Are you planning to franchise in a state that imposes financial assurance requirements? Find out why these obligations exist and what they could mean for your business.
It’s no secret that franchise laws vary widely from state to state. With regulations and filing requirements fluctuating so much, registering or renewing a financial disclosure document (FDD) can often feel daunting for franchisors trying to navigate the franchising process in different states.
To complicate things further, several states impose additional obligations on franchisors related to the capital they have available to open franchise locations. While these requirements serve the legitimate purpose of financially protecting franchisees, they also impose additional obligations on franchisors related to working capital for the projected costs of pre-opening training and support.
As a franchisor, it’s important to have a solid understanding of what’s expected when it comes to your franchise system’s financial assurance obligations. Below, we’ll explore financial assurance requirements in more detail, including which states impose them and how to satisfy them.
What is a Financial Assurance Requirement?
A financial assurance requirement is a condition imposed on a franchisor by a state regulator that limits the franchisor’s ability to register their FDD in that state until the condition is satisfied. Typically, these requirements are related to the working capital of a franchisor and their ability to adequately support franchisees during the pre-opening process.
Why do Financial Assurance Requirements Exist?
Financial assurance requirements are designed to protect franchisees from receiving insufficient support during the franchising process. These state-imposed requirements ensure that a franchisor has sufficient working capital to satisfy pre-opening training, support and other financial obligations related to a franchisee’s opening and operating of a franchised location within specific states.
Which States Impose Financial Assurance Requirements?
Certain states, called the Franchise Registration States, subject franchisors to supplemental regulations that require franchisors to register their FDD with a state regulator prior to offering or selling franchise opportunities. Although some of the Franchise Registration States impose financial assurance requirements during the FDD review process, not all of them do.
Generally, the most common states where financial assurance requirements are imposed include California, Hawaii, Illinois, Maryland, Minnesota, North Dakota, Virginia, and Washington. In some situations, South Dakota may also impose financial assurance requirements.
While New York does not impose financial assurance requirements, the state does have franchise capitalization requirements. In a situation where a state examiner determines that a franchisor doesn’t have sufficient capital while reviewing their FDD during the registration or renewal process, the franchisor will be required to add a specific risk factor to their FDD State Cover Page.
Undercapitalized franchisors in New York may also have other solutions available to them including deferral of initial fees, surety bonds or performance guarantees. If you’re planning to franchise in New York, a qualified New York franchise attorney can help you evaluate your options.
When are Financial Assurance Requirements Imposed?
Because the support of a franchisor is critical to the success of a franchise system, franchisors must be adequately capitalized to provide training and ongoing support to franchisees throughout the franchising process.
During the FDD registration or renewal process, if a state regulator determines that a franchisor’s working capital isn’t sufficient to satisfy the pre-opening training and support needs of franchisees in the state after reviewing a franchisor’s Item 21 financial statements, the regulator may impose financial assurance requirements on the franchisor as a condition for registration.
Item 21 Financial Disclosures
Under the federal Franchise Rule, franchisors are required to provide audited financial statements from their company’s most recently completed fiscal three year period within Item 21 of their FDD. These disclosures must include income statements, cash flow statements and balance sheets. They must also be prepared by a peer-reviewed Certified Public Accountant.
In states that impose financial assurance requirements, state examiners will review a franchisor’s Item 21 financial disclosures during the FDD registration or renewal process to determine whether the franchisor is sufficiently capitalized to support franchisees in that state.
If a state examiner determines that a franchisor is insolvent or lacks sufficient working capital to support franchisees after reviewing their Item 21 disclosures, the state regulator will then impose financial assurance requirements as a condition for registering the FDD and offering and selling franchise opportunities in the state.
How Much Working Capital is Enough?
Because the criteria for financial assurance requirements differ by state, in most states there is no specific dollar amount for franchisors to be considered solvent or sufficiently capitalized.
The exception is Virginia – the only state that has yet established a clear standard for financial assurance requirements. Under Section 13.1-562 of the Virginia Retail Franchising Act, a financial assurance requirement may be imposed in situations where an examiner has determined that a franchisor is “insolvent” or “in danger of becoming insolvent.” Per this standard, the state of insolvency exists when either “liabilities exceed assets” or the franchisor cannot satisfy its obligations when they mature.
In other states that impose financial assurance requirements, franchisors can generally expect state examiners to look at the following factors when determining whether a franchisor is sufficiently capitalized:
The amount of a franchisor’s available working capital.
The ratio of a franchisor’s working capital to liabilities.
The amount of shareholders equity that, typically, must be more than $100,000.
Projected franchise sales within the state.
The franchisor’s history of operations within the state.
How to Satisfy Financial Assurance Requirements
When a state regulator imposes financial assurance requirements on a franchisor, the franchisor is required to satisfy those obligations as a condition for FDD registration in that state. To satisfy those requirements, franchisors will agree to one of the following:
Deferral of Initial Franchise Fees
One of the most common options for satisfying financial assurance requirements involves agreeing to defer initial franchise fees. While this is the easiest solution on the list and requires only an amendment to the FDD and franchise agreement, deferral still carries risks. If the franchisee doesn’t open, is unwilling to pay their fees, or otherwise breaches their obligations, franchisors risk collections. This option also carries the risk of threatening broker relations since the broker fee will be temporarily unavailable.
Escrow for Initial Franchise Fees
Another option for franchisors to satisfy their financial assurance requirements is to agree to deposit the initial franchise fees into an escrow account with a state-approved bank. While this option mitigates the risk of collections, it can carry additional fees for the franchisor in addition to delaying FDD registration and jeopardizing broker relationships and commissions.
Posting of a Surety Bond
On the surface, the posting of a surety bond – a written agreement that a franchisor will perform their pre-opening training and support obligations to the franchisee for an amount determined by the state regulator – seems like the best option for franchisors to satisfy financial assurance requirements.
In practice, however, these bonds are expensive and difficult to procure. They are also often based on the franchisor’s financial situation – which, for undercapitalized franchisors, can sometimes pose a problem. Adding to the complexity, surety bonds can also significantly delay FDD registration.
As a franchisor, another option to satisfy financial assurance requirements is to have another company guarantee your franchise’s financial and performance obligations to the franchisee. For franchisors with a well-capitalized affiliate or parent, that individual could also provide this guarantee.
While this option holds the advantage of providing immediate access to initial franchise fees, franchisors should understand that they will be legally and financially liable to the guarantor. The guarantor (the other company, affiliate or parent) will also be legally and financially responsible to your franchisees and will be required to provide audited financial documents to the state.
Increasing Working Capital
As a franchisor, increasing the working capital of your franchise can help you meet your financial obligations to your franchisees. While this method isn’t technically a financial assurance requirement remedy, it can improve your financial situation in the eyes of a state examiner.
After infusing additional capital into the franchise, as a franchisor, you will be required to submit updated, audited financial statements with a request for the state regulator to reconsider the financial assurance requirements. It’s important to note that even if a regulator does reconsider the requirements, they may still impose other legal requirements preventing you from removing the capital from the franchise after their review.
If you’re ready to register or renew your FDD in a state that imposes financial assurance requirements, we can help you prepare. Contact us to find out how we can assist you in evaluating the best options for satisfying your financial assurance obligations.