Franchising is a way of financing expansion of businesses distributing products and services. It can create quicker growth while sharing risks and shifting the expansion costs. A franchisor normally provides the franchisee with training and on-going support for starting and operating a business that utilizes the franchisor’s trademark(s) or service mark(s), and its business systems. A franchisee usually supplies the start-up capital and manages the operation on a day-to-day basis. There is typically an initial franchise fee and on-going royalties that the franchisee pays the franchisor for the right to use the franchisor’s marks and systems, and for ongoing assistance by the franchisor.
Federal law defines franchising as having the following three elements:
(a) The franchisor has given the right to a franchisee to distribute goods and services under franchisor’s trademark, service mark or other commercial symbol.
(b) The franchisor provides significant assistance to or has significant control over the franchisee’s method of operation.
(c) Franchisee must to pay at least $500 before or within 6 months of opening for business.
If your business fits this definition, you must comply with the Federal Trade Commission Franchise Rule (FTC Rule), which regulates the offering of franchises. The FTC Rule requires that a prospective franchisee be provided with specific information about you, the franchisor, and the franchise opportunity. The required information must be provided in a document called a Franchise Disclosure Document (FDD) (previously called a Franchise Disclosure Statement or Uniform Franchise Offering Circular (UFOC)). The FDD will also include the franchise agreements and other contracts used by the franchisor.
Some states have their own franchise regulations. In twelve states, it is required to register the franchise before you can sell franchises in that state. In those states, you not only have to comply with the federal guidelines, but you also have to comply with the state guidelines. Other states do not require registration, but have specific laws that regulate the franchise relationship, such as termination and renewal of the franchise.
What businesses are the type that can be franchised?
Almost any type of business can be franchised – businesses that sell services or products, but not all businesses are candidates for franchising.
Is your business a candidate for franchising?
Operating a franchising business is different from operating the franchised business and different skill sets are involved for a franchisor who must sell franchises, train franchisees and provide continuing support to the franchisees in the system. You must determine if you or your employees have the skills and organization to be a franchisor, and you must also determine if the business lends itself to franchising.
Factors to consider:
Can your concept and prototype be reproduced with other persons operating it?
Is your prototype providing enough profit to provide a franchisee with an adequate return on their investment, after paying royalties?
Can your concept be successful in other locales?
Can your concept be easily put into a training program and taught to others?
What can you provide to your franchisees on an ongoing basis after you have trained them in your systems and assisted them in opening, such as group purchasing or marketing materials?
Does your concept require special certification or a unique attribute to be successful?
Do you have the personnel to continue to operate your current business and start a franchise company?
The fundamental elements of a successful franchise company:
Existing Concept – An operating business that is profitable and can be duplicated with other operators.
Brand Value – The business must have features and characteristics that distinguish it from the competition and provide a value to the franchisee. This is done through trademarks and service marks, store design if a retail location, advertising materials, and marketing programs.
Standardized Systems – This is the roadmap for how the business operates. These systems should be clearly illustrated in an operation manual and must be presented in a way that is transferable to franchisees.
People Power – You must have the proper people in your organization to market the franchise and meet the franchisor’s obligations under the franchise agreement. Those usually include people skilled in sales, finance, training, operations, and marketing.
Franchise Law Compliance – As stated above, there are federal and state franchise laws with which you will need to comply. This begins with having a Franchise Disclosure Document to deliver to prospects, and becoming registered in some states if you make offers in those states. There are also rules governing the type of advertising you are allowed to do and what types of representations may be made outside of the FDD.
Capital Requirements – Franchising a business, like any business venture, requires sufficient capital. The amount varies depending on the type of business and how quickly you want to grow the business. Initial costs include legal and accounting fees in preparing the agreements and FDD and fees to specialists to create manuals and other operation tools. There may also be sales fees and costs of marketing the franchise.
Business Plan – As with any new business, it is recommended that you have a good business plan that outlines the strategies and timetables in expanding the business through franchising.
Professional Advisors – Engaging experienced franchise counsel is especially important in starting a franchise business. Most attorneys have little knowledge of the intricate laws and regulations governing franchising and an experienced franchise lawyer can assist you in making many of the business decisions that accompany beginning a franchise, including issues of royalties, territory restrictions, purchasing requirements, term of the franchise, advertising funds, and operation manuals.
With the greater percentage of this country’s gross national product each year coming from sales of goods and services in franchise systems, recognizing when a business plan or distribution system falls within the definition of a franchise, under federal or state laws is important. It is also important to understand the risks to businesses, and the individual principals of those businesses, for failure to comply with these laws. Although many entrepreneurs dislike the cost of effective compliance with franchise laws, most successful franchisors realize that franchising is an excellent way to finance expansion of their business and that non-compliance with the franchise laws provides a potential for exceedingly greater costs. Compliance with all applicable laws is not difficult if handled properly from the beginning.
What is a Franchise?
Although there are numerous legal interpretations of what business relationships constitute a franchise, there are three basic elements of a franchise under both federal and state laws. The definition of a franchise under federal law, which is under the jurisdiction of the Federal Trade Commission (the “FTC”), is found in the FTC Rule (16 CFR Part 436), which was initially adopted in 1979, and substantially overhauled in January 2007. That definition contains the following three elements, all of which must be present to have a franchise: (1) use of another’s trademark, (2) substantial control or assistance by another; and (3) a required payment of $500.00 or more within six (6) months after commencing operation of the franchisee’s business (which can include payment for goods or services). Interpretation of each of these elements has been very broad, even extending the definition of a franchise to some business relationships more commonly referred to as distributorships. Therefore, many companies legally subject to franchise laws are not even aware of their compliance obligations.
Compliance Under the Law
The FTC Rule requires that certain disclosures be made by franchisors or their agents to prospective franchisees at least fourteen calendar days prior to receipt of a franchise fee or the signing of a franchise agreement and again when modifying existing agreements. These disclosures must be in a prescribed disclosure document form, the Franchise Disclosure Document or FDD (previously called the Franchise Disclosure Statement or Uniform Franchise Offering Circular or UFOC). The FDD is similar to a securities offering prospectus and in it the franchisor must disclose detailed information about its principals and business. In twelve states, the disclosure document must be registered with a franchise administrator after their review. These states each require slightly different disclosures, some more important than others to a particular franchisor. Texas does not require registration of the franchise offering.
Penalties for Non-Compliance
For each violation of the FTC Rule, the FTC may recover civil penalties up to $10,000 per day for each violation of the FTC Rule plus rescission or reformation of contracts, a refund of money, and payment of damages to individuals. The statute provides no excuse for ignorant or unintentional violations. Although the FTC is more likely to bring an action against a franchisor who fails to make proper disclosures and misrepresents the franchise, there have been several cases where the only apparent violations of the FTC Rule were a failure to provide the required disclosure documents.
Under most state laws, a franchisee can bring a civil action against a franchisor. Often such laws allow a franchisee to rescind a franchise agreement, obtain a refund of monies paid to the franchisor and, in some cases, obtain punitive or multiple damages for intentional misrepresentations or wrongdoings. In Texas, actions can be brought under the Deceptive Trade Practices-Consumer Protection Act and can result in multiple damages to a non-compliant franchisor.
A franchisor who fails to comply with disclosure and registration requirements is also subject to criminal sanctions. Under most states this would be a felony, and these states will usually apply such sanctions to any violation of the state’s franchise law, no matter how egregious. In addition, under most of the criminal statutes, it is only necessary to show that the franchisor intentionally offered or sold a franchise knowing that it was not registered, not that it intended to break the law.
Under both federal and state law, there may be personal liability for individuals acting on behalf of the franchisor as well as individual control persons of the franchisor. The FTC will invariably target for punishment the individuals responsible for a violation along with the franchisor. In addition, the FTC can assert individual responsibility on persons who control a corporate franchisor and have knowledge of its fraudulent practices.
Under many state laws, there are specific provisions which allow the state or a franchisee to hold certain individuals responsible for all damages awarded to franchisees under the statute. Often the laws apply to any person who violates the statute, which would include the corporate franchisor and any control person as well as the agent who made the misrepresentations or directed the non-compliance.
Even the best of franchise systems will ultimately have a franchisee who for one reason or another becomes disenchanted with the business. Failure by the franchisor to initially comply with all franchise disclosure laws will allow such a franchisee to have a much greater chance of success in a legal action against the franchisor. In addition, such a success might provide encouragement for other franchisees who are marginally dissatisfied and might not otherwise bring an action. With exposure to the franchisor for non-compliance with franchise laws potentially so large and the strong likelihood that corporate officers and directors will be personally liable and/or exposed to jail terms, a prudent franchisor will be certain that the business receives the expert advice necessary to insure full compliance with the law.
If you are thinking of buying a franchise, there are a few things that you should know to make the process a little bit easier. As a lawyer representing both franchisors (the sellers of franchises) and franchisees (the buyers), I have seen hundreds of franchise offerings and can offer some advice based on my experience.
Are you an entrepreneur?
You may think I ask that because franchisees should be entrepreneurs. Actually, it’s the opposite. To be a successful franchisee, you must be able to operate within a system of fixed rules. The primary reason to buy a franchise, rather than start a business from scratch, is to take advantage of someone else’s experience. Individuals who want to do things their own way may have trouble fitting into a system. The most successful franchisees are people who operate the business according to the system. Now, that doesn’t mean you shouldn’t be motivated or a self-starter. Those are generally necessary qualities in a franchisee. But if you are the type of individual who is always looking to buck authority and push the envelope, you probably should think twice about being a franchisee. Uniformity is important to the success of most franchise systems and franchisees who insist on doing things differently are not going to gain favor with the franchisor or other franchisees. Now, that doesn’t mean you can’t suggest innovations and improvements for the betterment of the system, but franchisees who always think their way is better probably shouldn’t be in a franchise system.
How do you choose a franchise?
Once you have determined that your personality fits being a franchisee, the search begins. There are many ways to find potential franchises. You may know what type of business you would like, based on past business experience, or you may have no idea. One way to find franchises is through web searches on the Internet. Any legitimate franchise company should have a website that can give you some idea of their business. There are also franchise expos held throughout the country that feature franchise companies with sales personnel on site to entice you in their franchise business. You have to be careful with these because the expo promoter is often just leasing space to the franchise sellers and they may appear to be better opportunities than they are. A good rule is to never commit to anything at a franchise show, and especially if they claim to have specials that you must take advantage of “today.” A legitimate franchise company will not use any pressure tactics. Another source is local or online bookstores that will often carry franchise guides you can purchase that list many companies with an outline of their franchise opportunity. And another way to search is to make inquiries at local businesses you like who are franchises. Finding the franchises is easy – determining which is right for you is the hard part.
When you make inquiries at a franchise company, you will usually either be sent the offering materials or an application to see if you are financially qualified. Although a few banks and the Small Business Administration (SBA) will loan money to purchase a franchise, they will usually only do so for certain very established systems and you will normally be required to pay cash for a portion of the initial costs. If you complete an application and receive approval, you should receive the company’s offering materials in the form of a Franchise Disclosure Document (FDD) that is required by the Federal Trade Commission. If a company does not furnish you with an FDD or asks for any fees without doing so, I recommend you go no further with them. Once you have received and reviewed an FDD, you can determine if you have interest in the particular franchise. The FDD will have information about the costs involved, the type of business you would operate and the obligations of both the Franchisor and you. It will also have audited financial statements of the franchisor in most cases which are important to see if the company is financially stable. All of the agreements that you would be asked to sign must also be included and information on current and past franchisees must also be in the FDD.
What do you do once you have decided you like a particular franchise?
Once you have found a franchise that you think you would like to purchase, and have reviewed the FDD, it’s time to hire a franchise lawyer and do your due diligence. At this point, you need the experienced eyes of someone who has reviewed and negotiated franchise purchases to guide you through the process. Most franchise agreements are written very one-sided in favor of the franchisor. But if you are going to invest in a business that will be governed by these agreements, you must understand what you are getting into and many times provisions can be negotiated to make them fair for both sides. There are good reasons why many of the provisions that may seem overly in favor of the franchisor are there, because a franchise system should have controls to require the franchisees to perform in such a way that benefits the other franchisees, but there are other provisions that could create an undue hardship on the franchisee in certain circumstances and should be changed. You should have the assistance of someone familiar with these contracts and who can explain to you the downside of agreeing to them. I will not only help you with these items, but provide assistance with how to do your due diligence on the business itself. In addition, like any new business, you will want to decide whether to own it personally or through an entity, and what type of entity works best for you. Many franchises also involve leasing a location and constructing either a free-standing building or finishing or remodeling space in a shopping center. It is important to know what the costs and time will be in your local area before agreeing to purchase a franchise.
What does a potential franchisee get from an experienced franchise lawyer?
Although many lawyers may say that they can review your franchise documents, I have found that unless the lawyer has actual experience in franchise offerings, you may not get what you need. The franchise relationship is a long term commitment on both sides and it is important to make certain that you are setting the relationship up in a way that gives you the best chance for success. When I represent a potential franchisee, I will review all of the documents, including the FDD and all agreements and prepare a written report on the franchise. I will then meet with you in person to review the report and advise you on any provisions that are onerous and that could affect your ability to be successful. I will advise you on how to perform due diligence by providing you with questions for the franchisor as well as current and former franchisees. And, if you like, I will represent you in negotiating the changes to the franchise agreement that you agree are needed. I can also advise you on the type of entity you should form and the costs involved and assist you in forming it. It amazes me how many people purchase a franchise and commit a large amount of money to the business without proper legal advice. I often represent these people a year or two into their agreement when there is a problem and most times it is a problem that would have been prevented with proper counsel before the purchase. And it almost always costs much more to fix the problem at the later time. If you are looking to purchase a franchise, I would be happy to discuss representing you so that you can truly get the deal you think you are getting.