Note: Franchising is a very complicated but extremely rewarding business venture. Please contact us for more information.
Franchising - a business relationship in which a franchisor grants to a franchisee the right to operate a business selling services or products developed by the franchisor - continues to grow as a business model. Franchising dominates certain industries and is becoming more popular in others. Unlike a buyer-seller relationship, franchising is an interdependent relationship in which success for either party depends, to a large extent, on the success of the other.
In a franchise relationship, the franchisor and franchisee pool their resources and capabilities. The franchisor contributes the business plan, initial capital and intellectual property including trademarks, know-how and experience and the franchisee contributes supplemental capital, operating experience and hard work.
Franchising is an interdisciplinary area of law. In addition to complying with laws explicitly regulating franchises, parties to a franchise arrangement must contend with a wide variety of legal and business issues: antitrust, contracts, business organization, consumer protection, intellectual property, securities and corporate law, Federal and state tax law and laws relating to the termination and renewal of franchises. Franchisors (or their advisors) should have a basic understanding of accounting principles, business sales, franchise sales programs and the use of operations manuals.
Franchisees (or their advisors) should be conversant with the same issues as franchisors, but should also understand how to evaluate different franchise opportunities, the constraints on franchise agreement negotiations and the services that the franchisee should expect from the franchisor.
Every franchise must comply with Federal and state franchise laws and regulations. It is essential, therefore, to understand the legal definition of a franchise. The fact that parties did not intend to form a franchise will be irrelevant in an enforcement action if the relationship satisfies the definition. An attorney who acts as counsel to either a franchisor or a franchisee must be able to (1) recognize a franchisor-franchisee relationship; (2) know which government authorities regulate franchises and the regulatory schemes administered; and (3) give advice regarding compliance with the regulatory scheme.
Although the statutory definitions differ somewhat from state to state, each contains the following elements: (1) the franchisor grants the right to use intellectual property in combination with a business method or format (brand identification); (2) the franchisor maintains quality control and uniformity over the products or services offered by the franchisee; (3) the franchisor provides assistance to the franchisee in the form of buying arrangements, site location, or cooperative advertising; and (4) the franchisee pays a fee to the franchisor ($500 or more).
Due to perceptions that franchisors often engaged in abusive conduct and that franchisees needed protection, Federal and state laws emerged relating to franchise registration/disclosure and the sale of business opportunity ventures which now govern every stage of the franchise relationship: offers and sales, operation, renewal, termination and succession. Franchises are as highly regulated as securities.
There are two basic types of regulatory schemes: (1) disclosure with registration, and (2) disclosure without registration but with mandated termination and renewal provisions. About 15 jurisdictions require that a franchisor offering franchises in the jurisdiction register the disclosure document. The remaining jurisdictions require that a disclosure document be provided, but the document need not be registered. Many of these jurisdictions impose mandated termination provisions that require that the franchisee receive reasonable notice of termination and the cause. The franchisee must also be afforded a reasonable opportunity to cure.
After the disclosure document is filed, the franchisor must amend if there has been a material change in the information. The disclosure document must contain audited financial statements for the past three consecutive fiscal years. Changes in financial statements are material changes.
In the typical franchise, the franchisor limits the geographical area in which a franchisee can operate, restricts the products or services a franchisee can offer, and requires the franchisee to buy from approved sources. In such an arrangement, antitrust issues can easily arise and case law has developed that adapts antitrust concepts to the franchise relationship. The franchisor may require a franchisee to sell only products licensed by the franchisor or produced from ingredients supplied by the franchisor to assure quality and to protect the business format of the franchisor. The franchisor may also require a franchisee to purchase only from approved sources as long as the franchisor sets standards and specifications and it is reasonably necessary to assure quality and to protect the business format of the franchisor. However, a franchisor cannot coerce a franchisee to sell products which are unconnected to quality standards. Kickbacks are also usually automatic antitrust violations.
Franchise Disclosure Document
The franchisor must provide a potential franchisee with a document that contains the disclosures required by the Franchise Disclosure Document (“FDD”). The disclosure document must be provided at the first face-to-face meeting of the parties or 10 business days before any money is paid or any agreement is signed in connection with the franchise, whichever is earlier.
The FDD contains 23 items, each a description of certain categories of information. The following list is a summary of the information required under each item: (1) identity of the franchisor, business organization, franchisor’s experience, predecessors and affiliates; (2) names, titles and positions of managers; (3) civil and criminal litigation history of the franchisor and its principals; (4) bankruptcy history of the franchisor; (5) initial franchise fees to be paid before the franchise operates and whether any franchise fees are refundable; (6) continuing franchise fees such as royalties, how calculated, when paid, and whether refundable; (7) the total investment that the franchisee must make in order to open the franchise (i.e., real property and construction costs, equipment and fixtures, initial inventory); (8) obligations of the franchisee to purchase goods and services from the franchisor or franchisor-approved sources; (9) the principal obligations of the franchisee under the franchise agreement; (10) financing arrangements offered by the franchisor; (11) the franchisor’s obligations, such as site selection, training and assistance during operation; (12) description of exclusive territory, if any; (13) trademarks or service marks; (14) patents and copyrights; (15) obligation of the franchisee to participate personally in or operate the business; (16) restrictions on products sold, customers, and sources; (17) terms of termination, renewal, transfer and dispute resolution; (18) arrangements with public figures; (19) earnings claims, basis for claims, and supplemental claims for particular locations; (20) number and locations of franchisees, terminations, cancellations, nonrenewals, and reacquisitions within the last three years; (21) audited financial statements (income and balance sheets) for the past three fiscal years; (22) each agreement that the franchisee will be expected to execute, including leases, notes, and development agreements; and (23) receipt evidencing the fact that the franchisee received the FDD.
Franchise Documents and Considerations
Franchise Agreement and Operations Manual. The most important document in the relationship is the franchise agreement. It governs the licensing, use of trademark, the business format, the responsibilities of both franchisor and franchisee, and the duration of the franchise. The operations manual should thoroughly detail the process for conducting the franchised business. It should specify (1) the manner in which the business is to be operated and (2) which tasks and responsibilities belong to the franchisee and which to the franchisor. The manual should also contain reporting, recruitment, training and administrative procedures to be followed uniformly by all franchisees.
Trademarks. The use of the franchisor’s brand name and logo is the main point of acquiring a franchise. Thus, it is advisable that the franchisor has them registered.
Franchisee Qualifications. Franchisors need specific criteria to determine who is qualified to be a franchisee. Qualifying for a franchise is not entirely about the money; it is also about building a long-term relationship. Franchisors should not be greedy and accept applications without qualifying franchisees, but should remember that there is a brand name and reputation to protect.
Marketing Plan. Franchisees expect the franchisor to have marketing materials and activities such as advertising, promotions and PR to help maintain interest in the brand. Since a marketing fund is financed by the franchisees from their gross sales, it should be apparent to them that they will enjoy significant benefits in comparison with independent competitors.
Franchise Support. Franchisees, as management trainees, will rely heavily on the expertise and guidance of the franchisor in opening and operating the franchise. The franchisor needs to be clear as to how it intends to train and assist the franchisee in finding a suitable site, constructing the franchise and training the staff. Ongoing support should include regular meetings for discussing franchisee concerns, as well as a franchise monitoring team.
Territorial Protection. The franchisor must be clear about the area of operations for each franchise so that franchisees are not forced to compete among themselves. The borders of each territory should be specified in the franchise agreement. The franchisor usually assigns exclusive rights to a particular territory within which no other franchisee may infringe.
Negotiated Changes. The purpose of the FDD is to assure that the franchise “deal” is fully disclosed to the franchisee before the franchisee is bound by the franchise agreement. As noted, the franchisor must amend its FDD (possibly in many states) if there is a material change in the information, such as differing deals among the franchisees. It is therefore difficult for the franchisor to agree to any negotiated changes in the franchise agreement.