As a condition of registering or renewing a franchise disclosure document (FDD), some states require that a franchisor provides a form of financial assurance to the state. This requirement only applies if the franchisor lacks sufficient cash flow to perform its financial, pre-opening training, and support obligations owed to its franchisees. These obligations are typically imposed on a franchisor when an examination of the franchisor’s FDD reveals that the franchisor lacks sufficient cash flow to meet its pre-opening obligations to franchisees. The standard under which this determination is made varies among the differing state statutes and regulations.
Some state laws have specific statutory criteria that must be met, while others provide a set of guidelines to consider when examining a franchisor’s audited financial statements found in their FDD. These guidelines generally include: the amount of working capital; the ratio of working capital to liabilities; the amount of shareholders equity in the franchise; the projected franchise sales within the state; and the franchisor’s operational history in the state.
Ultimately, if a franchise regulator in any of these states determines that a franchisor lacks sufficient working capital to satisfy its financial, pre-opening training, and support obligations on behalf of its franchisees within the state, a franchisor regulator may require the franchisor to provide the state a form of financial assurance as a condition of registering or renewing its FDD. Of the fourteen states that require FDD registration, nine of them impose these “financial assurance obligations,” which include California, Hawaii, Illinois, Maryland, Minnesota, North Dakota, South Dakota, Virginia and Washington. Additionally, while New York does not impose financial assurance obligations, state law similarly requires that a franchisor add a specific risk factor to its FDD based on the franchisor’s current financial status.
Of the forms of financial assurance that a franchisor may provide to the state, the following are most common: (1) deferral of the initial franchise fee; (2) placing the initial franchise fee in escrow; (3) posting a surety bond; and (4) obtaining a performance guaranty.
One of the most common forms of financial assurance utilized is when the franchisor defers its collection of initial franchise fees sold within the state. The franchisor is entitled to collect the fees once it has completed its pre-opening training and support obligations, and the franchisee has opened the franchise. An advantage of this option is that it does not impose a significant burden on the franchisor to arrange. However, there are two important disadvantages. Firstly, the franchisor’s receipt of the initial franchise fees may be delayed, potentially frustrating the franchisor’s financial situation. Additionally, there is a risk that the franchisor may not collect the fees in the event the franchisee fails to open or is unwilling to pay.
Placing the initial franchise fees in escrow is another commonly utilized form of financial assurance. Like the deferral option, the franchisor does not receive its initial franchise fees until the franchisor’s pre-opening obligations are met and the franchise opens. Once this occurs, the initial franchise fees in escrow are disbursed to the franchisor. This option affords more protection to the franchisor than the deferral option because it requires the franchisee to render payment of the initial franchise fee. It is disadvantageous to the franchisor in that it delays the franchisor’s receipt of the initial franchise fee and establishing a state-approved escrow account may delay the FDD registration process. However, because the initial franchise fee is paid by the franchisee in escrow, it mitigates the risk franchisors face when seeking the collection of unpaid franchise fees and ensures that a new franchisee has skin in the game.
A less commonly used form of financial assurance requires the franchisor to post a surety bond in an amount determined by the franchise regulator. This option differs from the deferral and escrow options in that it allows the franchisor to collect its initial franchise fee as soon as the franchise agreement is signed. However, the amounts of the bond can be expensive and slow down the registration or renewal process. Moreover, some states require a personal guarantee that the franchisor will perform its pre-opening training and support obligations, and some states may increase the bond value during the year. Various registration states have different formulas they use to determine the amount of the surety bond, but the general method is multiplying the number of franchises the franchisor intends to sell in that particular state by the amount of the initial franchise fee.
This form of financial assurance requires the franchisor to have another company, typically a financially stronger parent or affiliate, guarantee the franchisor’s financial and performance obligations to its franchisees and the state. This option, like posting a surety bond, allows the franchisor to collect its initial franchise fee once the franchise agreement is signed. However, in obtaining a performance guaranty, the company guaranteeing the franchisor’s financial and pre-opening obligations must typically submit its audited financial statements to the franchise regulator. This option is used less than the deferral and escrow options, as most companies are hesitant to become legally and financially responsible to the franchisor and its franchisees.
If a franchise regulator determines that a franchisor lacks sufficient working capital to meet its financial, pre-opening, and support obligations to its franchisees in the state, there are several options by which a franchisor may provide financial assurance to the state as a condition of registering or renewing its FDD. In some instances, a franchisor with insufficient working capital may avoid having to provide a form of financial assurance if the franchisor infuses more working capital to the company. Once done, the franchisor must submit updated, audited financial statements and request that the franchise regulator reconsider its decision to impose the financial assurance requirements. If upon reconsideration the regulator removes any imposed financial assurance obligation, the state may still impose requirements on the franchisor to prevent it from removing this infusion of capital. Overall, a franchisor should review the relevant state laws and regulations that impose financial assurance obligations on franchisors with insufficient working capital to determine the best option to fit its financial needs. Our dedicated attorneys could help you weigh your options and determine which best suits your needs and goals.