|
Something
we attempt to do in this column on a monthly basis is
to provide ideas in structuring and financing growing
companies. One issue that often comes up when a company
decides to franchise is what should the company’s optimum structure be? Many companies often franchise too early. These companies franchise before they have been adequately capitalized or planned a structure for the future. Often, these companies have not given a great deal of thought to both the legal and financial structure of their business. Further, they have not answered the basic question of what entity or entities should hold the business “concept” assets.
This question is much simpler for most public companies,
which need to be fairly concise and have all of their
assets in one entity.
Let’s look at the optimum structure for a franchisor. This structure creates flexibility and provides optimum value. In structuring a franchisor company, it is important to keep in mind the company’s future goals in the context of a consolidated picture for the potential investor community. The following three entity structures are what I like to see in a franchisor:
1. It is important to develop the corporate stores so as to prove out the concept. A separate entity needs to be set up to hold the assets of these stores and operate this business. The people running these corporate stores should be compensated as if they are running a franchisee business. (Note: This is an entirely different business than the franchisor.) These corporate stores, more often than not, are the proving grounds for the concept and may be the single most profitable aspect of the business enterprise.
2. The franchisor business should be a separate entity (assuming that it is adequately capitalized to meet state filing requirements). The franchisor’s intellectual property should be in this entity. (Intellectual property includes trade names, trade dress, concept rights, know-how’s, and proprietary information.) Furthermore, this entity will require an audit, so the entity should be kept as clean as possible of inter-company transactions, excess values for intangibles and shareholder loans (both from shareholders to the company and from the company to shareholders). This entity should have appropriate liquidity and positive equity. The liquidity and equity requirements are crucial for obtaining state franchising approval. Additionally, the cleaner your company is in terms of having the fewest liabilities (particularly contingent liabilities), the easier your audit will be. Moreover, a cleaner company will also make it easier for a potential franchisee to understand the structure of your company. This entity can be a wholly-owned subsidiary or part of a holding company, a corporation, or a limited liability company. The two best options (except in the State of Texas ) are a corporation (whether “C” or “S”) or a limited liability company (“LLC”), preferably formed in the State of Delaware . The LLC structure may create an issue for certain investors; however, starting with an LLC may create favorable tax benefits and an LLC can always be incorporated (whereas it is very difficult to convert from a corporation to an LLC).
3. A franchisor needs a separate entity to hold the real estate. This entity would lease the real estate to the store operating company (or in the case of a franchisor that needs to have office space, an office building lease). In many cases the real estate is an asset that does not have the same type of growth potential as that of operating assets; therefore, segregating real estate is a good idea. If necessary, real estate can always be rolled later into an operating entity, but spinning off real estate is very problematic. By keeping the real estate in a separate entity, one may be able to show a higher return on assets for both the operating and franchise company. Furthermore, with a real estate entity, one can implement a sales/leaseback and contain the tax issues on the sale to this entity, and also the tax benefits of depreciation..
In thinking through the entire structure, the franchisor needs to keep in mind the new accounting rule changes, particularly FIN 46 which provides that certain activities require a consolidation with another entity. This can be particularly problematic in the franchise industry as the accounting rules are presently unclear as to what is and what is not included-particularly for joint ventures between the franchisor and franchisees. Therefore, the franchisor needs to be very conscious of these interlocking relationships that may create consolidation problems that could bring in liabilities which may adversely affect the reported financial strength of the company.
In summary, the best approach seems to be to structure the company so that the various aspects of the business are segregated in separate entities. Separate entities can always be rolled together at a later time. Starting out with separate entities is much easier and more beneficial than having to uncouple the various functions of the business in the future.
Dennis L. Monroe is a partner and the chairman of Krass Monroe, P.A., a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation. The firm is located at 8000 Norman Center Drive, Suite 1000, Minneapolis, MN 55437-1178; (952) 885-5999. For previously published articles and information on Krass Monroe, please refer to our Web site at www.krassmonroe.com .
|
