One of the key risks franchisors face is ensuring that franchisees can uphold their financial commitments, particularly when franchise fees are deferred until construction is complete. If the franchise fee is deferred regardless of the amount, can a franchisor require a bond to secure payment?
What Type of Surety Bond is Required?
For franchisors requiring added security on deferred franchise fees, a financial guarantee bond is the best solution. This type of bond ensures that the franchisee will pay the deferred franchise fee once construction is complete, protecting the franchisor if the franchisee defaults.
Typically, there is no required bond form, so a generic financial guarantee bond form is used. The franchisor should clearly outline the bond requirement within the franchise agreement, making it a contractual obligation for the franchisee to obtain the bond before proceeding.
How is a Franchisee Evaluated for Financial Soundness?
What does the underwriting process involve? Underwriters conduct an in-depth analysis of both corporate and individual financials to assess whether a franchisee is financially sound enough to meet their obligations. Franchisees will need to submit a detailed application that includes:
Corporate financial statements (latest income statement and balance sheet)
Personal financial statements from key owners
Liquid cash verification to demonstrate available funds
Details of any outstanding liabilities or obligations
This process ensures that not only can a franchisee afford the fee, but they have the financial backing to sustain the business until they reach the payment milestone.
Understanding Deferral States and Their Impact on Franchisors
What are deferral states, and how do they impact franchise sales? In the United States, certain states require franchisors to register their Franchise Disclosure Documents (FDDs) before offering or selling franchises within their jurisdictions. These states, known as franchise registration states, often assess a franchisor's financial stability during the registration process. If a franchisor’s financial condition is deemed insufficient to meet pre-opening obligations, the state may impose financial assurance requirements before allowing franchise sales.
One of the most common financial assurance methods is requiring the deferral of initial franchise fees until the franchisor has fulfilled its pre-opening obligations and the franchise is operational. The states that may impose financial assurance requirements, including franchise fee deferrals, include:
California
Hawaii
Illinois
Maryland
Minnesota
North Dakota
Virginia
Washington
Challenges for Franchisors in Deferral States
What financial risks do franchisors face when selling franchises in deferral states? While deferral states aim to protect franchisees, they introduce significant financial challenges for franchisors, particularly when brokers and multi-unit deals are involved:
Broker Fees Are Paid Upfront Without Guarantee of Payment
Many franchisors use brokers to help find and onboard new franchisees. Typically, brokers are paid 40% of the franchise fee upfront, even though the franchisor hasn’t received the franchise fee due to state-imposed deferrals.
If the franchise never opens, the franchisor is left without the franchise fee but has already paid a significant amount to the broker, resulting in a net loss with no recourse to recover the funds.
Increased Risk in Multi-Pack Deals
Some franchisees purchase multiple locations in a multi-pack deal, agreeing to open several franchises over time.
If the franchisor is required to defer all franchise fees, they could be out a substantial amount of money before even seeing a return. If the franchisee defaults or fails to open all locations, the franchisor absorbs the full financial loss.
Alternative Financial Assurance Methods Add More Complexity
While deferring franchise fees is the most common method, some states allow alternative financial assurances, such as escrowing fees, posting a surety bond, or obtaining a performance guaranty.
Each method presents its own cost and administrative burden, requiring careful planning to ensure compliance while managing cash flow.
How Long Does the Process Take?
If the franchisee has all their financial information ready, the underwriting process generally takes 24-48 hours. However, given the difficulty of qualifying for these bonds, franchisees should prepare their financial documents well in advance to avoid delays.
What is the Estimated Cost?
The cost of a financial guarantee bond ranges between 1-10% of the bond amount. The percentage varies based on the franchisee’s financial strength, as stronger financials lead to lower premiums.
Most of these bonds also require some form of collateral, typically wired to the surety company. The amount and type of collateral required depend on the franchisee’s financial standing. Franchisors should communicate this potential requirement to franchisees early in the process to ensure they are prepared.
What Happens if the Franchisee Defaults?
How does a franchisor file a claim against the bond? If a franchisee fails to uphold their contractual obligations, the franchisor, as the obligee, can file a claim with the surety company. A claims examiner will then assess whether the claim is valid. If approved, the surety company will pay out the claim to the franchisor.
However, unlike traditional insurance, the franchisee remains responsible for repaying the surety company. The surety will first pull from the collateral before seeking additional repayment from the franchisee to recover the funds.
Franchisor’s Role in Helping Franchisees Qualify
How can franchisors assist franchisees in obtaining a bond? Franchisors can play a proactive role in helping franchisees navigate the bonding process. The key steps include:
Educate Franchisees on Bond Requirements – Clearly outline the necessity of a financial guarantee bond in the franchise agreement and explain its purpose.
Work with an Experienced Surety Broker – Ensure the franchisee connects with a broker who specializes in financial guarantee bonds and understands the underwriting process.
Prepare Required Financial Documents – Assist franchisees in gathering corporate and personal financial statements, cash verification documents, and any other required information.
Explain the Underwriting Process – Guide franchisees through how underwriters assess financial risk and what they should expect in terms of evaluation timelines and potential collateral requirements.
Recommend a Trusted Surety Company – Direct franchisees to sureties with a track record of working with franchised businesses and providing fair underwriting terms.
Provide Ongoing Support – If a franchisee faces challenges in qualifying, franchisors can offer guidance on improving financial standing or structuring agreements to make bonding more feasible.
How Rikor Can Help
At Rikor, we understand the financial challenges franchisors face in deferral states and the importance of securing franchise fees while maintaining compliance. Our expertise in surety bonds and financial risk management allows us to provide franchisors with the tools and strategies needed to mitigate risk and protect their brand.
We help franchisors:
Identify the right financial guarantee bond solutions to secure deferred franchise fees.
Navigate state-specific financial assurance requirements to ensure compliance.
Work with trusted surety providers to streamline the underwriting process for franchisees.
Develop risk management strategies to minimize financial exposure when using brokers or multi-pack deals.
If you need support in structuring a compliant and financially secure franchise system, Rikor is here to help.
Learn more about how Rikor supports franchisors at protectmyfranchise.com.
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