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Can a Franchisor Require or Purchase a Surety Bond for Deferred Franchise Fees?

Updated: Mar 20

Franchisors face significant financial risks when franchise fees are deferred, particularly until construction is complete or other milestones are met. This raises two key questions: Can a franchisor require a bond from franchisees to secure deferred payments? Alternatively, can a franchisor purchase a surety bond to mitigate their own risk? This article explores these options, their implications, and the broader context of financial assurances in deferral states.


Understanding Deferral States

In the U.S., certain states—known as franchise registration or deferral states—require franchisors to register their Franchise Disclosure Documents (FDDs) before offering or selling franchises. During this process, states like Illinois, Maryland, and Washington assess the franchisor’s financial stability. If it’s deemed insufficient to meet pre-opening obligations (e.g., providing training, equipment, or real estate), these states may impose financial assurances, such as deferring initial franchise fees until the franchise is operational. Other states, including California, Hawaii, and Virginia, may also apply similar requirements. These rules protect franchisees but can delay cash flow, prompting franchisors to explore alternatives like surety bonds.


Can a Franchisor Require a Bond from Franchisees?

A franchisor could theoretically mandate that franchisees obtain a surety bond to guarantee payment of deferred franchise fees, regardless of the amount. However, this is uncommon and may deter prospective franchisees due to added costs and complexity. While legally permissible in some cases (depending on the franchise agreement and state regulations), franchisors should weigh the practicality and market impact of imposing such a requirement.


Can a Franchisor Purchase a Surety Bond for Deferred Fees?

A more feasible option is for the franchisor to purchase a franchisor surety bond to cover deferred franchise fees across all franchisees in a deferral state. Unlike insurance, surety bonds require the franchisor to guarantee repayment to the surety if claims arise. This approach, though not widespread, allows franchisors to collect fees without waiting for state approval, offering a competitive edge and reducing financial risk. Bond amounts may vary—some states set fixed limits (e.g., $100,000 in Washington), while others base it on factors like the number of units multiplied by the initial franchise fee. However, it comes with significant considerations.


Key Factors to Evaluate

Underwriting Process

  • The surety will assess the franchisor’s financial stability through a rigorous underwriting process, typically requiring:

    • Income statement and balance sheet

    • Personal financial statement of the owner

    • Ownership structure details (including partners and affiliated entities)

  • If multiple owners are involved, additional financial data may be requested, even for silent partners.


Cost and Collateral

Bond premiums typically range from 1-10% of the bond amount, depending on risk and financial health. The bond amount itself varies by state—some set a fixed cap (e.g., $100,000 in Washington), while others may scale with the number of franchises and fees deferred. Duration also differs; for example, Illinois requires bonds to remain active for four years unless obligations are met. Many sureties require collateral, which could strain the franchisor’s liquidity, especially when bonding large sums of deferred fees.


Risk Exposure

  • If the franchisor fails to meet obligations (e.g., supporting franchisees pre-opening), the surety may pay out, and the franchisor must reimburse the surety.

  • Higher deferred fee totals increase financial exposure.


Regulatory Benefits

  • Some deferral states accept surety bonds as an alternative to fee deferrals, enabling faster fee collection. This requires submitting bond forms to state examiners (e.g., the Illinois Attorney General or Maryland Securities Division) and ensuring compliance with state-specific franchise laws, such as the Illinois Franchise Disclosure Act or Maryland Franchise Law.


Purchasing a surety bond is viable but demands careful analysis of costs, risks, and operational impacts. Franchisors should consult surety experts and legal counsel before proceeding.


Financial Assurances in Deferral States

What Are Financial Assurances?

Financial assurances are state-imposed mechanisms ensuring franchisors can fulfill pre-opening obligations to franchisees. Common in deferral states, they protect franchisees from financial loss if a franchisor underperforms or defaults.


Common Methods

Escrowed Funds

  • Franchise fees are held in escrow until milestones (e.g., construction completion) are met.

  • Challenges: Funds are controlled by the state or its appointee, complicating access.


Surety Bond

  • A franchisor-purchased bond compensates franchisees if obligations aren’t met, such as failing to provide real estate, equipment, or training, or engaging in misrepresentation or fraud (as emphasized in Illinois law). Offers flexibility but involves underwriting and costs, with conditions varying by state (e.g., Washington caps liability at $100,000, while Virginia focuses on penalties).


Performance Guarantee

  • A financially stable parent company or affiliate backs the franchisor’s obligations.

  • Requires disclosing the guarantor’s financials, which may not suit all franchisors.


Challenges of Deferred Fees in Deferral States

Deferral states, while protective of franchisees, create financial hurdles for franchisors, especially in specific scenarios:


Broker Fees

  • Brokers often receive 40% of the franchise fee upfront, even if the franchisor hasn’t collected it due to deferrals.

  • If a franchise fails to open, the franchisor incurs a net loss with no recourse to recover broker payments.


Multi-Unit Deals

  • In multi-pack agreements, franchisees commit to opening multiple locations over time.

  • Deferred fees for all units can leave franchisors out substantial sums, with full loss exposure if the franchisee defaults.


Conclusion

Deferred franchise fees pose a balancing act for franchisors: ensuring franchisee protection while safeguarding their own financial stability. A franchisor surety bond offers a potential solution, allowing fee collection without delays while meeting state requirements. However, it introduces underwriting challenges, costs, and risks that must be carefully managed. Franchisors should also prepare to update their Franchise Disclosure Document (FDD) to replace fee deferral language with bond provisions, coordinating with legal counsel to file amendments with state examiners. By understanding state regulations, partnering with surety providers, and implementing robust financial strategies, franchisors can navigate these complexities effectively.


How Rikor Can Help

Rikor specializes in guiding franchisors through insurance compliance, risk management, and franchisee education. If you’re facing gaps in your coverage strategy or need clarity on protecting your brand, we’re here to assist.


 
 
 

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