Franchise FAQ

A franchise exists whenever three elements are present. Under federal law, the three elements include the following: (1) the license of a trademark, service mark or logo; (2) the payment of money to the licensor or its affiliates; and (3) significant control or assistance.

Trademark

The trademark element is very broad under federal law. A traditional trademark “license” is not required to trigger coverage. According to the Federal Trade Commission, all that is needed is the right to sell goods or services associated with the licensor’s mark. This is true even if the agreement specifically disclaims any license of a mark. For example, in a typical distributorship relationship, the distributor purchases the manufacturer’s products and resells them. If the products bear the manufacturer’s trademark, the trademark element is met even if the distributor has no other rights to use the mark.

Money

In order to be a franchise under federal law, the licensee must pay the licensor or its affiliates at least $500 (subject to adjustment based on changes in CPI) within the first six months after opening the business. This element is commonly misconstrued, even by experienced business lawyers. Many people think you can avoid franchising as long as you don’t charge a “franchise fee.” Some people believe simply changing the name of the fee from a “franchise fee” to a “license fee” will get you out of franchising. Others incorrectly believe that eliminating any up-front fee and simply charging “royalties” or “training fees” will keep you out of the franchise realm. In reality, ALL payments to the licensor and its affiliates are franchise fees with one exception – payments for reasonable quantities of inventory at bona fide wholesale prices. Every other payment is a “franchise fee” regardless of how it is described, including payments for goods or services. The exclusion for purchases of inventory is designed to keep true distributor relationships out of the world of franchising. However, many manufacturers unwittingly make themselves “franchisors” by charging additional fees or by charging more than a “bona fide wholesale price” for inventory (i.e., hidden franchise fees).

Control/Assistance

Many people believe a relationship is a franchise only if the licensor controls every aspect of the business. This is absolutely wrong. First, a franchise relationship can exist without ANY controls if the licensor provides significant assistance. For example, if the licensor provides marketing support, training, accounting services, financial assistance or other assistance, the element can be met. Often, providing an operating manual is considered “significant assistance.” The general rule of thumb is that if the licensee is relying on the licensor to ensure its success or to learn how to operate a new business, the control/assistance element is met. On the flip side, a franchise can also exist where there is no assistance, but the licensor instead exerts significant controls (for example, controlling hours of operation, imposing site selection or store appearance requirements, imposing territorial limitations, etc.).

Most states have a similar definition of a franchise, although the third element varies. In some states, the third element is a marketing plan prescribed by the franchisor. In other states, the third element is the existence of a community of interest between the franchisor and franchisee. The meaning of a “community of interest” is somewhat vague and has been interpreted in several ways by the courts. However, if the relationship would satisfy the control/assistance element under federal law, it will likely be a franchise under state law as well.

Franchises are regulated under both federal and state law. Generally, all franchise laws fall within one of three distinct categories: disclosure laws, registration laws or relationship laws. At the state level, the structure of franchise regulation varies by state. Some states have disclosure laws, some have registration laws, some have relationship laws, some have all three, while others do not regulate franchises at all (in which case the federal franchise rule still applies).

As a general matter, the federal disclosure law applies in all states that do not have a comprehensive franchise disclosure law. Currently, there are 15 states that have comprehensive franchise disclosure laws and 14 states that have franchise registration laws. There is no registration requirement at the federal level and there are no generally applicable franchise relationship laws at the federal level (there are federal relationship laws that apply to specific industries).

Disclosure laws

Disclosure laws require that franchisors disclose certain specified information to prospective franchisees before selling a franchise. These disclosures are intended to allow franchisees to make informed business decisions before making any significant financial commitment. Under federal law, a franchisor must give a prospective franchisee a Franchise Disclosure Document at least 14 days before the franchisee signs a binding agreement or pays any money to the franchisor or an affiliate. The Franchise Disclosure Document must be updated on a periodic basis.

The individuals who offer and sell the franchises are prohibited from making misrepresentations about the franchise offering. In addition, the sellers may be prohibited from disclosing certain information even if the information is true. For example, a franchise seller generally may not disclose any earnings information unless that information is disclosed in Item 19 of the Franchise Disclosure Document. It is highly recommended that all individuals who will offer and sell franchises complete a comprehensive franchise sales training program that highlights the “dos and don’ts” of selling franchises.

Registration Laws

Currently, 14 states require that franchisors register with the appropriate state agency before offering or selling any franchises within the state. There is no registration requirement at the federal level. The registration process is relatively straightforward, although obtaining an initial registration can take a few months in a few registration states. Franchise registrations must be renewed annually.

Relationship Laws

Unlike disclosure and registration laws, relationship laws seek to protect franchisees by regulating conduct between the parties during and, in some instances, after the relationship ceases. These laws can either impose affirmative obligations or prohibit certain activities. For example, franchise relationship laws commonly prohibit franchisors from terminating or failing to renew a franchisee unless the franchisor has “good cause” and provides the franchisee with a written notice of default and reasonable cure period.

In most industries, establishing a franchised distribution network does require a significant investment in order to “do it right”. However, there are a number of shortcuts you can take to minimize expenditures in order to test the waters to see if franchising is right for you. Some common expenditures include the following:

Franchise Lawyer

In terms of legal fees, you need to hire a lawyer to create your Franchise Disclosure Document, which will include your Franchise Agreement and all other agreements franchisees must sign to operate the franchise. We offer these services (including a half-day franchise sales training seminar) on a flat fee basis. We also offer alternative fee structures where you can pay a portion of these legal fees over a period of time as you sell franchises. Please contact us if you are interested in discussing our fee structures.

Other franchise related legal services may include: (i) applying for a federally registered trademark; (ii) forming a new entity that will act as the franchisor; (iii) reviewing or developing operations manuals (oftentimes, the client develops the manuals or, better yet, hires a franchise consultant to do so); (iv) registering the franchise offering in franchise registration states; and (v) filing business opportunity exemptions in certain states. Trademark and franchise registration applications also require the payment of filing fees with the USPTO and franchise registration states.

Once you have begun franchising, certain ongoing legal representation will likely be necessary to operate your franchise system, including the following:

• Preparing periodic and annual updates to the Franchise Disclosure Document;
• Preparing and filing applications, renewals and amendments of franchise registrations and business opportunity exemptions;
• Negotiating and documenting transactions with franchisees;
• Providing general advice on various franchise matters;
• Providing advice regarding compliance with franchise sales, advertising and relationship laws; and
• Responding to state investigations.

We offer our clients annual “package plans” that include these services for a flat monthly fee. We would be happy to discuss a package plan that suits your anticipated legal needs.

Franchise Consultant

Many franchisors hire franchise consultants to help them structure and launch their franchise. You may need to hire a franchise consultant to prepare your operations manuals and marketing materials and provide strategic consultation services. We strongly recommend that all franchisors hire a good franchise consultant to assist with the development of their franchise model.

Auditor

In many cases, you will need to hire a CPA to prepare audited financial statements relating to the franchisor’s financial condition. Under federal law, a newly formed franchisor is allowed to begin offering franchises without an audit as long as certain conditions are met. However, several franchise registration states will not register the offering unless the Franchise Disclosure Document includes audited financial statements.

Capitalization of Franchisor

Once you form the franchisor entity, you will need to provide the initial seed capital. It is important to adequately capitalize the company for a number of reasons, including:

• Protecting the owners’ personal assets from claims against the franchisor (if inadequately capitalized, a court may “pierce the corporate veil” and subject the owners’ assets to claims by the franchisor’s creditors);
• Providing “healthy” financial statements in the FDD to satisfy prospective franchisees that the franchisor can meets its financial obligations; and
• Avoiding an “impound” from a franchise registration state, which in most instances prevents a franchisor from collecting any money from the franchisee until the franchisee has opened the franchised business.

Business Related Expenses

To properly launch a franchise, you will need to spend money to develop the infrastructure necessary to administer and support your franchise network. For example, you may need a separate office, franchise management software, franchisee training materials, etc. You may also need to hire additional franchise support staff. In order to sell franchises, some franchisors need to spend significant amounts of money on franchise marketing activities as well as franchise brokers.

How long does it take to franchise?

The answer depends on a variety of factors. In terms of the legal work, we have launched a franchise in less than a week. More commonly, preparation of a Franchise Disclosure Document will require at least a few weeks after submission of a substantially complete franchisor questionnaire (we send you this questionnaire to begin the process). A “complete” FDD must include the financial statements and table of contents to the operations manual. These items can delay the process of completing the FDD.

Once the FDD is complete, we can begin the franchise registration process, assuming the client wants to offer and sell franchises in one or more franchise registration states. In most franchise registration states, we can complete the registration process within a 2 to 4 week period (only a few days are required to become registered in a handful of “notice filing” states). However, a few registration states, such as Maryland and Illinois, can be slow to review and respond to franchise applications. The length of time to obtain a franchise registration also varies depending on the time of year. The process tends to take much longer during the Spring, which is franchise renewal season and the regulators’ busiest time of year.

Although franchise law does not require that a franchisor obtain a federally registered trademark, it is very risky to franchise without one. A franchisor should be able to protect its franchisees’ right to use the licensed marks. A franchisor should also be able to stop unauthorized third parties from using its marks. Without a federal registration, it may be difficult for a franchisor to accomplish these tasks. A registered mark also adds value to the franchise. As the network grows and the goodwill associated with the marks increases in value, it becomes much more problematic and expensive if it turns out the franchisees’ use of the marks infringes on the rights of third parties (in which case the franchised network may have to convert to a new mark).

Not all franchisors hire franchise consultants. However, franchise consultants provide valuable insight and can significantly improve the short term and long term success of your franchise system. We have worked with many franchise consultants and would be happy to provide referrals upon request. However, you should be very careful in your selection of a franchise consultant. We have heard many horror stories about franchise consultants who engage in “questionable” business practices and provide limited value to their clients. In particular, you should be wary of any franchise consultant that offers to prepare your Franchise Disclosure Document or perform other legal services. Beside the fact that these practices may be illegal, it is a strong indication that the company lacks the integrity of a good franchise consultant.

Ideally, you would like to be able to sell area development or regional development franchises. In direct franchising (i.e., single unit franchising), each franchised outlet is owned by a different franchisee. A single unit structure requires the most franchisor support because each franchisee requires training and assistance with the development, opening and ongoing operation of the business.

In an area development model, a single franchisee purchases multi-unit development rights, meaning that the franchisee commits to open multiple franchised outlets according to a pre-determined development schedule. Once the franchisee has opened the first outlet, he or she will require significantly less support for each subsequent opening, thereby reducing the burdens on the franchisor.

In a regional development model, a regional developer (or RD) buys development rights to a large territory. The RD then solicits third parties within the development territory to purchase franchises. The franchisor signs the franchise agreements with these franchisees but delegates certain initial and ongoing support functions to the RD. Essentially, the RD provides certain services within the RD’s territory that would otherwise be performed by the franchisor. In exchange for these services, the franchisor shares initial franchise fees and ongoing royalties with the RD. The regional development model has been successfully used by a number of franchise systems to achieve rapid growth.

Although these methods of expansion can be desirable because they can accelerate growth while reducing the need for support resources, they do carry significant risks. First, it can be difficult to sell area development or regional development franchises unless you already have successful single unit franchisees that have proven the viability of the business model. Second, the problems caused by a bad area developer or regional developer are exponentially worse than the problems caused by a bad single unit franchisee.

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The most common form of international franchising involves a master franchise structure. Under this model, the franchisor basically sells the franchising rights to the entire country (or in some instances a portion of the country) to a master franchisee. The master franchisee assumes responsibility for the offer and sale of franchises and the administration of the franchise network in the country. In exchange for these rights, the master franchisee usually pays a significant initial fee for the master franchise rights and then splits the ongoing revenues generated by the franchise system with the franchisor. In some systems, the master franchisee entity consists of a joint venture between the franchisor and the local partner who provides the funding and takes primary responsibility for the daily management of the franchise system. The joint venture may be used by the franchisor as a means to exert additional control over the local partner. This structure may also provide tax advantages (for example, the franchisor may extract its fees in the form of distributions rather than payment of royalties). However, these JV models can present significant challenges in terms of local corporate law issues.

The master franchise structure offers many advantages. First, the franchisor may not have the resources to establish a regional office in the foreign country or travel to the foreign country to administer the franchise system and provide the necessary support. In addition, the local partner is more familiar with the country and can provide valuable insight in terms of modifying the system to improve appeal to the local culture, identify and establish relationships with local suppliers, and communicate with franchisees in the local language. The drawback to the master franchise model is that the master franchisee plays such an important role in developing your brand that a bad master franchisee can seriously jeopardize the chances of your brand succeeding in the country.