Certain State franchise authorities provide the sole regulatory buffer between unproven rookie franchisors and prospective franchisees. They are the only regulators that review or even receive a pre-sale copy of a franchisor’s franchise disclosure document (FDD), a uniform set of franchise offering disclosures that provide significant, but not complete, information about a prospective franchisee’s investment. (The federal franchise regulator, the Federal Trade Commission, does not review the FDD before it is used in a franchise offering).
There are, however, only a limited number of states that require an FDD to be filed with their franchise authorities and even fewer that conduct a thorough review. There are fewer still that have or wield any authority to impose any substantive conditions on the franchise offering. Nevertheless, these few states may temper the otherwise unbridled sales instincts of many emerging franchisors, even if they are not currently offering franchises in any of these states. Finally, a prospective franchisee in a non-registration state can borrow at least one page from the state franchise authorities’ playbook.
So, who are these states? What do they do? What don’t they do? And what preventative devices do they have in their toolbox?
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A common observation is that there are 14 “registration” states. That’s not entirely accurate, however, as not all “registration” states conduct any sort of FDD/franchise examination or review.
- North Dakota
- New York
- Rhode Island
- South Dakota
Among the states listed above, only 10 conduct any meaningful compliance review, and the thoroughness of the reviews varies considerably among these states. And Indiana, Michigan, South Dakota and Wisconsin are effectively notice states, with no review at all.
For the states that conduct a review, they typically look at the following issues:
- Compliance with the applicable state franchise law
- FDD disclosure compliance review
- Financial statements
- Prior convictions of any franchisor officer or director under the applicable state franchise law
- Financial statements
- The auditor’s opinion letter or review report
- Notes to the financial statements
- The current ratio
- The quick ratio
- The amount of working capital
- The proportion of tangible and intangible assets
- The amount and maturities of debts
- The debt/equity ratio
- The amount of equity
- The earnings history
- The proportion of receivables compared to other assets and
- The quality of receivables
- The franchisee’s initial investment exceeds the franchisor’s shareholder equity
- The franchisor’s operating history may be too limited to assist you in judging whether or not to make the investment
- Your spouse’s personal assets will be at risk because he or she must sign a personal guarantee
- Substantially all of the franchisor’s assets are intangible
- You may only settle a dispute by arbitration and you may arbitrate or bring a lawsuit against the franchisor in a certain state and that arbitration or lawsuit will be governed by the laws of that state
- A large number of units closing within a specified number of years
- The franchisor controls the amount, size and location of customer accounts
- The franchisor may take away territorial protection or exclusivity if the franchisee fails to achieve a certain sales volume or satisfy some other contingency.