remain insulated from personal liability to third parties.
However, while a business entity serves an important role in protecting franchisees, franchise owners should be aware that those protections are not absolute. Franchisees will almost never be permitted to escape liability from one important actor – their franchisor. This is because most franchisors require their franchise owners to sign personal guarantees if a business entity is used.
Personal guarantees come in different forms. However, under most personal guarantees, the signer agrees to be personally liable to the franchisor for their business entity’s obligations under the franchise agreement. Personal liability to a franchisor can manifest itself in many ways. For example, if the franchised business entity defaults on its royalty obligations, the franchisor can seek payment from the franchise owner. If the franchised business entity is terminated by the franchisor for any reason, the franchisor can seek breach of contract and other damages directly from the franchise owner. If the franchise owner attempts to compete with the franchisor after the franchise agreement has terminated, the franchisor may be able to enjoin the owner from engaging in competition. At the licensing stage, franchisees often misunderstand whether they are personally liable under their franchise agreements. This typically happens when a franchisee is pressed for time, and has not yet set up a business entity by the time he signs the franchise agreement. The franchisee proceeds with signing because the franchise agreement specifically states the franchise can be transferred into a business entity at a later date. In this situation, many franchisees understand they are personally obligated on the day they sign the franchise agreement, but believe this personal liability will disappear when the business gets transferred into their newly-formed entity.
Unfortunately, the transfer almost never extinguishes personal liability. While most franchise agreements allow the franchise to be transferred into business entity, they do not specifically release the franchisee from personal liability. The transfer therefore obligates the new business entity, while the business owner also remains personally liable.
As set forth above, most franchisors require their franchisees to be personally liable if they enter into the franchise agreement using a business entity. So the transfer situation described above does not put franchisees in a worse position than they would have been in had they originally used a business entity at the outset. However, the problem is that many franchisees enter into franchise transactions believing that a business transfer will relieve them from liability. Had they fully understood their personal liability would remain throughout the duration of the franchise agreement, they may not have proceeded with the transaction. For such individuals, the business transfer provisions can be misleading and can cause surprise down the road.
Franchisees should always consider using a business entity from which to conduct their business. Business entities serve a useful purpose in the business world, and allow franchisees to protect themselves from third-parties. However, the protections will typically not protect franchisees in disputes with franchisors. Franchisee must understand this reality, so that they can gauge risk and understand their exposure to problems down the road.
If you have any questions regarding the content of this article, or any other franchise law matter, please contact Brian Loffredo at 301.575.0345 or by e-mail at firstname.lastname@example.org.
Before Buying a Franchise Identify Your TRUE Investment
Your approach as a potential franchise buyer is to identify the real investment dollars you’ll need to get the franchise to profitability. The initial source of this information is Item 7 in the FDD. Item 7 is a schedule that details the estimated investment in the franchise. This schedule includes the cost of various items, including: the initial franchise fee, training related expenses, rent, insurance, professional fees for legal and accounting services, supplies, equipment, licenses and permits and additional working capital. Depending upon the specific franchise, there may be added categories. When reviewing the Item 7 schedule it’s important to know that franchisors are not required to list every type of fee or expense that might be part of the investment in the franchise but rather the likely investment needed to start the franchise. As you work to establish your investment number keep in mind the words “estimated” and “typical.” Item 7 is a guide, and as such, you should use this information accordingly.
Why Doesn't Chipotle Franchise?
I’m a huge Chipotle fan and I’m not ashamed to admit it. I love a big fat carnitas burrito with every possible topping (is that even the right word for what you put on a burrito?) on it, especially guac. But every time I’m outside of New York I wonder why there aren’t more Chipotles out there. Sure there are a bunch (at the end of 2014 there were more than 1,700) but their numbers pale in comparison to other “fast food” giants like McDonald’s or Subway (they have more than 36,000 and 43,500 restaurants respectively). So why hasn’t Chipotle followed suit and gone the obviously successful franchising route?
Choosing Between a Product and a Service Franchise
There are basically two types of businesses that can be offered by an individual. They can offer Products to their customers which are tangible goods meant for the customer's consumption or they can offer them Services which are intangible and work to make the life of the consumer easier and more convenient. With technologies advancing rapidly and the global demands of consumers changing there is a very thin line dividing the service and product segment of the consumers demands. An example of this can be the purchase of a car from an auto dealer. The dealer not only offers the vehicle at a competitive rate but now has to offer different services as well, such as financing options, after-sales services, ready documentation and other non- tangible services. This kind of merging has made it very difficult to draw a clear line as to the service and product industry but for the sake of argument we will consider a theoretical perspective where you have to choose a traditional product franchise or a service franchise.