June 2013 Archives

This is not a franchise post, but if you have been reading my blog for some time, you will know that it's on an issue that is important to me: film incentives for Nevada. 

As I've previously written, Nevada was one of the few states in the country without tax incentives for companies that film their movies or television shows here.  

It's always been my opinion that the lack of these incentives has discouraged companies from filming here -- even when the action is set in Nevada.

Fortunately, that is all changing due to recent action from our legislature.  The Nevada legislature recently passed SB 165, which was signed into law by Governor Sandoval on June 11, 2013. 

As a result, beginning on January 1, 2014, Nevada will offer tax credits to motion picture, television, and commercial productions that shoot at least 60% of their production here in Nevada and spend between $500,000 and $40 million in the state.

Those companies are eligible to earn a transferrable tax credit worth 15-19% of their in-state qualified expenses. These "qualified expenses" include Nevada cast members, labor, crew members, and other Nevada expenditures.

I am really looking forward to watching the film industry in Nevada grow!

You can read the text of the bill by clicking here.  

A federal court in Hawaii recently issued an opinion finding that a distribution agreement is not a franchise under Hawaii's Franchise Investment Law. The defendant in the case, Pace-O-Matic ("Pace") is the manufacturer of gaming devices, which include "skill stop" gambling machines.

The plaintiff, Prim, LLC entered into a distribution agreement with Pace to become the exclusive distributor for Pace's "amusement devices" in an area that included Hawaii.

In October 2010, Pace sent Prim a notice of default, and terminated the exclusivity portion of the agreement between the parties. Prim sued in the U.S. District Court for the District of Hawaii. Among other things, Prim asserted that Pace violated Hawaii's Franchise Investment Law (Haw. Rev. Stat. §480-2 et seq.) by failing to deal with Prim in good faith and by terminating Prim's franchise without good cause.

Pace sought summary judgment on that claim, arguing that there was never a franchise between Prim and Pace, and that Prim never paid Pace a franchise fee.

The Court noted that, under Hawaii law, a franchise consists of an agreement "in which a person grants to another person, a license to use a trade name, service mark, trademark, logotype or related characteristic... and in which the franchisee is required to pay, directly or indirectly, a franchise fee." Haw. Rev. Stat. §482E-2.

Examining the Distribution Agreement, the Court found that the contract did not provide that Prim could use Pace's name, trademarks, or proprietary software, and that instead Prim's role under the contract was to "purchase games" from Pace and "exercise its best efforts to develop markets for the games and distribute" them.

Citing the U.S. Court of Appeals for the Ninth Circuit's decision in Gabana Gulf Distribution, Ltd. v. Gap Int'l Sales, Inc., 343 Fed. App'x 258, 259 (9th Cir. 2009), the Court noted that a distributorship is "not the same thing as a franchise relationship." In this regard, the Court noted that "[t]he very essence of a franchise relationship is that the franchisee represents the franchise to the public; a franchise is not created whenever one company purchases and distributes another company's products."

Considering that the Distribution Agreement only allowed Prim to purchase Pace's products, and did not permit Prim to "substantially associate" with Pace's trademarks, the Court found that the Distribution Agreement did not create a franchise.

The Court also found that Prim did not pay Pace a franchise fee. Under Hawaii law, a franchise fee is "any fee or charge that a franchisee . . . is required to pay or agrees to pay for the right to enter into a business or to continue a business under a franchise agreement," but does not include "the purchase or agreement to purchase goods at a bona fide wholesale price." Haw. Rev. Stat. §482E-2.

The Court cited its previous opinion in JJCO, Inc. v. Isuzu Motors America, Inc., 2009 WL 1444103, at *4 (D. Haw. 2009), aff'd, 2012 WL 2584294 (9th Cir. July 5, 2012) for the "guiding principle is that, unless the expenses result in an unrecoverable investment in the franchisor, they should not normally be considered a fee." The Court found no evidence suggesting that the money paid by Prim to Pace for products was anything other than a bona fide wholesale price, or that it constituted an "unrecoverable investment" in Pace.

Based on its finding that the Distribution Agreement did not create a "franchise" within the meaning of Hawaii law, the Court granted summary judgment for Pace on that claim.

The case is validation for companies that operate through networks of independent distributors.  Where the distributor: (1) is not permitted to "substantially associate" its business with the manufacturer; and/or (2) pays only the bona fide wholesale price for its merchandise (and no other form of compensation) to the manufacturer, the relationship will typically not be considered a franchise under state laws. 

That being said, the "hidden franchise" problem can exist any time a business wishes to structure its model to avoid being considered a franchise. There are many traps for unwary business owners in this area of the law; as a result, it's critically important for a distribution business seeking to avoid being labeled as a franchise to consult with an attorney experienced in franchising before using any particular business model.

What makes a person think about taking his or her present business and franchising it, becoming a franchisor? It isn't just the fact that they have heard of Ray Kroc and what he did with Mc Donalds or the miraculous story of Wendy's having come into what everyone thought was an already overcrowded hamburger franchise universe, having to practically give away their first few franchises, and then eventually becoming another superstar franchise organization.

Of course, every franchise salesperson claims that his or her franchise offering is going to be the McDonald's of the widget industry, as McDonald's has become the quintessential term for ultimate franchising success.

No. It takes more than that. We think the typical potential franchisor has a profile that goes beyond mere anecdotal celebrity references to the rich and famous.

An irreducible minimum requirement, before anyone is eligible to even think franchising, is a business operator who had at least several years successful experience operating the 'model'. The 'Model' is not the franchise company. The model is the business that the franchisees will operate if the concept is sound. Throughout this article you must constantly distinguish between the model, the business to be franchised, and the franchising company. They are completely different kinds of businesses. The failure to constantly keep this distinction in mind is one of the leading causes of early franchisor failures.

In all likelihood, a reasonably franchisable concept will be operated by its owner in multiple locations, all running successfully. This evidences that the concept is replicable and that it can be run by managers who can be trained. If the owner has to be everywhere all the time to keep the multiple units afloat, that is a strong sign of replication difficulty.

Either the system is too complicated to teach to a lot of people, or it is idiosyncratic, the extension of the owner's unique personality, unlikely to be successfully replicated with others at the helms of the various units.

In such a scenario, it is to be expected that customers have helped plant the seed of franchisability in the owner's mind. People come in, have the customer experience for that business, and exclaim their pleasure, their having been impressed with the idea and the manner of its execution, and their belief that it would be very nice to have such a business in their home town. 'Have you ever thought of franchising this?' will have been asked many times.

Eventually, the owner's thought processes turn into the franchise thinking neighborhood, and he starts talking to people who are in franchising, no matter at what level they may happen to live.

The model owner starts hearing money talk - initial fees of $30,000, royalties of 6% - 8% of gross sales, an advertising fund swollen with franchisee contributions of another 2% of gross sales, area development agreements through which entire states are sold off with large initial fees and a contractual requirement to build out and open a substantial number of stores within a very short time.

The model owner goes to the library and reads up on success stories of multi-millionaires who made it big from franchising.

There are no stories of franchisor failures - wrong spin control. In the world of franchise literature, everything is wonderful all the time, prospects are always bright, franchisor organizations constantly bestow awards upon their membership at conventions held in exotic places.

Soon, the model owner is slavering over a virtual feast of franchising good fortune and is ready to write checks to get the structure established, to get to the first sale. The entire focus becomes sales fixed, there is a great hurry to get to that first closing, and carts get put in front of horses.

The franchise sale is the last step in establishing a potentially successful franchise system, not the first. To be sure, even after the sale there are details like franchisee training, site selection and store opening assistance, but even these post sale responsibilities have to be prepared and tested well before the first sale closes.

Where does one start, then, in deciding to franchise. One starts with trying to find the answers to the feasibility issue.

Albeit I have a very good business that I have operated successfully in several locations for several years, how can I find out whether this concept, configured as I have configured my own businesses, has very good potential as a vehicle for franchising? If more people began here, at the real beginning, fewer franchisors would be in failure and fewer franchisees would have wasted their investments in an incompetently evaluated franchise opportunity.

Unfortunately, so many new franchisors start with lawyers drawing up contracts and disclosure documents, a fantasy trip with zero value and enormous potential for harm.

What the lawyers have never learned is that the legal work has to match the business concept, not vice versa.

The legal work is done last. Then it can, if done by attorneys who understand the franchising business as well as simply being able to draft contracts, become a charter that has rational positive value to the franchise relationship rather than merely being some set of rules cut and pasted out of somebody else's franchise documents, that most surely won't fit the situation to which it is being applied in many very difficult areas, and that become litigation breeding machines.

The business comes first, not the legal work.  (Part 1 of a four-part series on Why New Franchises Fail.)

The franchisor may negotiate with a prospect, subject to the limitations discussed below.