Some states will look at a new franchisor, or in their perception an undercapitalized franchisor, and require what the industry calls “financial assurance.” A financial assurance provides “assurance” to the state regulators that you, as the franchisor, will have an incentive to perform your obligations and won’t go broke before the franchisee opens, or if you do go broke before the franchisee opens, the franchisee will not lose their franchise fee. Typically, although this is more of a guideline and not a rule, the states like to see at least $100,000 in non-borrowed cash on your balance sheet if you are a new franchisor or at least $100,000 net worth if you have been franchising for at least a year.

It is worth noting that not only do the state regulators look at your balance sheet, but your prospects do as well. So, a new franchisor with $5,000 in the bank who is looking to charge franchisees a $30,000 franchise fee will not appear as strong as a well-capitalized startup franchisor.

If you have a financial assurance requirement in place in a state, you will see an orange outline around the state. This should serve to remind you that you won’t be able to collect the initial franchise fees for any franchisee with whom you sign a deal who is a resident of that state.

The types of Financial Assurance you may provide are:

  • Deferral of all initial fees owed to you until you’ve performed all of your pre-opening obligations (our recommendation)
  • Posting of a surety bond
  • Placement of the initial fees in escrow
  • A guarantee of performance by your affiliate or parent company

The types of Financial Assurance available to you varies from state to state and may vary within a state depending on the state examiner assigned to your filing.

We recommend this option as it’s the simplest and least expensive way to handle the financial assurance requirement. You simply do not collect any initial fees owed to you until you’ve performed all your pre-opening obligations and the franchisee’s business is open and operating. The fee deferral option doesn’t require involvement from any outside institutions like the state or a bank. While some states may require a written agreement to govern the fee deferral, such agreement would only be between you and your franchisee. While there is some risk that the franchisee may walk away prior to opening, as long as they’re spending money on things like an attorney, incorporation or formation of an entity, and a real estate search, they’re less likely to quit.

The definition of “open for business” is something with which you want to be careful. For a brick-and-mortar business, it’s easy – when they open their doors to the public! For service businesses, a franchisee may be open for business but may not have a client yet. You will want to discuss the definition of “open for business” with us so we so we can spell it out in your franchise agreement very clearly.

This method requires you to post a surety bond usually calculated according to the number of franchises you intend to sell in a state multiplied by the total of all initial fees listed in Item 5 of your FDD. Bonds are expensive, and while some clients have had success, finding an insurance company with which to work at an affordable price can be a challenge – the list is always changing and the fees vary widely. If you are interested in this form of financial assurance, reach out to your Spadea Lignana legal team so we can talk it through and connect you with a few companies that may handle the transaction.

Escrow requires you to place the initial fees in an account at a state bank that agrees to act as your escrow agent. Some state banks will require you to have a bank account (savings, checking, etc.) with them before they will agree to act as your escrow agent. The process is often cumbersome and expensive.

The biggest challenge is having the funds released from escrow. The bank would need to go through the state to begin the release process, at which time you will have to prove to the state examiner that you have performed all of your obligations to the franchisee. The examiner will then correspond with the franchisee to let them know there has been a request to release the funds. The franchisee would need to state whether or not you’ve fulfilled your obligations to them, and then based on the franchisee’s statement, the state would go back to the bank to advise on release. Each of these communications is afforded its own time period for response (30 days, 15 days, etc.). In our opinion, this puts too much control in the franchisee’s hands, and it doesn’t set the right tone in terms of leadership and who is in charge of the relationship.

This method may be used if you have an affiliated company that has adequately strong financials and can act as a guarantor for you. In this scenario, it is the guarantor’s audited financials that are used in Item 21 of the FDD, along with a Guarantee of Performance form signed by an officer of the guarantor. In effect, this method removes the financial assurance, because the guarantor is guaranteeing your obligations. If the guarantor does not want their financials in the FDD or does not want their financials audited (which can be very expensive), this method may not be employed.

A Certificate of Deposit is another type of financial assurance with the caveat that it is not available in all states that may require some form of financial assurance.

As an example, within Illinois: Posting a Certificate of Deposit for each franchise intended to be sold in Illinois (Section 200.506 of the Rules); each CD posted must be in the amount of the initial franchise fee. The CD requirement must be disclosed in Item 5, or on each Illinois addendum, and in the appropriate section of the Agreement. Item 5 or each Illinois addendum must also disclose that the Illinois Attorney General’s Office imposed the financial assurance requirement due to Franchisor’s financial condition. If a Development Agreement is being offered, the CD must include the development fee, which cannot be released until the first franchise opens.

Depending on the state, and if Posting a Certificate of Deposit is an option, each state’s details and requirements should be read carefully and followed specifically. Each state might have slightly different details to comply to.

These pages are for informational purposes only and do not establish an attorney-client relationship between the author and the reader. Additionally, we make no representations or warranty to any of the information as legal information is subject to change over time. Before taking action on any of the information presented, you must discuss this with your attorney to ensure it is relevant and applicable to your current situation.