Financial Assurance, Franchise Fee Deferral, and Escrow Requirements when Registering a FDD
A financial assurance requirement is a financial obligation imposed on a franchisor by a state regulator as a condition for registering a franchise disclosure document (“FDD”).
Within certain franchise registration and filing states – most commonly California, Illinois, Maryland, Minnesota, Virginia, Washington – a financial assurance requirement may be imposed on your franchise system if the state examiner determines that, as evidenced by your financial statements, you do not possess sufficient working capital to satisfy your pre-opening training and support obligations to new franchisees. The state examiner will also evaluate Item 20 of your FDD to determine the number of franchises that have been sold and your anticipated training and pre-opening support obligations.
What is a Financial Assurance Requirement?
A financial assurance requirement is a condition imposed on a franchisor’s FDD registration by a state regulator. When a financial assurance requirement is imposed, the state regulator is questioning the franchisors financial ability to fund the franchisor’s pre-opening training and support obligations on behalf of franchisees.
How You Satisfy a Financial Assurance Requirement?
The state examiner imposing the financial assurance requirement will advise you of your options. Although each state varies, most commonly, you will be presented with selecting between one of the following 5 options:
- Increase Working Capital
Option 1 requires that you supplement and increase your working capital. Basically, you would be depositing and infusing more capital into your franchise company. The pros and cons of selecting this option include:
Pros – If you add sufficient working capital the state will withdraw its financial assurance requirement and you will be able to directly receive initial franchise fees at the time of signing the franchise agreement.
Cons – The capital may not be available to you. Also if you do infuse more capital into your franchise company you will be required to obtain an updated audited balance sheet.
- Guaranty by Parent or Affiliate
Option 2 requires that you have a well-capitalized parent or affiliated company guaranty your obligations to franchisees. the franchisors performance obligations to its franchisees. The pros and cons of selecting this option include:
Pros – If you have a parent or affiliate that is well capitalized and can make this guaranty the state will withdraw its financial assurance requirement and you will be able to directly receive initial franchise fees at the time of signing the franchise agreement.
Cons – You may not have a well-capitalized parent or affiliate and even if you do you may not want to subject this company to the legal liability of guaranteeing franchise obligations. Also, you will be required to submit audited financial statements of the company guaranteeing your obligations.
- Franchise Fee Deferral
Option 3 requires that you agree with the state and with your future franchisees within the state that payment of the initial franchise fee will be deferred and not paid by the franchisee until, depending on the state, the franchised business is opened or you have completed all of your pre-opening training and support obligations.
Pros – In terms of registering your FDD and responding to the state examiner, this is the easiest of all options. All that is required is an amendment to your FDD and franchise agreement and a response to the examiner.
Cons – You are deferring receipt of your initial franchise fee and run the risk of collections should the franchisee elect to not open or otherwise breach its obligations to you. Also, fee deferrals jeopardize broker relations and commissions.
- Escrow Initial Franchise Fee
Option 4 requires that you establish an escrow account with a third-party financial institution. Once the escrow account is established the franchisees initial franchise fee would be deposited into the escrow account and not released until, depending on the state, the franchisee has opened the franchised business or the franchisor has satisfied its pre-opening training and support obligations.
Pros – This option alleviates most of the collection risk in selecting a franchise fee deferral under option 3.
Cons – Selecting this option will take time and delay your FDD registration. There will be administrative costs associated with establishing the escrow account and having it approved by the state examiner. Also, as with a fee deferral, this option creates risk when working with brokers as the franchise fee will be unavailable to pay broker commissions.
- Post a Surety Bond
Option 5 requires that you purchase a surety bond from a licensed and authorized insurer to guarantee performance of your pre-opening obligations.
Pros – If you can cost-effectively purchase and obtain a surety bond, you will be able to directly receive initial franchise fees at the time of signing the franchise agreement.
Cons – Obtaining a surety bond is difficult and expensive. Also, issuance of a surety bond will be based, in part, on an evaluation of your financial and the same reason as to why the state examiner imposed a financial assurance requirement may be the same reason why you are denied a surety bond or why it may be cost prohibitive.
What Option is Most Commonly Selected by Emerging Franchisors?
Option 3 – franchise fee deferral. The reason is that satisfying this financial assurance requirement is relatively easy and, typically, does not delay the FDD registration process. Also, this is because, for most emerging franchisors, options 1 (increase working capital), 2 (guarantee by parent or affiliate), and 5 (post surety bond) are not economically viable.
In addition to Option 3 (franchise fee deferral), option 4 (escrow initial franchise fee) is a viable option. Although option 4 may delay the registration process as an escrow account is established, this option alleviates a significant portion of collection risks.
For more information about State Registrations, check out our interactive State Registration Map.