Take Advantage of These Franchise Registration Tips

05/01/2006 / Joseph Fittante

The goal of every franchisor that attempts to register or renew its Uniform Franchise Offering Circular (the “UFOC”) is to complete the process in the least amount of time. While the federal franchise law mandates disclosure as opposed to registration, 14 states require the franchisor to register, and annually renew, its UFOC prior to making offers and sales in that state, and 11 of these states will issue comment letters requiring changes to the UFOC if the state examiners believe the UFOC fails to comply with the commenting state’s law or the guidelines for preparation of the UFOC (the “Guidelines”).

In the competitive climate of franchise sales, a premium is placed upon adeptly navigating the registration maze without having to respond to a comment letter, because the issuance of a comment letter delays registration, which directly affects the franchisor’s sales abilities. In fact, the franchisor who must respond to a comment letter and ends up quibbling with an examiner over the comment letter is comparable to emperor Nero, who, legend has it, played his violin while a fire destroyed the city of Rome, failing to recognize the importance and urgency of the situation. No one, not the franchisor, its franchise administrator, nor its lawyer, wants to be known as “Nero”; the one who quibbled with a state examiner over a defect in franchise registration materials, while the franchisor’s registered competitors sold franchises to the franchisor’s prospects.

Hopefully, the five “Golden Rules” discussed below, plus the bonus Golden Rule, will save the franchisor, its franchise administrator or its counsel, from becoming the next “Nero.”

Golden Rule #1 Be Well Capitalized - And if you Can’t be Well Capitalized, Be Clairvoyant (or at Least Act that Way)

Franchise examiners have traditionally been sensitive to the financial strength of franchisors selling franchises in the examiner’s state. This sensitivity has arguably been heightened by recent bankruptcies of some well known publicly held companies. Accordingly, there may be no faster way for a franchisor to draw a comment letter from an examiner than to show a low or negative net worth on its financial statements. At least one state also expects to see a positive current ratio (current assets exceeding current liabilities).

If you find yourself with a poor financial statement, rather than try to “slip it by the examiner,” take a proactive approach. First, determine whether changes can be made in the franchisor’s capital structure to alter the financial picture. For example, if there is debt owed to owners or affiliates of the franchisor, converting that debt to equity or long-term subordinated debt can dramatically improve the franchisor’s net worth and current ratio. Even if this change cannot be made retroactively to year end, consider making the change and including in your UFOC updated unaudited financial statements showing the improved financial picture.

If you cannot change the financial statements, determine what financial assurance measures the state allows (typically, escrow, bond, deferral of initial fee or guaranty, if applicable) and implement such a measure at the time you submit your UFOC to the state. (Virginia is the only registration state where such an option, other than a guaranty, is not contemplated by law.) If you choose the bond route, speak with the state beforehand to determine the amount of the bond the state requires. (Typically, the state will require a bond in an amount equal to the number of franchises the franchisor seeks to sell in the state, multiplied by the initial franchise fee.) If you choose the escrow route, determine whether the state requires a specific escrow agreement or if the state has any rules related to where the escrow agent is located.

Golden Rule #2 Legalese to Franchise Regulators is what George Carlin’s Seven Dirty Words were to the FCC

Most lawyers are fond of legalese, thinking of it as a validation of the thousands of dollars spent on law school education. Additionally, since lawyers have written that way for years, it may just seem easier. Unfortunately, “legal antiques” and repetitive and passive phrases are, for the most part, prohibited by the Guidelines. Accordingly, it is not uncommon for a franchise examiner to deny registration of a franchise application until the applicant revises its UFOC to conform it to the plain English requirements mandated by the Guidelines. In fact, examiners located in California have been known to request computer diskettes containing the UFOC so they can make the changes themselves.

To avoid this issue, prior to submitting the UFOC to a state, make a list of the legalese words that are specifically prohibited by the disclosure requirements and then use a word processing program to locate those words in the UFOC. After locating the words, change them to words “real people” understand. You can also use a word processing program to identify passive phrases, which can then be changed to active voice phrases, if appropriate.

Golden Rule #3 Be Consistent

In the rush to “get to market” or to meet renewal filing deadlines, sometimes the little things get missed. Unfortunately, it is these little things that may stand between registration in a state and having to respond to a comment letter that ultimately delays registration. Accordingly, it is extremely important to be consistent throughout the UFOC. For example, if you change the initial franchise fee disclosed in Item 5, or update the initial investment amounts in Item 7, these changes must be carried throughout the document, and specifically be reflected in the initial fee and initial investment disclosures included on the Cover Page. Likewise, be sure all changes in the franchise agreement are carried forth into the UFOC. Failure to be consistent in this regard will likely draw a comment letter from a state.

Another place where a failure of consistency will likely lead to a comment letter is in Item 20 of the UFOC, where a franchisor must make numerous disclosures including, in chart form, the number of franchise outlets leaving the system during the year and the number operating at year end in each state. Along with this disclosure, the franchisor must provide, as an exhibit to its UFOC, a list showing the name, address and telephone number of each franchisee in its system and a list of those franchisees that left the system in the fiscal year then ended. Franchise examiners can count, and will frequently check for consistency between the total number of franchises operating at year end in the Item 20 chart and the number of franchisees listed in the exhibit showing the franchisees in the system as of year end, as well as for consistency between the number leaving the system and the list of those who left the system during the year. Confirm that these numbers are consistent prior to filing, and if they are not (and in certain situations there may be legitimate reasons why they are not) explain the inconsistency in the state cover letter, which will hopefully eliminate the need for the examiner to send a comment letter ultimately delaying registration.

Another place where franchisors get tripped up in the registration process is in the advertising area. Currently, eight states (California, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, and Washington), require a franchisor to file its advertising with the state prior to its use in that state. Review the advertising to ensure that the information contained in it is consistent with the information contained in the UFOC and does not make earnings claims or other representations in violation of applicable law. For example, it is not uncommon for advertising to refer to the initial franchise fee or the franchisee’s initial investment. If the advertising is inconsistent with the information contained in Items 5 or 7 of the UFOC, failing to correct the inconsistency prior to filing will likely lead to a comment letter.

Golden Rule #4 Be Complete

One of the easiest disclosures to make in a UFOC is the Item 2 disclosure of the 5 year employment history of the officers and directors of the franchisor. However, it is common for examiners to comment on these disclosures because the franchisor fails to account for the entire 5 year period. If a person was retired or unemployed during the relevant time period, the franchisor should state that in Item 2. A franchisor that attempts to gloss over the period of retirement or unemployment will commonly receive a comment letter from the examiner pointing out the error and further delaying the registration process.

The sole reason a franchisor uses franchise brokers is to increase its offers and sales of franchises. Therefore, if the franchisor’s registration in a state is delayed due to a defect in the information provided in the UFOC related to the brokers, the delay becomes even more frustrating. When using brokers, the franchisor must remember to disclose the brokerage company, as well as its officers and directors, and executives with management responsibility to market or service the franchise opportunity. Further, Washington, New York and Illinois require brokers to be registered with the state before they can offer and sell franchises in the state. Failure to make the appropriate disclosure related to a brokerage company or network, or the failure of a broker to be registered in a state requiring registration, may in a best case scenario delay registration, and in a worst case scenario, allow a disgruntled franchisee to rescind its franchise agreement.

Golden Rule #5 Read the Fine Print

It is not uncommon for a franchisor’s auditor to reference information in the notes to the financial statements related to the franchisor’s system, such as total number of franchisees operating at year end, and information related to the amounts paid by franchisees to the franchisor, such as the amount of the initial franchise fee or a royalty percentage. All of this information should be consistent with the information contained in the body of the UFOC. Additionally, if the franchisor sells goods or products to its franchisees, the franchisor must disclose the franchisor’s total revenues and the franchisor’s revenues from all required purchases and leases of products and services. Accordingly, the franchisor should confirm that the total revenue number it has disclosed in Item 8 is consistent with the total revenue number contained in the franchisor’s financial statements. Inconsistency in either of these disclosures is likely to lead to a comment letter from an examiner regarding the inconsistency.

Bonus Golden Rule #6 Play Nice with Others

If, even after following the Golden Rules discussed above, the franchisor still receives a comment letter from a state examiner (which on occasion has been known to happen), it is important to remember three things when dealing with the examiner. First, no matter how unreasonable one thinks the examiner is being, they are trying to do their job. Second, no franchisor wants to become interesting to a regulator. Third, and most importantly, THE EXAMINER HAS SOMETHING YOU WANT. This is not to say that a franchisor or its counsel should give in to every request of an examiner. However, when dealing with an examiner, the franchisor should keep the foregoing points in mind (especially the last one), because, while the franchisor or its counsel takes time to respond to a comment letter, or argues with an examiner over a comment, Rome may be burning in the form of a competitor’s sale of franchises to YOUR prospects.

This article originally appeared in the May 2006 issue of Franchising World Magazine, a publication of the International Franchise Association. It is reprinted here with permission of the publisher.