Should You Set Up a Corporation To Operate Your Franchise?

By Bradley  J. Hansen

For most franchisees, setting up a corporation can be one of the cheapest and most valuable investments they make during the operation of their franchise.  While most franchisees understand that a “corporation” offers some form of protection, many still have questions about the nature of the protection a corporation provides and what benefits they can receive from setting up a corporation.

What is a Corporation?

A corporation is a legal entity separate and apart from its owners, officers, directors and employees.  While most small businesses, including franchisees, incorporate for the purpose of achieving limited liability, there are certain circumstances under which the owners can nevertheless be held liable for a corporation’s debts.  These include circumstances when the corporation’s creditors are allowed to “pierce the corporate veil” and pursue the corporate owners personally.  As such, the law requires that corporations be operated in a way that does not ignore corporate formalities which could erode the corporation shield.  

Benefits of Setting Up a Corporation

In addition to the benefits offered by the “corporate shield”, a corporate entity may offer many other attractive qualities for small and large business owners.  For instance, depending on the corporate entity you set up, you can potentially avoid paying thousands of dollars a year in taxes, take advantage of deducting business losses, and structure beneficial health care and retirement plans.     

Franchisor’s Requirements

While most franchisors are relatively impartial about franchisees operating their franchise through a corporation, it is important to know that you will likely face many restrictions on how the corporation can be set up and operated.  Indeed, many franchisors may require that you set up as a specific corporate entity. 

Others may require that you sign the franchise agreement individually, then subsequently enter into a transfer and assignment agreement to the corporate entity.  This may entail signing releases and giving up other rights under your franchise agreement.  Most importantly, almost every franchisor will require that you sign a personal guaranty of the corporation’s obligations under the franchise agreement.  As a result, you get little “personal” protection from your franchisor.   

Conclusion

Creating a corporation is the cheapest way to avoid personal liability available under the law.  While corporations are not a magical solution to every business problem that you may face in the operation of your franchise, they can be excellent tools in protecting personal assets.  In setting up a corporation to operate your franchise, you should fully understand any requirements your franchisor may impose on you and what consequences you may face in complying with such obligations.  In doing so, you will be better prepared to make informed decisions about what corporate entity makes the right fit for your business.

The Anatomy of a Franchise Agreement – A Continuing Series

Transfers & Sales of Franchise Businesses
 

There are many reasons why a business owner may choose to sell his or her business.  Some may choose to sell in order to realize the profits from operating a successful business, while others may choose to sell in order to cut their losses.  In other instances, individuals may choose to sell based on age, health or other personal reasons.  In franchising, the reasons for selling are no different.  However the conditions and impediments imposed on a franchisee can be dramatically different from those involved in the sale of an independent business.

The Disclosure Documents

Before purchasing a franchise, franchisors are required to disclose in their Uniform Franchise Offering Circular the conditions of a sale or transfer of the franchise.  The franchisor is also required to direct the potential franchisee to what specific section or sections of the franchise agreement govern sales and transfers.  Here, a franchisee will find the many hoops that they typically must jump through before a sale or transfer can occur.

Planning for Your Sale or Transfer

Before deciding to sell your franchised business, you should take the time to closely scrutinize the restrictions and conditions you must meet before you can consummate a deal.  Many franchise agreements prohibit a franchisee from advertising the business for sale without first receiving approval from the franchisor. 

Your franchise agreement may also specify that you must submit information about the proposed transfer or sale several months before the planned transaction, meaning that you must plan well in advance of when you wish to transfer ownership or sell your business. Your failure to do so could result in the franchisor’s refusal to consent to the proposed sale or transfer. 

Conditions on the Sale or Transfer

Many franchise agreements require as a condition to any sale or transfer that the franchisee not be in “default” of its obligations under the agreement.  This means that all of your outstanding royalty and advertising payments must be satisfied, regardless of whether you dispute any of the charges.  You must also ensure that there are no outstanding quality assurance defaults.  This is especially important in quick service and hotel franchises.

Almost every franchise agreement contains some form of transfer fee that must be paid to the franchisor assuming the fee was disclosed in the offering circular and included in the franchise agreement.  In some instances, these fees can be deal breakers when you are trying to sell to a third-party.  Ultimately, if the fee is too high, your buyer could back out or you could end up eating it in the sale price just to close the deal.

In many franchise agreements, you are required to offer the sale of your business to the franchisor before the franchisor will agree to an assignment or sale of the business.  You should always be wary of clauses that permit the franchisor to drag its feet in responding to your offer.  If you have a potential buyer willing to purchase your business, but they must wait sixty or more days while your franchisor decides whether to purchase it, the buyer could get cold feet and back out of the deal.  Additionally, you may find that if you do not make the sale within six months that you must re-offer it to the franchisor.

Conclusion   

      Understanding the requirements and restrictions you face under your franchise agreement before you decide to sell or transfer your business can benefit you greatly.  At a minimum, it will help you get your chickens in row so that you are prepared for lengthy delays, negotiations and unforeseen situations that can negatively impact the sale of your business.  It will also help ensure a smooth and orderly transaction between you, your franchisor, and your buyer.

Case Updates: Recent Legal Decisions That Could Impact Franchisees

 

Dunkin’ Donuts, Inc. v. Sharif, Inc.

Dunkin’ Donuts recently succeeded on its termination claims against a former franchisee and successfully defended against the former franchisee’s claims that Dunkin’ unreasonably withheld its consent to a transfer of the franchise agreement. In finding for Dunkin’, the Court determined that Dunkin’ did not unreasonably withhold its consent in approving the transfer where the potential purchaser (an existing Dunkin’ franchisee) was in default of its existing agreement.
 

Birmingham News Co. v. Horn –

The Supreme Court of Alabama recently upheld a decision to hold a franchisor of newspaper dealers liable for promissory fraud. The former newspaper franchisees sued when their franchisor failed to renew their franchise agreements. The arbitrators ruled that the nonrenewal was unlawful even though the franchise agreements allowed for nonrenewal. The arbitrators based their decision on the parties’ course of dealing and the supplier’s representation that the agreement would be renewed unless good cause could be shown for nonrenewal. The arbitrators found that these representations amounted to fraud and awarded damages to the franchisees.
 

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The American Association of Franchisees and Dealers (AAFD) held its 2006 Annual Conference in Orlando, Florida April 30 – May 3, 2006. As a member and attorney on the AAFD’s LegaLine, Brad Hansen attended this year’s conference where franchisors, franchisees and vendors gathered to discuss legal and business issues facing today’s franchise world.

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