FRANCHISING A BUSINESS
Franchising accounts for a growing percentage of the goods and services sold throughout the world. Franchising allows the manufacturer of a product, the provider of a service or the owner of a retail business to expand using the time, entrepreneurial drive and financial investment of people who want to own their own businesses. By using the capital and energies of motivated operators, a system can expand more rapidly than it could using the franchisor’s own capital and personnel. This allows an entrepreneur to capitalize on his or her window of opportunity to expand and, hopefully, beat present and future competition to the market. As the system grows, the benefits of size may allow the system to enjoy group purchasing, cooperative advertising, growing name recognition and goodwill and other advantages of scale.
The attraction of purchasing a franchise for the buyer is the prospect of providing a proven product or service or operating an established and tested business concept using a refined system in connection with a recognized name. This appeals to those who do not want to start a business from scratch with all the trial, error, uncertainty and expense that entails.
As with any relationship, there are trade offs for both the franchisor and franchisee. The franchisor sacrifices some degree of control since it is not the direct supervisor of the franchised business as well as limiting its revenues from the operation of the business. For the franchisee, while his or her time and money has been expended in establishing and operating the business, it is the franchisor who controls many aspects of the business and it is the franchisor to whom the franchisee must pay a portion of the proceeds from the business’s operations whether or not the business is profitable.
What is a Franchise?
Franchising is a method of distribution by which goods or services are marketed by parties licensed by the owner of the name or mark under which the goods or services are sold. The franchisor usually dictates many aspects of how the business will be operated, such as the appearance of the facility, its method of operation, the products it sells or the services it provides, reports that must be provided, sources of supply that must be used, advertising that must be done, records that are to be kept and so forth. The franchise agreement that governs the relationship is normally for a set period of years, often with renewal options. An initial franchise fee is normally charged and ongoing payments are usually required, often based on a percentage of the franchisee’s sales. The franchisor usually provides some degree of continuing assistance to the franchised business and monitors the operation of the business to insure contract compliance and to protect its names and marks.
The legal definition of a franchise differs slightly among the states and under the Federal Trade Commission trade regulation rule covering franchising, discussed below. In California, a “franchise” means a contract or agreement, either express or implied, whether oral or written, by which: (1) a franchisee is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by the franchisor; (2) the operation of the franchisee’s business under such a plan or system is substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising or other commercial symbol designating the franchisor or its affiliate; and (3) the franchisee is required to pay, directly or indirectly, a franchise fee. Each of these elements has been the subject of interpretation by the California Department of Corporations and by the courts.
It is very important to note that the name given to a relationship has no affect on the legal standing of the arrangement. If it meets the definition of a franchise, it will be a franchise under the law. Calling an arrangement a “license”, “joint venture”, “partnership” and so forth, will not prevent the relationship from being subject to the franchise laws. Failure to comply with these laws can result in severe civil and criminal penalties as well as liability to those who purchase the franchise.
What makes a Business “Franchisable?”
Most businesses are capable of being franchised. If it makes business sense for a business owner to consider opening additional outlets as company-owned units, it usually makes business sense to open outlets as franchises. Ideally, before a business is franchised it should have been operating long enough to have proven its commercial attractiveness, worked out most of its kinks, be somewhat unique in the view of the consuming public, be capable of being duplicated, not be dependent on the personality or unique skills of its founders, be capable of being taught to others and be subject to systemization. The prospective franchisor should have the necessary finances and personnel to develop, market and sell the franchising program and to train and supervise its franchisees. The business must provide the franchisee with the opportunity to make a reasonable return on his or her investment and adequate compensation for the time and effort devoted to the business
Regulation of Franchising
Franchising is a regulated method of distribution. There are laws and regulations governing the offer and sale franchises in 14 states, including California. Most of these laws require the filing or registration of the franchise, including all of the franchising contracts that are part of the transaction, and approval by the concerned state prior to the offer of the franchise to residents of that state or if the franchise will be operated in that state. In addition, the state must approve the financial condition of the franchisor, as further discussed below.
In addition to the state laws, the Federal Trade Commission (“FTC”) has adopted a rule that imposes franchise disclosure requirements on franchisors throughout the United States although there is no separate filing with the FTC. Under the FTC rule, and in most of the states with laws governing the offer and sale of franchises, a franchisor (the seller of the franchise) must present a Franchise Disclosure Document to each prospective franchisee (the buyer of the franchise) at least 14 days before any binding contract is signed or any money or other consideration changes hands. The Franchise Disclosure Document is a disclosure document, akin to a public stock offering prospectus, which describes the franchisor, its principals, the key terms of the contracts that the franchisee may be required to sign, and other details about the business being franchised. Also described in the Franchise Disclosure Document are the trademark and service mark rights of the franchisor as well as its financial condition.
It is essential that a federal trademark or service mark registration, or at least an application for registration, be on file with the United States Patent and Trademark Office when the franchise is offered since the identifying marks and names are an important attribute of a franchise. A current audited financial statement, and in some cases an unaudited interim financial statement, must be included as part of the Franchise Disclosure Document.
If the franchisor will offer or sell franchises to residents of California, or if the franchised business will be located in California, the Franchise Disclosure Document and its exhibits must be submitted to the California Department of Corporations for review and approval prior to the offer of the franchise in California. Similar disclosures, but not necessarily prior registration and approval, must be made in all other states, either under the Federal Trade Commission rule or under franchise registration laws similar to those in California. Filing fees are required to be paid to each state where filing is undertaken. No filing is made, nor fee paid, to the Federal Trade Commission. State initial filing fees run from $250.00 to $750.00. In California, the fee for the initial franchise registration application is $675.00.
The Franchise Disclosure Document must contain copies of all agreements the franchisee may be required to sign. The basic contract is usually called a Franchise Agreement. This agreement sets forth the rights and obligations of the parties in connection with the franchise. Depending on the complexity of the business involved, a Franchise Agreement may run to over 50 pages. Additional agreements may be appropriate, such as an area development agreement, an area representation agreement, a deposit agreement, leases, subleases, confidentiality agreements, releases, conditional lease assignments, security agreements and so forth.
Legal expenses will be incurred by the franchisor for the preparation of the Franchise Disclosure Document, the Franchise Agreement and the other contracts that the franchisor and its attorneys decide are advisable, for searching a trademark or service mark, filing an application for trademark or service mark registration with the U. S. Patent and Trademark Office, preparing franchise registration applications and dealing with the appropriate state agencies in connection with the franchise registration process. In addition, if audited financial statements have not been prepared by the franchisor in the past, accountants will have to be employed to audit the franchisor’s financial statements. In many cases added to those expenses are costs for the formation of a new entity to serve as the franchisor, any required license agreements allowing the franchisor to use the necessary names and marks, the preparation of marketing materials for use in connection with the solicitation of franchisees, preparing operating and other manuals, designing of training programs and any incremental costs required in connection with the franchising business, such as hiring staff, advertising for franchisees and working capital. It is likely that the total start up costs for initiating a new franchising program will be $50,000.00 or higher.
The good news is that once the initial work is done, the cost of maintaining a franchising program from a legal standpoint is relatively minor. If the business will be franchised in more than one registration state, there will be additional legal work to be done but that work utilizes the existing franchising documents and, with some exceptions, the cost is moderate for revising those documents to comply with individual state franchise laws. To continue franchising in registration and filing states, franchise registrations must be renewed, or annual reports filed, yearly. Audited financial statements must be prepared annually as long as the franchisor continues to franchise and must be included with the franchisor’s registration renewals or annual reports. Once federal trademark or service mark registrations are obtained, only periodic filings are required to maintain those registrations. Over the course of the registration year, if there are material changes in the information contained in the Franchise Disclosure Document, amendment applications must be filed in the states in which the franchise is registered, as well as in the documents used in nonregistration states.
Certain states have Seller Assisted Marking Plan or Business Opportunity laws that, by their definitions, include franchises. However, these laws exempt franchises that have complied with the FTC rule, state franchise laws or, in some cases, that operate in connection with a registered trademark. In 5 states, a one-time, or annual, filing must be done to obtain or maintain the desired exemption.
Most registration states, and many states that do not require the registration of franchise offerings, have laws regulating parts of the franchise relationship, such as the termination and transferability of the franchise agreement and the rights of heirs to inherit the franchise. Many registration states have limitations on the terms of the franchise agreement, such as provisions restricting the venue of legal actions or on releases by the franchisee of claims against the franchisor under applicable franchise laws.
The timetable for the preparation of franchising documents and their registration with the California Department of Corporations runs about 3 months; one month for the legal work, one month for the prospective franchisor to review and revise the documents and one month for the California Department of Corporations to review the papers. Of course, if any of those tasks are completed sooner, approval will be obtained more rapidly.
In registration states, if the state agency administering the state’s franchise law does not feel that the franchisor’s financial condition is adequate to perform the initial services it promises to provide to its new franchisees, the agency may condition the registration on the franchisor obtaining a surety bond, agreeing to defer the initial franchise fees or the opening of an impound account. An impound account is similar to an escrow account with a bank into which all initial franchise fees must be deposited. The bank cannot release those funds to the franchisor until the franchisee certifies to the state agency that the franchisor has performed all of its initial services as promised in the Franchise Agreement. The agency then authorizes the bank to release the funds to the franchisor.
There are various exemptions and exclusions from compliance with the some of the registration requirements of the California Franchise Investment Law, and under the FTC rule. These provide limited exemptions and exclusions based on various circumstances, such as franchising by large, well financed franchisors, sales to experienced franchisees, sales of fractional franchises, those for whom the franchise is only a small part of their overall business, etc.. These can be explored under appropriate circumstances. Not all franchise registration states have similar exemption rules so that an exemption from registration in one state may not relieve the franchisor from registration in other states or compliance with the FTC rule.
Franchising can be an excellent way to expand a business rapidly, especially if the franchisor devotes sufficient resources to marketing the franchise and to performing its initial and ongoing duties to its franchisees. It is essential that a prospective franchisor understand the demands, challenges, costs and intricacies of franchising. Franchising involves not only complex legal rights and duties, it also demands an awareness of the human element in this unique relationship. Franchisors and franchisees both feel they “own” the business. An understanding of their interdependence, and a mutual respect for the contributions of each to the hoped-for success of the business venture, is essential for the long-term satisfaction of the parties. Experienced counseling and guidance in the development of the franchising program and throughout the life of the system is essential to minimize legal exposure and to maintain a healthy relationship between a franchisor and its franchisees.
Return to Franchise & Distribution page
