Franchising & licensing two powerful ways to grow your business

F RANCHISING &
L ICENSING
THIRD EDITION
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F RANCHISING &
L ICENSING
THIRD EDITION
TWO POWERFUL WAYS TO
GROW YOUR BUSINESS IN ANY ECONOMY
ANDREW J. SHERMAN
American Management Association
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Library of Congress Cataloging-in-Publication Data
Sherman, Andrew J.

Franchising & licensing : two powerful ways to grow your business in
any economy / Andrew J. Sherman.—3rd ed.
p. cm.
Includes bibliographical references and index.
ISBN 0-8144-7222-2
1. Franchises (Retail trade)—United States. 2. License
agreements—United States. I. Title: Franchising and licensing. II.
Title.
HF5429.235.U5S54 2003
658.8Ј708—dc21
2003012749
᭧ 2004 Andrew J. Sherman.
All rights reserved.
Printed in the United States of America.
This publication may not be reproduced,
stored in a retrieval system,
or transmitted in whole or in part,
in any form or by any means, electronic,
mechanical, photocopying, recording, or otherwise,
without the prior written permission of AMACOM,
a division of American Management Association,
1601 Broadway, New York, NY 10019.
Printing number
10987654321
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To my first franchisee,
Matthew Harris Sherman,
and to my wife, Judy Joffe Sherman.
I thank them for their
never-ending support and patience.

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CONTENTS
Preface to the Third Edition ix
Acknowledgments xi
Part 1. An Overview of Intellectual Capital Leveraging Strategy 1
1 Leveraging Intellectual Capital to Create Growth
Opportunities and Profitable New Income Streams 3
Part 2. Franchising as a Growth Strategy 9
2 The Foundation of Franchising 11
3 Developing the Operations and Training Programs 21
4 Developing System Standards and Enforcing Quality Control 37
5 Federal and State Regulation of Franchising 59
6 Compliance 89
7 Structuring Franchise Agreements, Area Development
Agreements, and Related Documents 105
8 Protecting the Intellectual Property of the Franchise System 135
9 Managing Disputes 165
10 Developing Sales and Marketing Plans 191
11 Taking Your Franchise Program Overseas 215
vii
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viii
CONTENTS
Part 3. Financial Strategies 231
12 Business and Strategic Planning for the Growing Franchisor 233
13 Capital Formation Strategies 243
14 Management and Leadership Issues in Building a Successful
Franchising Organization 281
15 The Role of the Chief Financial Officer and Related Financial

and Administrative Management Issues 297
16 Special Issues in Mergers and Acquisitions 317
17 Managing the Transfer and Renewal Process 333
Part 4. Alternatives to Franchising 345
18 Strategic and Structural Alternatives to Franchising 347
19 Structuring Licensing Programs and Agreements 361
20 Joint Ventures and Strategic Alliances 383
Appendix. Resource Directory: List of State Administrators and
Agents for Service of Process 397
Index 429
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PREFACE TO THE THIRD EDITION
It is hard to believe that nearly 15 years have passed since the publication of
the first edition of Franchising & Licensing in 1991. The impact of technology
and globalization has had a permanent effect on the dynamics of the fran-
chise relationship. When the manuscript was being written for the first edi-
tion in the late 1980s, I could not have envisioned the many changes in the
evolution of today’s franchise relationships that can be managed or the diver-
sity in the number of industries and companies that would pursue franchising
as their primary growth strategy. It has been an honor to work with compa-
nies launching franchising programs in dozens of different industries and at
various stages of growth, ranging from start-up to Fortune 500 companies.
At the time of this writing, global events and geopolitical concerns are
overshadowing and restraining some of the many successes that the franchis-
ing community has enjoyed since the publication of the second edition. We
are in the middle of war with Iraq, we now live with the threat of terror
attacks against our homeland following the events of September 11, 2001,
our economy is as weak as it has been in over 10 years, and oil and energy
prices are on the rise, making the cost of growing a business very high. In
tough economic times, the development of creative strategies to leverage

your intellectual capital becomes especially important.
How have these conditions and events affected franchising and the over-
all growth of a company?
❒ From the franchisor’s perspective, the weak capital markets have lim-
ited access to the resources needed for more organic or traditional
growth strategies, thereby making franchising the strategy of choice to
accomplish growth objectives and brand-building.
❒ From the franchisee’s perspective, more families in a post-9/11 environ-
ment (and with job losses averaging 300,000 per month) want to take
greater control over their own destiny and are pursuing many different
types of franchised opportunities as a way of owning their own business.
ix
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x
PREFACE TO THE THIRD EDITION
❒ The threats of domestic terrorism, coupled with a very strong residential
real estate market, has fueled the growth of many different types of
home improvement and home services franchisors as Americans invest
more money in making their homes safer and more comfortable. This
trend has not helped the hospitality and restaurant industries, unless
carry-out or home delivery services are offered.
❒ Fears of terrorism at home and abroad have also slowed the pace a bit of
international franchising expansion (although the number of attendees
and exhibitions at the 2003 International Franchise Expo in Washing-
ton, D.C., in April were just as strong as prior years). These fears have
had an impact on franchise systems in the travel, hotel, car rental, and
related industries.
❒ The ease of access to technology as well as a desire to avoid the hassles
(and fears) of going to a shopping mall have fueled an increase in on-
line sales of products and services, forcing franchising systems to offer

sites that facilitate e-commerce as well as create a balance for sharing
the upside of these new sales and customers with the franchisees in
their systems. The improvements in Internet technology and travel/lo-
gistics concerns have also changed the ways in which franchisees are
being recruited and data gathered. The impact of the Internet on fran-
chise sales (as well as the legal implications thereof) are discussed in
new sections of Chapters 6 and 10 of this third edition.
And yet, as volatile as the world and global and domestic economy have
been since the publication of the second edition, franchising has remained
relatively stable. Each year, hundreds of new companies launch franchising
programs for the first time and tens of thousands of families invest in the first
franchised business as the first step in their journey toward achieving the
American dream. Even with all of the new technology and all of the new
developments, franchising is, and always will be, about mutual commitment,
trust, fairness, and communication in a uniquely interdependent relation-
ship that has helped fuel our economy for nearly 100 years.
The factors discussed above help explain the rationale for the new sub-
title to Franchising & Licensing: ‘‘Two Powerful Ways to Grow Your Business
in any Economy.’’ History has shown that the leveraging of intellectual capi-
tal can be an effective and capital-efficient way to perpetrate business growth
whether economic conditions are weak or strong. Companies of all sizes and
in many different industries are realizing that their intangible assets can be a
source of new revenue and profit centers that can also bring greater control
and predictability and loyalty to their distribution channels. The critical im-
portance of adopting this more strategic perspective to the management and
leveraging of intellectual capital is discussed in greater detail in the new
chapters of this third edition.
Andrew J. Sherman
Washington, D.C.
April 2003

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ACKNOWLEDGMENTS
The concepts and issues discussed in this book are the result of over 25 years’
experience in franchising, from both a legal and a business perspective. It
would be impossible to thank all of the people with whom I have had the
pleasure of working along the way. The support of my many loyal domestic
and international clients and my colleagues at McDermott, Will & Emery,
including Tim Waters, Grant Bagan, and Harvey Freishtat, deserve special
mention.
There are certain individuals whose time, hard work, support, and pa-
tience should be acknowledged. I wish to thank Debra Harrison for her assis-
tance in reviewing and editing several chapters and to Patricia O’Keefe for
her assistance in updating Chapter 21. I owe special thanks to my assistant,
Jo Lynch, who often serves as my right arm, and for her organizational skills
and patience. The Franchising, Licensing and Distribution Department at
McDermott, Will & Emery makes it happen on a daily basis.
There are also certain well-recognized individuals in the franchising
and emerging business communities who have been friends and mentors
over the years. For their support, advice, and general friendship, I want to
especially thank Bob Gappa at Management 2000, Jerry Darnell, John Rogers
at Davis & Company, John Reynolds at the International Franchise Associa-
tion, Tom Portesy and Richard Macaluso at MFV Expos, Verne Harnish of
Gazelles, my partner of nearly ten years Al Schaeffer, Burt Alimansky at Ali-
mansky Capital Group, Dr. Eckhard Flohr of EF*LAW, John May at New Van-
tage Partners and Bill Keating at the Dickinson School of Law.
Ray O’Connell of AMACOM Books was there as always to provide moral
support in pulling this entire project together. He is an excellent orchestrator
and sounding board. I also want to thank Mike Sivilli at AMACOM for his
masterful editing, and Irene Majuk at AMACOM for her skillful media
relations.

Last, but certainly not least, I am grateful to my wife, Judy, and to my
son Matthew, and daughter, Jennifer, who once again sacrificed time with me
so that I could complete this manuscript. I couldn’t ask for a more supportive
family.
xi
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PART 1
A
N
O
VERVIEW OF
I
NTELLECTUAL
C
APITAL
L
EVERAGING
S
TRATEGY
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C
HAPTER
1
Leveraging Intellectual Capital to Create
Growth Opportunities and Profitable New
Income Streams
Intellectual capital consists of human capital, intellectual property, and rela-
tionship capital and are the key assets for driving growth in all types of eco-

nomic conditions.
The biggest challenge that many companies face is how to keep growing
in a slowing economy. The focus of this book is on two key strategies—
franchising and licensing—as methods for leveraging the intellectual capital
of a company into new revenue streams, market opportunities, and profit
centers. For many years, companies of all sizes and in many different indus-
tries did not understand how to harvest their intangible assets, and they tra-
ditionally viewed these assets more passively as a way to defend market
share instead of proactively as a source of new opportunity.
The strategic views toward the use of intellectual capital have evolved
in the boardroom over the past three decades, as described in Figure 1-1.
Figure 1-1. The evolution of strategic views toward the use of intellectual
capital in the boardroom over the past three decades.
Traditional View IP assets enhance the company’s competitive advantage and strengthen its ability
to defend its competitive position in the marketplace (IP as a barrier to entry and
as a shield to protect market share) (Reactive and Passive Approach)
Current View IP assets should not be used merely for defensive purposes but should also be
viewed as an important asset and profit center that is capable of being monetized
and generating value through licensing fees and other channels and strategies,
provided that time and resources are devoted to uncovering these opportunities
(especially dormant IP assets, which do not currently serve at the heart of the
company’s current core competencies or focus) (Proactive/Systemic Approach)
Future View IP assets are the premiere drivers of business strategy within the company and
encompass human capital, structural/organizational capital, and customer/relation-
ship capital. IAM systems need to be built and continuously improved to ensure that
IP assets are used to protect and defend the company’s strategic position in domes-
tic and global markets and to create new markets, distribution channels, and reve-
nue streams in a capital-efficient manner to maximize shareholder value (Core
Focus/Strategic Approach)
3

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4
AN OVERVIEW OF INTELLECTUAL CAPITAL LEVERAGING STRATEGY
As demonstrated in Figure 1-2 below, the harvesting of intellectual capi-
tal is a strategic process that most begin by having the company’s manage-
ment team and qualified outside advisors take an inventory in order to get a
comprehensive handle on the scope, breadth, and depth of the company’s
intangible assets. In these times of distrust and disappointment by share-
holders in the management teams and boards of publicly held companies,
corporate leaders have an obligation to these shareholders to uncover hidden
value and make the most of the assets that have been developed with corpo-
rate resources. The leadership of the company will never know if it has a
‘‘Picasso in the basement’’ unless it both: (1) takes the time to inventory
what’s hiding in the basement and (2) has a qualified intellectual capital
inventory team that is capable of distinguishing between a Picasso and your
children’s art project. Once these assets are properly identified, an Intellec-
tual Asset Management (IAM) system should be developed to ensure open
communication and strategic management of these assets. At that point, the
company is ready to engage in the strategic planning process to determine
how to convert these assets into profitable revenue streams and new opportu-
nities that will enhance and protect shareholder value.
The strategic planning process will help uncover opportunities for
growth. Key questions include:
❒ What patents, systems, and technologies have noncompeting applica-
tions that could be licensed to third parties to create new revenue
streams, joint ventures or partnering opportunities, distribution chan-
nels, or profit centers?
❒ What brands lend themselves to extension licensing or co-branding op-
portunities?
❒ What distribution channels or partnering opportunities can be strength-

ened if the company has greater control of or provides additional sup-
port and services to the channel?
❒ What types of growth and expansion strategies are being used by the
company’s competitors? Why?
❒ Where are the strategic/operational gaps in the company’s current li-
censing and alliance relationships?
Figure 1-2. The harvesting of intellectual capital: A strategic process.
Inventory of Intellectual Capital Assets
Building Intellectual Asset Management (IAM) Systems
Strategic Planning to Maximize IP Assets
Franchising
Licensing
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5
LEVERAGING INTELLECTUAL CAPITAL TO CREATE GROWTH OPPORTUNITIES
As you can see in Figures 1-3, 1-4, and 1-5, the strategic planning process
will help identify the different types of protectable intellectual property and
the ways in which it can be leveraged into new opportunities.
The balance of this book is devoted to the various types of intellectual
capital leveraging strategies, with a focus on business format franchising in
Chapters 2 through 17, licensing in Chapters 18 and 19, and joint ventures
and strategic alliances in Chapter 20.
Figure 1-3. Identification through the strategic planning process.
Protectable Types of
Intellectual Property
• Patents
• Trademarks (including brands and slogans)
• Copyrights
• Trade dress
• Trade secrets

• Distribution channels
• Show-how and know-how
• Website design and content
• Customer and strategic partner relationships
• Proprietary processes and systems
• Knowledge and technical workers
Possible New Opportunities and
Revenue Sources
• New independent ventures
• Joint ventures
• Licensing
• Outright sale
• Co-branding
• Franchising
• Enter new markets
• Sell products
• Licenses
• Cooperatives, consortiums
• Outsourcing
Figure 1-4. Leveraging intellectual capital.
Phase 3
Go To Market
Phase 2
Develop the IP
into a Commercial Product
Phase 1
Identify IP and Evaluate Commercial
Potential
Raw
IP

Preliminary
Screening
Create new
external business
in for-profit
subsidiary
Create new
internal business
area
Create new
product with
existing business
area
License or sell to
third party
Commercialization Screens
• Could this IP be transformed
into a product?
- Does someone own this
IP?
- Competing patent?
• Is the product needed by
the market?
-Potential uses and
applications
- Likely markets
• Are there barriers to entry
if we develop a product?
- Competitive advantage
• Is there revenue potential?

• Could someone make money
doing this?
Business Plan
Development
• Product and market
definition
• Detailed market analysis
• Competitive analysis
• Internal/external
business decision
• Risk factors
• Financials
Product and
Market Analysis
• Product and market
definition
• Detailed market analysis
• Competitive analysis
• Financials
Licensing Type and
Market Analysis
• Type of license (idea
product, turn-key)
• Customer and Market
Analysis
• IP protectability analysis
• Financials
Capability Gap
Assessment
• Capabilities required?

• What are gaps and how
will it fill them?
• What partners can share
the risk, expand
revenue potential, and
help fill in the gaps?
• What is likely value
sharing required to attract
and retain partners?
Capability Gap
Assessment
Capability Gap
Assessment
• What capabilities exist
within our business area
to deliver this product?
• Are partners required?
• What capabilities are
required to manage
these licenses?
• How will we provide
support?
Prepare for
New Business
• Identify leadership
• Staffing
• Agreements
• Licenses
• Investment decisions
Go to Market

Prepare for
New Product
Rollout
• Staffing
• Investment decisions
• Create licensing or sales team
• Sales team
• Develop licensing and leveraging
team
• Draft key leveraging
agreements
Go to Market
Go to Market
Prepare for
licensing or
sale
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6
AN OVERVIEW OF INTELLECTUAL CAPITAL LEVERAGING STRATEGY
As demonstrated in Figures 1-5 and 1-6, a key part of the intellectual
capital planning process involves deciding your strategic development alter-
native once the applications have been analyzed and after the fit with your
core business has been determined.
Figure 1-5. IPPLA phase 2 analytical process.
Fit with current
businesses?
NO
YES
Patents and
Trade Secrets

Research and
Development
Intellectual
Capital
NO
YES
Fit with existing
products and markets?
YES
NO
License joint
venture or sell
to third party
NO
Create new
external business
via spin-off or
newly established
subsidiary
Create new
internal business
division
YES
Create new
product within
existing
business area
Should we make this
a new business?
Can we create a viable

business internally?
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7
LEVERAGING INTELLECTUAL CAPITAL TO CREATE GROWTH OPPORTUNITIES
Figure 1-6. Phase 2 strategic options.
Create a new spin-off
venture that involves
seed investment from
our firm
Create spin-off entity where costs will
be shared with a joint venture partner
License the product to a third
party in exchange for an equity
stake (instead of cash)
Develop one or more business format
franchising programs based upon
current brands, technology, and systems
Brand merchandising
licensing
License technology to
third party
Form a partnership
Develop single product
instead of multiple versions
Low High
Shorter
Longer
Time to payback
Investment Required
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PART 2
F
RANCHISING AS A
G
ROWTH
S
TRATEGY
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C
HAPTER
2
The Foundation of Franchising
Over the last five decades, franchising has emerged as a leading intellectual
property leveraging strategy for a variety of product and service companies
at various stages of development. Recent International Franchise Association
(IFA) statistics demonstrate that retail sales from franchised outlets consti-
tute nearly 50 percent of all retail sales in the United States, estimated at
over $1 trillion and employing over 10 million people in 2002. Notwith-
standing these impressive figures, franchising as a method of marketing and
distributing products and services is really only appropriate for certain kinds
of companies. Despite the favorable media attention that franchising has re-
ceived over the past few years as a method of business growth, it is not for
everyone. There are a host of legal and business prerequisites that must be
satisfied before any company can seriously consider franchising as an alter-
native for rapid expansion.
Many companies prematurely select franchising as a growth alternative
and then haphazardly assemble and launch the program. Other companies
are urged to franchise by unqualified consultants or advisors who may be

more interested in professional fees than in the long-term success of the fran-
chising program. And still others move too quickly in the development of
their franchising program without devoting the time and resources to the
establishment of an effective and viable business and economic model.* This
has caused financial distress and failure at both the franchisor and franchisee
level and usually results in litigation. Current and future members of the
franchising community have a duty to take a responsible view toward the
creation and development of their franchising programs.
Responsible franchising starts with an understanding of the strategic
essence of the business structure. As Bob Gappa of M2000 has been preach-
ing for many years, there are three critical components of the franchise sys-
tem—the brand, the operating system, and the ongoing support provided by
the franchisor to the franchisee. The brand creates the demand, allowing the
* This should include a pro forma for both the franchisor as well as the typical operating
franchisee to ensure fairness and economic viability for both parties to the relationship.
11
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12
FRANCHISING AS A GROWTH STRATEGY
franchisee to initially obtain customers. The brand includes the franchisor’s
trademarks and service marks, its trade dress and de
´
cor, and all of the in-
tangible factors that create customer loyalty and builds brand equity. The
operating system essentially ‘‘delivers the promise,’’ thereby allowing the
franchisee to maintain customer relationships and build loyalty. The ongo-
ing support and training provide the impetus for growth, offering the fran-
chisee the tools and tips to expand its customer base and build its market
share. The responsibly built franchise system is one that provides value to
its franchisees by teaching them how to get and keep as many customers as

possible, who consume as many products and services as possible, as often
as possible.
In fact, most litigation in franchising involves the gap between the ac-
tual needs of the franchisees to remain competitive in the marketplace and
the reality of what support the franchisor is capable of providing. The genesis
of the disappointment begins during the recruitment phase of the relation-
ship and continues beyond the start-up as the franchisee struggles to remain
competitive unless the franchisor delivers on its promises and is committed
to providing excellent initial and ongoing training and support.
Reasons for Franchising
There are a wide variety of reasons cited by successful franchisors as to why
franchising has been selected as a method of growth and distribution.
Through franchising, they are able to:
❒ Obtain operating efficiencies and economies of scale.
❒ Increase market share and build brand equity.
❒ Use the power of franchising as a system to get and keep more and more
customers—building customer loyalty.
❒ Achieve more rapid market penetration at a lower capital cost.
❒ Reach the targeted consumer more effectively through cooperative ad-
vertising and promotion.
❒ Sell products and services to a dedicated distributor network.
❒ Replace the need for internal personnel with motivated owner/opera-
tors.
❒ Shift the primary responsibility for site selection, employee training and
personnel management, local advertising, and other administrative con-
cerns to the franchisee, licensee, or joint venture partner with the guid-
ance or assistance of the franchisor.
In the typical franchising relationship (see table below for examples), the
franchisee shares the risk of expanding the market share of the franchisor by
committing its capital and resources to the development of satellite locations

modeled after the proprietary business format of the franchisor. The risk of
business failure of the franchisor is further reduced by the improvement in
competitive position, reduced vulnerability to cyclical fluctuations, the exis-
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