“Tax, Liability Issues go Hand-In-Hand With Multi-Unit Operation”		«BACK
	by Dennis L. Monroe
	from Franchise Times Articles,June-July 2000 Issue

This article is intended to provide the reader with an understanding of what franchisors may require and ways to work through what may seem to be unreasonable requirements. We will discuss three areas regarding financing and capital structure.

1) Capital Structure. What will the franchisor require of the franchisee's capital structure in association with obtaining adequate funds for acquisition and development?

2) Legal Structure. What kind of legal structures will the franchisor allow?

3) Obtaining Approval for Structure Change. How does the franchisee provide for approval of changes in the future from its franchisor?

Capital Structure. Generally, capital structure can be divided into two areas: (a) the equity requirements a franchisor may impose on a franchisee as it relates to acquiring and developing stores; and (b) what kind of ownership will be allowed in the franchisee entity.

Equity Requirements. Most franchisors have a requirement that any unit opened or acquired can be financed only to the extent of 75 or 80 percent of the cost, including all soft costs. This means a 20 to 25 percent equity injection is required of a franchisee. The idea behind the equity requirement is that a franchisee should not be under-capitalized and thus run out of money if the unit or acquisition does not perform as expected.

What is equity? Obviously, the franchisor would like to see a pure cash infusion by the operating franchisee. In many cases this is not realistic. As we have discussed in previous articles, one of the most user-friendly types of financing available is mezzanine financing. Mezzanine financing looks like equity but bears interest and has a payback. Many franchisors are fairly sophisticated and will allow mezzanine financing to qualify as equity. But there are other franchisors who have put burdensome restrictions on the use of mezzanine financing and will only allow the mezzanine financing to qualify as equity if it does not have any type of current interest payment, has no required principal payments, and the mezzanine lender must stand still for a period of five to seven years. This is not realistic in today's lending market; however, many franchisors still persist in this approach.

A number of franchisors are taking a somewhat more progressive approach and allowing the multi-unit operator, when developing new stores or making acquisitions, to meet the equity requirements by use of embedded equity (i.e., permitting equity in existing stores to qualify for the equity requirements of newly developed or acquired stores). This is accomplished through a valuation process, normally using a store operating profit multiple less the debt. If the value of the existing stores exceeds the present equity requirement, then the surplus is used for the equity requirements in new stores.

From a tax standpoint, many franchisees like to make shareholder loans in order to satisfy the franchisor's equity requirements. In effect, these are equivalent to equity contributions by the franchisee, but, for certain tax reasons, are preferable to pure equity. A sophisticated franchisor should view shareholder loans as equity. In many cases, the franchisor will want the franchisee to sign a standby agreement providing a stand still of all repayments on these loans until there is an adequate seasoning of the stores and a determination of adequate resources for the franchisee's business.

In addition to the above equity requirements, often the franchisor wants the franchisee to demonstrate on a proforma basis that the profits from the new store or proposed acquisition will be able to service all of the fixed charges associated with the units. The franchisor usually defines "fixed charges" as rents, royalties, and senior debt payments. This is another example of the franchisor being actively involved in the capital structure and financing of the franchisee's business.

Ownership Requirements. Most franchisors have a requirement that any person with voting rights in the franchisee entity must sign on the franchise agreement. This franchisor requirement is changing. One of the first major franchisors to make the change was Burger King. A number of years ago, Burger King established an entity franchise approach in which the franchisee was the entity and not the individual owner. Many other franchisors still demand the franchise be in the individual operator's name. Therefore, when the franchisee approachs potential investors, the franchisor should be consulted to assure that an investor, even with a non-voting interest, is not required to incur direct liability under the franchise agreement. Most franchisors are allowing more creative ownership of the franchisee, such as in trusts, partnerships and, at times, even private foundations.

Legal Structure. Now that we have discussed capital structure, let us discuss the legal structure. Franchisors have always been actively involved in prescribing the type of legal structure a franchisee can use. Most franchisors still allow an individual franchisee to operate his or her businesses as a sole proprietorship. In addition, all franchisors allow their franchisees to operate their businesses as a corporation. The corporation can be a C corporation (taxed as its own entity) or an S corporation (which allows a flow-through of tax attributes to the shareholders).

Most franchisors now permit the use of limited liability companies ("LLC"). In many cases the LLC seems to be the best vehicle for operating a franchise business. The LLC allows flexibility and favorable tax treatment. However, the LLC may not be appropriate if the franchisee is raising equity. In that case, a C corporation is generally more desirable.

In addition, most franchisors allow the real estate used by the franchisee in its operations to be owned separately. The real estate is normally held in some type of partnership-either a limited partnership, a general partnership or an LLC. We believe this is the appropriate structure to provide flexibility and optimum tax savings.

Obtaining Approval for Structure Change. Most franchisors have requirements relating to the governing documents (the bylaws or operating agreements) of either a corporation, a partnership, or an LLC. For example, one requirement can be that the governing documents must provide that the entity's purposes for existence be limited to operating the franchisor's concept. In addition, the franchisor normally requires the governing documents specifically provide for the franchisor's right of first refusal and that owner's rights are subject to the franchisor's rights.

Franchisors are often suspicious of changes in the franchisee's corporate ownership structure. Franchisors will require approval of any change in the ownership structure of the company. In addition, this change may result in a triggering of a right of first refusal in favor of the franchisor. Sometimes a franchisee may be unaware of the franchisor's rights. For example, a transfer of the real estate by the franchisee to a separately controlled entity may trigger the franchisor's right of first refusal, even though ownership of the store operations remains unchanged.

In conclusion, keep these four key elements in mind: (1) it is important for franchisees to educate themselves as to the franchisor's requirements related to capital formation and legal structure; (2) it may be necessary to push the franchisor into the 21st century as to capital formation and legal ownership; (3) look for ways to adhere to the franchisor's requirements, but always make sure you are taking advantage of all the latitude the franchisor can give regarding structure; and (4) get pre-approval from the franchisor as to intended future corporate changes.

The entire area of franchisor/franchisee relationships requires the help of competent lawyers and accountants who understand franchisor requirements and who work in this industry. Make sure you consult appropriate advisors before starting a franchised business.

Dennis L. Monroe <../ourpeople/monroe.html> is a partner in the law firm of Krass Monroe, P.A. specializing in the multi-unit franchise mergers and acquisitions financing and tax areas. The firm is located at 1650 West 82nd Street, Suite 1100, Minneapolis, MN 55431, (952) 885-5999.