Franchising is a popular way to take advantage of a promising business activity but is subject to regulation at both the federal and state level. The regulations are similar to those applicable to securities' registrations. CPAs are a natural to assist franchisors in planning and executing a franchise network.

In the U.S., franchising is a highly regulated method of doing business. The F.T.C. has detailed regulations requiring pre-sale disclosures by franchisors. In addition, approximately one third of the states have laws mandating registration and pre-sale disclosures for a franchise.

A franchisor's financial data is used by government regulators, as well as prospective franchisees, service providers, suppliers, and banks. This data helps these users make decisions to approve a franchisor's registration or sales program, buy a franchise, lend money, or provide goods. Entrepreneurs and managers also need this information to create, plan, and control their ventures.

Accountants have a key role in any successful franchise program. Audit, tax and consulting services are critical to a successful franchise. Accountants who perform these tasks well can help franchisors earn profits, obtain approval for their offering circulars, operate effectively, avoid litigation, and prevail when disputes cannot be avoided.

To serve the franchisor the accountant should be familiar with key aspects of the franchise program and governing regulations. The franchisor's lawyer can provide information in these areas. However, the lawyer may be new at representing franchisors or assume the accountant already has this knowledge and thereby not provide all the information the accountant could use to help the franchisor.

THE FRANCHISOR'S BUSINESS PLAN

The basic ingredient of a franchise operation is a successful product or service. Many people will ask the successful entrepreneur if franchises are available. This often encourages the business owner to consider franchising. Other entrepreneurs, on their own initiative, believe that business concepts that have worked for them can be successfully franchised. However as this interest develops, the entrepreneur may find a lack of experience needed to be a successful franchisor.

A key way for accountants to help a prospective franchisor is to encourage preparation of a business plan. The plan helps the franchisor set and reach goals. It also helps the lawyer draft a franchise agreement and offering circular. A good plan even simplifies the process of obtaining government approvals needed to offer and sell franchises.

The structure of a franchisor's business plan resembles those of other new ventures. It is often divided into sections describing the purposes of the plan, background of the venture, analysis of the relevant product and market, description of management's experience, and historical and prospective financial data.

The franchisor's business plan has several purposes. Its primary purpose for the franchisor is to determine the viability of operating a franchise program and to help develop a strategy for success. The business plan may be presented to prospective management personnel, potential lenders and investors, lessors, suppliers and others. However, it must not be distributed to prospective franchisees. Franchise laws prohibit distribution of most forms of information to prospective franchisees unless it is an offering circular complying with strict Federal and state requirements. Even franchise advertising must be filed with government regulators before distribution in California and most other states that have franchise laws.

Strict restrictions limit the use of financial data, such as earnings histories or prospective financial statements, in the offering documents. The Federal and state laws governing use of earnings and prospective financial statements have detailed rules for the format of this data, the disclaimers accompanying it, how the data must be collected, and when and how it may be given to prospective franchisees.

Giving a business plan to a prospective franchisee may automatically violate the franchise laws. For example, one court ruled that improperly providing information incurably taints any sale of a franchise to that recipient. If this rule were followed, in some states a franchisee who improperly receives a franchisor's business plan could have an automatic right to undo any purchase of a franchise.

The business plan is for the benefit of the franchisor and not the franchisee. Preparing the business plan helps the new franchisor develop goals, recognize potential obstacles, fine-tune the franchise program, and reduce the risk of having dissatisfied franchisees. The business plan helps the franchisor focus on goals and plans, while improving the ability to communicate these through the offering documents.

Preparing the business plan before the new franchisor meets with legal counsel also has benefits. A well-prepared business plan helps familiarize the lawyer with the franchisor's goals. It helps the lawyer preparing franchise agreements and disclosure documents. Any step that reduces the number of drafts of these documents has the additional benefit of reducing legal fees and the time to enlist franchisees into the program.

The business plan's financial data should include prospective financial statements. Successful franchisors plan not only for their own performance but also for performance of franchisees. Although the data cannot be provided to prospective franchisees, it should include prospective financial results for franchisees.

Developing prospective financial statements for franchisees helps the franchisor structure the franchise program. The process facilitates determining how much to charge as initial franchise fees, royalties, advertising fund contributions, and fees for other services to be provided. Calculating various fee structures and performance levels aids in developing a program yielding revenues and profit margins satisfactory to franchisees TABULAR DATA OMITTED as well as the franchisor.

Prospective financial statements help evaluate the level of the franchisees' initial investment, the identification of target franchisees and the evaluation of how franchisee investments will be financed.

Prospective financial statements also assist the franchisor in deciding which products and services are best suited for franchisees to offer, the size and layout of franchisee premises, the number and type of personnel, and similar information franchisees expect the franchisor to provide.

Professional Standards

In assisting the franchisor the accountant must maintain an eye on professional standards. For example, if the accountant becomes associated with a financial forecast, he or she should be aware of the 1986 Guide for Prospective Financial Statements, and various Statements of Position that were subsequently issued by the AICPA. CPAs should not be wary of such association but view it as an opportunity for additional service.

CAPITALIZATION

An important financial consideration for new franchisors is the amount of capital needed to achieve a successful operation and to satisfy regulatory requirements. Many state regulators refuse to grant registrations to franchisors they deem undercapitalized. Other regulators will grant registration subject to performance bond, surety bond, escrow, or guaranty requirements.

The amount of capital a franchisor needs depends on numerous variables. In estimating the amount of necessary capital, the franchisor needs to consider the nature of the business, the level of investment by franchisees, the number of franchises expected to be sold in the foreseeable future and the specific needs for start-up expenses, debt service, equipment, and real estate.

Some regulators use internal rules of thumb to decide how much capital a franchisor should have. A test used in California involves three variables:

* costs incurred in granting new franchises, such as expenses for site selection, training, travel and supervising the new franchisee;

* the estimated number of franchises to be granted in the foreseeable future; and

* the franchisor's total outstanding liabilities.

The first two items indicate the minimum capital the franchisor should possess to provide services to new franchisees. The franchisor's liquid assets, after subtracting total liabilities, should exceed this minimum capital amount.

ESTIMATING THE FRANCHISEE'S INITIAL INVESTMENT

Franchisors must disclose to prospective franchisees in writing extensive information about their program. Usually, the disclosure is provided by a "Uniform Franchise Offering Circular." Another document, called the "FTC Format," is allowed in many states, but is used less often.

The disclosure laws are modeled after state and Federal securities laws. Required franchise disclosures loosely track state and federal government disclosures for securities offerings.

One of the first financial data requirements for the Franchise Offering Circular is a table disclosing a new franchisee's anticipated initial investment. Detailed footnotes describing the key assumptions for the data are often included. The accountant should carefully evaluate the source and accuracy of the data in the table and footnotes to help the franchisor avoid claims by disappointed franchisees that the initial investment information was not accurate.

FINANCIAL STATEMENTS

Disclosure laws require the offering prospectus to include the franchisor's financial statements. These must be prepared in accordance with GAAP. The disclosure document must include audited statements for the preceding three years, or such shorter period the franchisor has been in existence, and interim financial statements (which need not be audited) dated within 90 days of filing the proposed offering circular with the government.

Normally, each of the following financial statements of the franchisor must be part of the offering circular:

* A balance sheet, which need not be audited, dated within 90 days of filing the proposed offering circular in that state. An unaudited interim balance sheet, or audited fiscal year-end balance sheet, not older than 90 days, could satisfy this requirement.

* If an unaudited balance sheet is used to meet the above requirement, an audited balance sheet dated as of the end of the franchisor's last fiscal year ending 90 days or more before the filing date of the offering circular.

* Audited profit and loss statements for the three fiscal years ending with the date of the most recent audited balance sheet described above.

* Interim profit and loss statement for the period, if any, between the close of the last fiscal year and the date of the first balance sheet described above.

Some franchisors are wholly- or majority-owned subsidiaries of other companies. Some states permit the offering circular to include the above financial statements of the parent company. When this is allowed, financial statements of the subsidiary franchisor, which may be unaudited, are still filed with the state but not included with the offering circular. California is an exception, and the subsidiary franchisor's unaudited statements are included in the offering circular. An additional condition to this procedure requires the parent company to guaranty performance of the franchisor's obligations.

Some franchisors own the securities of other corporations. In this situation, financial statements should be included on a consolidated basis. For example, regulations of the California Commissioner of Corporations require that when the franchisor owns at least 50% of the outstanding voting securities of a corporation, the financial statement must reflect, on a consolidated basis, the financial condition of the franchisor and each subsidiary.

States can require that the offering circular include a separate financial statement for each entity related to the franchisor. States can also require the offering circular to include financial statements of any company that controls 80% or more of the franchisor.

Annual Updates and Renewals

In some states the franchisor's offering circular must be updated annually. Other states have a slightly different rule, requiring the franchisor to file an annual report with the agency that regulates franchisors. Both kinds of annual filings include updated financial statements. The accountant should consider adopting a reminder system so that the annual audit occurs in sufficient time to avoid delay in renewing the franchise registration. Generally, the franchisor has no more than 90 days to prepare a revised disclosure document to provide prospective franchisees.

Some franchisors find the timing of the annual renewal or annual report inconvenient in relation to their fiscal year. State agencies that regulate franchises will usually cooperate with the franchisor to establish a registration period that coincides with the franchisor's fiscal year, or that is otherwise convenient for the franchisor.

The accountant can assist the franchisor in selecting a time during the year when it will be convenient to make the annual filing. If possible, the accountant, along with legal counsel, should help the franchisor select an appropriate fiscal year.

The state regulator will require a manually signed written consent from the auditor for use of the audit report in the offering circular. The accountant should expect the franchisor's counsel to request the consent.

Disclosure of Material Changes

The franchise offering circular may need to be updated more often than yearly. It must be updated whenever there is a material change in its information. Generally, a material change is any fact, circumstance or set of conditions having a substantial likelihood of influencing a reasonable franchisee or reasonable prospective franchisee in making a significant decision relating to the franchise, or that has a significant financial impact on a franchisee or prospective franchisee.

Some states address the concept of materiality, and thus, the concept of a material change in the offering circular's information, in more detail. For example, regulations in Illinois state that, "a decrease in the franchisor's income or net worth" is an example of a change that may be considered material.

The accountant should alert the franchisor whenever he or she becomes aware that a material change in, or affecting the franchisor has taken place or is about to occur. The accountant need not limit this notification to material changes in the franchisor's financial condition or operating results. However, these are areas that the accountant may recognize since these kinds of events or changes may be reflected in the franchisor's annual or interim financial statements.

* The author thanks David Laufer, Esq. and Wiliam C. Staley, Esq. of Kindel & Anderson, and John Smither, CPA, of Ernst & Young, for their valuable comments on drafts of this article.

David Gurnick is with Kindel & Anderson, a law firm in Los Angeles, California. He is a member of the American Bar Association Forum on Franchising and is active in the Los Angeles County Bar Association.