The State Bar of California
State Bar of California

Intro to Business Organization Law

Business 101 involves issues of concern when starting any business – whether a franchise or not.

1. Entity

A number of different types of entities are available to you as a business person. A sole proprietorship is basically no entity at all. We do not recommend it because there is no protection from personal liability. The same is true for general partnerships; partners are personally liable for partnership debts. There are certain legal entities that limit your liability as an investor or shareholder. These are corporations, limited liability corporations and limited partnerships. The major benefit of these entities is that, properly structured, you may avoid personal liability for debts. Certain tax benefits may also flow from having an entity. You will need to retain a CPA to inform you what the best entity from a tax perspective is.

2. Personal Guarantees

A personal guarantee means that you are securing the obligation with your own personal assets: Your house, money and personal property. If you formed an entity to own your franchise, signing a personal guarantee means you are giving up some of the limited liability which was probably the major reason you chose to organize that way. Franchisors, lenders, and major vendors usually ask for personal guarantees. Try not to agree to one if you can. Even if your franchisor insists, we typically recommend that you form an entity anyway, because your business will have other creditors who do not have guarantees.

3. Licenses and Insurance

Certain businesses require local, county or state licenses. Food preparation, construction, real estate, barbershops come to mind. These may or may not be disclosed on the franchise offering – so you need to do your own due diligence.

You should ensure you have appropriate insurance coverage for liability and in case of fire or other property damage. Also consider the need for disability insurance in case you are injured and cannot work. Business interruption insurance can protect your income in the event your location is damaged by some unforeseen event.

4. Capitalization / Pro Forma Profit and Loss Statements

You need to evaluate the franchise as a business unless it is merely a hobby for you. If you want to make money, you should analyze your potential by way of a pro forma. Detail your expected income and expenses. The difference is your profit. What are your major expenses in running a business? Rent, cost of goods, salaries, and build-out if you have a physical location. These happen in every almost every business. In a franchise, you tack on royalties, ad fees, initial franchise fees and other fees. Do not forget to figure an appropriate salary to pay yourself. This is going to be your source of income. And if you are borrowing money your will need figure in the loan payments as an expense.

5. Employees

If hiring employees you will have to pay them the minimum wage, proper overtime wages, make withholdings, provide workers comp insurance, and comply with employment laws. You must provide them with meal breaks and rest breaks. We recommend that you consult a lawyer. The State of California also has websites that can help you.

If you give employees paid vacation, you cannot have a use it lose it policy but you can have a policy where no additional vacation accrues until the employee uses up all his vacation. When you fire someone, you have to pay them immediately all amounts owed. When they quit, you have pay them within 72 hours.

If you don’t follow these rules, awful things can happen. You can subject to what are called waiting time penalties for up to 30 days wages and you can be subject to the employee’s attorney’s fees and other penalties. Don’t fall into the trap of thinking you can hire an “independent contractors” to work for you. If you control what they do and how they do it, they are employee’s not independent contractors no matter what your agreement states. Moreover, you can be personally liable for unpaid minimum and overtime wages under Federal law.

6. Leases

This is a complex commercial obligation for which you should seek legal counsel. A lawyer can help you negotiate beneficial provisions. Commercial leases are much different than residential leases. If you break a commercial lease the landlord can sue you for the balance of the term and in many cases does not have to even try to re-rent the premises. Sometimes you can get a provision that if the franchise is terminated you can get out of the lease – try to get this.

Our law firm also helps franchisees review leases and negotiate terms.

7. Marketing / Publicity / Competition

Another important consideration is how you will market your goods and service. When you have a franchise, the franchisor may take care of some of this marketing, but not all of it. But they will exercise controls over how you can market and the content of the advertisements. Depending on the franchise, there may be national network television ads – something a small business likely could not do. But if it’s a new franchise there likely will not be a national ad program. In addition it’s important to analyze the competition in your market, where they are located and aspects of their business including pricing.

8. Exit Strategy

Various circumstances may arise where you or your heirs might need to get out of the business. For example, you might get sick or disabled; or die. With your own business you have maximum flexibility. But with a franchise there is a contract that will cover what you can and cannot do. If you decide you want to sell the business, you may be limited in the terms, who you can sell to and the price you can receive. In your own business, this would not be the case.

9. Buy-Sell Agreements

There are usually multiple franchise agreement terms and rules that will apply to the transfer of your business or if you buy an existing franchise. One issue to be aware about when buying a business with equipment is that here may be liens on the equipment. You do not want to be in position of paying for equipment and finding out somebody else has a superior interest. Therefore, you should conduct a UCC search with the state. There are a myriad of other issues involved for which you should seek competent legal counsel.

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