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Franchising offers benefits to both those seeking to franchise their business (“franchisors”) and those seeking to participate in an existing and successful business (“franchisees”). It allows franchisors to grow their business and reduce risk by using the money and talents of others. It allows franchisees to participate in a mature business with established practices and products or services. In the past, however, franchising has given rise to fraud and other deceptive practices on the part of franchisors. In response to these abuses, the Federal Trade Commission (“FTC”) and several states established statutes and regulations governing franchisors’ offering of a franchise and the franchise relationship. 1 Accordingly, it is imperative that both franchisors and franchisees understand the nature of the franchise relationship and its legal consequences.
What is a franchise?
A franchise is defined by three elements under FTC rules. 2 These elements are often referred to as (1) the “grant,” (2) “control,” and (3) the “franchise fee.”
The “grant” 3 is the grant by one party to another of the right to offer, sell, or distribute goods and services under the grantor’s trademark, logo, trade name, or advertising.
“Control” 4 is the franchisor’s ability to “exert a significant degree of authority over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation . . . .” This control may manifest itself in the franchisee’s operations, employee or management training, product lines, store or business appearance, or geographic location. The amount of control that must be exerted (or is capable of being exerted) by a franchisor for a franchise to exist is not apparent. In many franchises, the franchisor provides an Operating Manual to the franchisee that specifies how the franchise business is to be run. The presence of such a document clearly satisfies the “control” element of the FTC’s definition.
The “franchise fee” is the franchisee’s payment to the franchisor for the right to enter into and maintain the franchise relationship. This fee is distinct from any payments for the purchase of inventory or merchandise for resale, and thus often distinguishes a franchise from other business relationships, such as distributorships or dealerships, in which there is no separate payment for the right to enter into the relationship.
If the all three of the above-described elements are present in a business relationship, that relationship is a franchise, regardless of the name the parties give to it. Typically, the franchisee/franchisor relationship is governed by a written franchise agreement setting out the rights and obligations of the parties, and all three elements will be evident from this agreement.
There are several key players in a franchise relationship. First and foremost there is the franchisor – the individual or entity seeking to franchise its existing business. Although franchisors are often thought of as mature operating systems, such as McDonald’s or Holiday Inn, franchisors frequently are smaller companies or start-ups with only one or a handful of locations. Larger franchisors offer better-established products and may have a more refined operating system. Smaller franchisors offer participation in the potentially larger growth a new business can generate. Often a newer franchisor offers less market saturation (geographic and economic) than a larger franchise as well. Additionally, a first-time franchisor may be more likely to negotiate the terms of the franchise agreement. As discussed subsequently in this article, state and federal regulatory schemes largely impose compliance burdens on franchisors. It is therefore crucial that a prospective franchisor obtain effective legal counseling before franchising its business.
Franchisees – the individuals or entities that pay money to own and operate a franchised unit – also come in all shapes and sizes. Some franchisees are first-time business owners and own and operate one unit. Others own dozens or even hundreds of franchised units and may even operate in multiple franchise systems. Although franchisee regulation is fairly light, franchisees nonetheless require competent legal counsel to understand the franchisor’s required disclosures and their rights and obligations as franchisee under a franchise agreement and applicable state and federal law.
The other major players in the franchise relationship are the Federal Trade Commission and the various state regulatory bodies that govern franchises. These government entities impose regulations with which franchisors must comply, and provide key rights to franchisees.
Federal Trade Commission
The most important legal consequence of a franchise relationship is that, absent an exemption (see discussion below), the franchisor must provide a Franchise Disclosure Document (“ FDD”) to a franchisee at least 14 days before the parties sign a franchise agreement. 5 Under federal law, a franchisor is not required to file the FDD with the FTC or otherwise register with any federal agency.
The full list of FDD-required franchisor disclosures is too lengthy to fully detail in this article, but it includes an overview of the franchise, applicable franchise or other fees, litigation between the franchisor and other franchisees, franchisor financial statements, patents and other intellectual property, the prospective franchisee’s territory or location (if restricted in any way), and the franchisor’s bankruptcy history, if any. Additionally, an FDD must contain either financial performance representations about actual or potential franchised or non-franchised units’ performance, or a disclaimer of all financial performance representations. 6
The FDD allows a potential franchisee to make an informed decision before investing in a franchise. Additionally it serves as a marketing tool for the franchisor and can prevent any misunderstandings between the parties. Failure to provide an FDD may result fines, 7 or FTC-mandated rescission of the franchising agreement or refund of franchise fees. 8 Additionally, many states (but not the FTC) provide a private right of action to franchisees for failure to provide an FDD. State and federal liability may also extend not only to the franchisor, but to its officers and principals.
State Registration Requirements and Relationship Laws
The FTC franchise rules require disclosure but not registration with the FTC or any other federal agency. In contrast, some states require a franchisor to register with a state agency before offering a franchise. Some states require only a filing of notice of intent to franchise 9; others require filing of the franchisor’s FDD or additional documents. 10 In some instances, there is an FDD-review period for the applicable state agency to rule on the effectiveness of a franchisor’s registration. 11
Many states also have franchise relationship laws governing the franchisee-franchisor relationship and prohibiting certain types of franchisor conduct, such as discrimination in the award of franchises or early termination of a franchise agreement. 12 Because of the wide variety of state franchise laws and registration requirements, counsel to multi-state franchisors must be aware of state-specific legal issues and possibly consult or retain local counsel before their clients begin franchising in a particular state.
The FTC provides a number of exemptions from its franchise-disclosure requirement for relationships that fit the FTC’s franchise definition. For example, there is an exemption for large franchisees that have been in business for at least five years and have a net worth of at least $5 million 13 and an exemption for franchisees that invest more than $1 million. 14 There are also exemptions for “fractional franchises” 15 and “insider” franchises in which a majority owner of the franchisee was recently an executive or other insider of the franchisor. 16
States with franchise registration or disclosure laws often have exemptions mirroring the federal exemptions, but sometimes offer additional exemptions. 17 Again, the importance of familiarizing oneself with state franchise law or consulting local counsel before franchising in a given state cannot be overemphasized.
The Franchise Agreement
The franchise agreement governs the relationship between the franchisor and franchisee. As such, both parties should be represented by counsel in the negotiation and preparation of the agreement. Even if a franchisor refuses to negotiate the terms of the franchise agreement (as sometimes occurs), a franchisee should engage counsel to explain the provisions of the agreement and the franchisee’s obligations. This document has significant consequences that all parties must understand.
The franchise agreement must “grant” the franchisee the right to offer, sell, or distribute goods and services under the franchisor’s s trademark, logo, trade name, or advertising. The agreement should also provide the franchise’s term, and any termination and renewal provisions. 18 Geographic restrictions or exclusive territories should also be set forth (city, state, etc.). The number of units to be franchised must be specified –as previously mentioned, some franchise agreements cover only one unit, others multiple units. The types and amount of applicable fees should always be described in detail; generally there is an initial franchise fee payable by the franchisee and ongoing royalty payments based on profits or revenues. There may be a renewal or early-termination fee. Additionally, many franchisors charge franchisees for system-wide marketing and advertising costs.
The franchise agreement should set forth the obligations and rights of the franchisee and franchisor. Most (but not all) franchisors provide franchisees with an operating manual describing how a franchise is operated and the franchisor’s minimum standards. Although this document is separate from the franchise agreement, it is often referenced in the agreement and provides mandatory and suggested guidelines on franchise unit operation. Operating manuals are crucial franchise documents; new franchisors should devote significant time to developing an effective manual.
In addition to an operating manual, some franchisors provide on-site or remote training services, site-selection and site-design services (or mandated site designs), and even financing. Franchisors may also offer franchisees the ability to participate in advertising and marketing efforts, subject to the fees mentioned above.
Typically the agreement provides a specific date by which the unit (or units) must be open and operational. Franchisees must maintain system operating and quality standards, but the ways standards are monitored vary from system to system ( e.g., customer satisfaction scores, revenue trends, on-site inspections, etc.). Most franchise agreements also provide confidentiality provisions (protecting franchisor trade secrets or other intellectual property) and in-term non-compete covenants. 19 Franchise agreements also specify any required or preferred vendors or providers of supplies or materials need to operate the business. This requirement insures system quality and uniformity; frequently volume rebates or other benefits are also available from suppliers and vendors. Alternatively, some franchisors sell raw materials or products directly to franchisees either at cost or at a profit.
Any required guaranties of the franchisee’s obligations are also generally mentioned in the franchise agreement, although the terms would be set forth in a separate guaranty agreement. Guaranties are often required from the principals of a franchisee that is an entity.
So called “boilerplate” provisions, while frequently overlooked, are also important in franchise agreements. Dispute resolution and choice of law are vital if a dispute over the agreement arises, particularly considering the wide variety of state franchise laws. The franchise agreement should also address assignment/change of control/sale of business (for both the franchisor and franchisee. Typically, franchisees must obtain franchisor consent for a franchise transfer, but a franchisor can transfer its business and assets freely.
Although franchising offers benefits to franchisors and franchisees, it also carries with it significant legal consequences and potential pitfalls for inexperienced franchisors and franchisees. Before entering into a franchise agreement, both sides should engage effective legal counsel to fully understand their rights and responsibilities under the franchise agreement and applicable law.
1 California established the first franchise laws in 1970. The FTC franchise rule was first enacted in 1979. Before this time, franchising was largely unregulated.
2 16 C.F.R. § 436.1 (2009).
3 Note that some commentators have further separated the first element into the (a) “grant” and (b) the “trademark.”
4 This element is sometimes referred to as the “continuity of interest” element.
5 16 C.F.R. § 436.2(a).
6 Id. §§ 436.4-436.5.
7 15 U.S.C. § 45(m).
8 Id. § 57b.
9 Mich. Comp. Laws § 445.1407a.
10 E.g., Wis. Stat. § 553.26.
11 E.g., 815 Ill. Comp. Stat. 705/10.
12 E.g., N.J. Stat. §§ 56;10-1 – 56:10-15.
13 16 C.F.R. § 436.8(a)(5)(ii).
14 Id. § 436.8(a)(5)(i).
15 Id. § 436.8(a)(2). A fractional franchise is a franchise in which the franchisee or any of its directors or officers has more than two years experience in the same business and the parties have a reasonable basis to anticipate that sales arising from the fractional franchise will not exceed 20% of the franchisee’s total dollar volume in the first year of operation. Id. § 436.1(g). An example would be a fast food location that is located inside a gas station or grocery store.
16 Id. § 436.8(a)(6).
17 See, e.g., Minn. Stat. § 80C.03(c) (providing exemption for franchisees that are also banks, financial organizations, or life insurance corporations).
18 Subject to any applicable state franchise termination or renewal restrictions.
19 Some franchise agreements provide for post-term non-competition covenants as well, but these are of questionably enforceability in many states.
About the Author
Mr. Hutchison is an associate at GableGotwals in Tulsa, Oklahoma. Mr. Hutchison’s practice focuses on business transactions, including Banking and Commercial Lending, M&A, Securities and Corporate Finance, and Franchise Law. Mr. Hutchison is a member of the American Bar Association’s Forum on Franchising, Section of Business Law, and the Young Lawyer’s Division, as well as the Oklahoma Bar Association and the Tulsa County Bar Association. He can be reached at (918) 595-4800 or at firstname.lastname@example.org.