Franchising Basics

Franchising Basics

You have a unique business concept, and you have one, two, or perhaps ten successful operating locations. You may be considering taking on additional debt or equity financing to expand further. Before you do so, consider franchising. Franchisers can expand the reach of their concepts quickly, while leveraging the expertise, enthusiasm, and sweat of new entrepreneurs acting as franchisees.

What Is A Franchise?

The Federal Trade Commission (“FTC”) Franchise Rule defines a franchise as any continuing business relationship or arrangement having three elements: (1) substantial association with the franchiser’s trademark, (2) the payment of a fee by franchisee to franchiser, and (3) the provision of substantial assistance by franchiser to franchisee, or the exertion of substantial control by franchiser over franchisee.

It does not matter how the parties label a commercial relationship. A license, joint venture, dealership, distribution arrangement, or even a co-owned LLC can qualify as a franchise if these three elements are met.

  • Substantial Association.

The “substantial association” element of the Franchise Rule is most often met by a license for franchisee to use the franchisor’s name. This is almost universally the case in food, restaurant, and retail concepts.  However, usage of the name is not always required. In some instances, courts have found that an association with the franchisor that results in the franchisee deriving goodwill from the reputation of the franchisor, even when the franchisor’s name is not used, can satisfy this element. Courts interpret this element broadly.

  • Payment of a Fee.

As far as the Franchise Rule is concerned, the fee element can be satisfied not only by the payment of something labeled a “franchise fee,” but by royalties, required purchases, consulting fees, and more. Courts also construe this element broadly, so almost any required payment from the franchisee to franchiser will satisfy this rule. Exceptions exist, but they are interpreted narrowly.

  • Significant Control or Significant Assistance.

The third element of the Franchise Rule can be met in either of two seemingly disparate ways. First, the franchiser can exert a significant level of control over the operations of the franchisee. Such control may be established through requirements in a franchise agreement, license agreement, LLC operating agreement, franchise handbook, or even by oral instructions from franchiser to franchisee. Simply ask, can the franchiser control something important about the franchisee’s operations? If so, this element is met.

Second, the franchiser can offer significant assistance to the franchisee to meet this element. Does the franchiser provide training? An operations manual? Guidance on FF&E, hiring, logistics, sourcing, compliance, or management? If so, this element will be met. Once again, this element is broadly construed by the courts, as the purpose of the Franchise Rule and state analogs is to protect prospective and current franchisees from predatory franchise tactics. Notice a pattern here?

Regulation of Franchising.

FTC Disclosure Requirement

The FTC requires that if an arrangement meets the elements of a franchise, certain disclosures must be made by the franchiser prior to signing an agreement. Such disclosures are contained in franchise disclosure documents, also known as FDDs.

FDDs must contain information on 23 different disclosure topics: the franchiser and its parents, predecessors, and affiliates; the business experience of its principal officers, directors, and managers; litigation; bankruptcy; initial fees that the franchisee must pay; other fees; an estimate of the franchisee’s initial investment; restrictions that the franchiser imposes; the franchisee’s obligations; financing that might be available through the franchiser; the franchiser’s obligations to provide assistance and information about advertising, computer systems, and training; the territorial rights of franchisee; the franchiser’s trademarks; its patents, copyrights, and proprietary information; the franchisee’s obligation to participate in the actual operation of the franchise business; restrictions on what the franchisee may sell; information about renewal, termination, transfer, and dispute resolution; any public figures who endorse the franchise; optional financial performance representations; information about outlets and franchisees; the franchiser’s financial statements; a list of contracts required of the franchisee; and a receipt form.

The FTC only requires disclosure, not registration, but registration is required by some states, discussed in the following section.

State Requirements

Thirteen states have enacted supplemental franchise laws and require additional registration of the franchiser’s FDD. These states are California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, Virginia, Washington, and Wisconsin. In these states, franchisers must file and register their FDD prior to offering or selling a franchise.

Other states, including Michigan, Oregon, and South Dakota have supplemental franchise laws beyond the FTC Franchise Rule but do not require registration. In all instances, the FTC Franchise Rule must be followed (unless the franchise is subject to exemption) regardless of whether there is a supplemental state law to follow.

At least sixteen states also have promulgated “relationship laws” to protect the rights of franchisees in existing franchise relationships. These laws typically restrict franchisers’ power over terminations, renewals, costs, and other issues in the franchise relationship. These laws often require “good cause” for termination by franchiser, as opposed to termination based on an immaterial or minor breach of the franchise agreement. Good cause is frequently supplemented by a requirement of a notice of default and an opportunity to cure before a franchise may be terminated.

Ramifications of Improper Disclosure or Other Violations.

The importance of compliance with FTC and state laws relating to franchising cannot be overstated. The FTC and state attorney generals can bring both civil and criminal actions on behalf of franchisees, and liability can extend to directors, officers, and owners of the franchiser personally.

In the event that disclosures are improperly made, or not made at all, franchisees may have a litany of potential remedies, including the ability to rescind the franchise agreement, recoup fees paid, seek actual or statutory damages, and recover attorneys’ fees. In sum, businesses considering the establishment of a “franchise system” or something that could be construed as such, should seek experienced franchise counsel to guide them through the disclosure and registration process.

 

Clark Partington’s Intellectual Property Group is equipped to answer questions related to your specific situation. With offices in Pensacola, Destin, Santa Rosa Beach, Tallahassee, and Orange Beach (Alabama), we are a full-service firm covering this part of the Gulf Coast.  To reach one of Clark Partington’s Intellectual Property attorneys, contact Kris Anderson at (251) 225-4122 or kanderson@clarkpartington.com.

 

This publication should not be construed as legal advice.  Its applicability is dependent upon specific facts and circumstances and is provided for informational purposes only.  You should not act upon this information without seeking advice from a lawyer licensed in your own state.