Are you a business owner interested in learning how to franchise your business? Are you an entrepreneur considering starting your own business with franchising in mind? If you answered yes to either question, this is guide is for you. We break down how to franchise your business and highlight the most important steps. This is the ultimate guide on how to franchise your business.
I. How to Franchise Your Business – The Background
A. What is a franchise?
We’re all familiar with franchises. Many of America’s largest corporations are franchises. We can all probably name five or six without blinking. McDonalds, Burger King, Taco Bell, Ace Hardware, Serve Pro. But what exactly is a franchise? How do companies get to that stage? How do you franchise your business? This article is the ultimate breaks it all down and gives you the ultimate overview on how to franchise your business
Legally, the term “franchise” does not have one uniform definition. Many federal and state franchise laws share common definitional approaches, but there’s no one answer. What qualifies as a franchise under federal law may not qualify under a particular state’s laws. A franchise in one state may not be a franchise in all states.
Fundamentally, a franchise is defined by the coexistence of three elements:
The right to use a trademark. This element involves a grant of rights to use another’s trademark to offer, sell, or distribute goods or services. While not every trademark license creates a franchise, every franchise has some form of trademark license.
The right to use a marketing system. Depending on the jurisdiction, this element takes one of three variations, but all focus on the licensor’s assistance with or control over the licensee’s entire method of operation causing the public to regard all licensed outlets as a unified marketing concept. In some states, the required assistance or control may take the form of a prescribed marketing plan or what some jurisdictions more broadly describe as a “community of interest.”
The existence of the first two points in exchange for a fee. This element involves payment of a required fee by the licensee. Franchise status hinges entirely on whether an arrangement meets the applicable statutory definition.
A business cannot avoid a franchise relationship simply by disclaiming its existence. If the specific elements coexist, the relationship is a franchise. This is true even if the parties do not refer to the relationship as a franchise.
B. What laws govern franchises and the franchise relationship?
Franchises are governed by both federal and state laws. These law take the form of disclosure laws, registration laws, and relationship laws.
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i. Disclosure laws
Disclosure laws are pre-sale laws that govern the franchisor’s conduct in making franchise sales. These laws are designed to prevent franchisors from making material misrepresentations to entice consumers into a franchise system.
(a) Federal Disclosure Law – The Amended Franchise Rule
Perhaps the most recognizable disclosure law is the Federal Trade Commission’s Franchise Rule. The FTC’s Rule on Franchising was enacted in 1979.
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The FTC enacted the Franchise Rule in response to a boom in the franchise industry after World War II. During that time there were significant instances of fraud in connection with the offer and sale of franchises. The 1979 Rule required pre-sale disclosure and prohibited certain practices the FTC deemed unfair or deceptive in nature. The FTC’s goal was to provide the minimum information needed to make an informed decision to enter into the franchise relationship.
In 2007, the Rule was amended to clarify points of ambiguity and adjust to changes in technology.
The form of disclosure prescribed by the Franchise Rule is referred to as a “Franchise Disclosure Document” (“FDD”).
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The FDD consists of 23 “Items” covering a variety of subjects. In addition, each FDD must contain copies of all material contracts a franchisee must sign. This includes the franchise agreement and any other agreement the franchisor arranges for the franchisee. The franchisor must also include its financial statements, and other key information. Franchisors are solely responsible for ensuring the adequacy and accuracy of the information included in the FDD.
Franchisors must give each prospective franchisee their FDD at least 14 calendar days before closing a franchise sale. The franchisor cannot count the day it delivers the FDD to the prospect or the 14th day after receipt of the FDD. In essence, this means that a total of 16 calendar days must pass between FDD delivery and the prospect signing.
If the information disclosed in the FDD changes materially before the end of the fiscal year, the franchisor must update the FDD when the material change occurs. The FTC defines a “material change” is one that is likely to affect a prospective franchisee’s investment decision, and should be viewed through the lens of a prospective franchisee. The FTC’s Compliance Guide, material changes include events such as bankruptcy filings and the filing of legal actions against the franchisor that could negatively impact the franchisor’s financial condition.
(b) State Disclosure Laws
All franchise transactions in the US are governed by the Franchise Rule. Some are also governed by state disclosure laws as found in these 15 states:
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|Michigan||Minnesota||New York||North Dakota||Oregon|
|Rhode Island||South Dakota||Virginia||Washington||Wisconsin|
Of these states, all but Oregon also have registration laws (described below).
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Under federal and state law, a franchisor must update its FDD annually (typically within 90 to 120 days of the end of its fiscal year) with new information affecting the franchise from the previous calendar year.
To comply with disclosure requirements applicable to the transaction, parties must identify and evaluate any applicable state disclosure laws, which differ by state. For example, some states have broadly written disclosure laws, so that a franchisor must register if any of these circumstances exist the prospective franchisee:
• lives in the state.
• plans to open the franchised business there.
• has a place of business in the state.
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Some states instead have disclosure laws that apply to a more limited set of circumstances. Others do not have disclosure laws, but instead have business opportunity laws written broadly enough to apply to franchisors.
Most of these business opportunity laws specifically exempt franchise offerings, but only if the franchisor complies with the disclosure requirements under the Franchise Rule. As a result, these business opportunity laws, while not franchise disclosure laws, contain enforcement mechanisms to ensure that franchisors that sell franchises in the state comply with the Franchise Rule.
ii. Registration laws
Like disclosure laws, registration laws are pre-sale laws. Fourteen states have registration laws and all states that have disclosure laws, with the exception of Oregon, also have registration laws.
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There is no federal registration law. As a result, franchisors that comply with the Franchise Rule’s disclosure requirements can sell in states that do not require registration without having to file their document with any governmental authority.
Under the vast majority of state registration laws a franchisor must:
- register in the jurisdiction before offering to sell or selling franchises in the jurisdiction by filing its FDD and application forms with the jurisdiction’s applicable regulatory agency; and
- The NASAA issues standard forms that most jurisdictions follow.
- renew its registration annually.
If a franchisor is not registered in the relevant jurisdiction, a franchisor typically cannot either:
- offer to sell a franchise in the registration jurisdiction; or
- sell a franchise in the registration jurisdiction.
To ensure that they comply with registration requirements applicable to the transaction, parties must identify and evaluate any applicable state registration laws.
Registration laws differ by state and it is possible that more than one state’s registration laws apply to a given transaction. For example, some states have registration laws that:
- Are written broadly, so that a franchisor must register if:
- the prospective franchisee lives in the state;
- the prospective franchisee plans to open the franchised business in the state; or
- the franchisor has a place of business in the state.
- Apply to a more limited set of circumstances.
iii. Relationship laws
Relationship laws are post-sale laws that apply only after a franchisee has purchased a franchise and the parties have begun their contractual relationship.
While there is no federal franchise relationship law, 22 states and two territories have franchise relationship laws:
|North Dakota||Rhode Island||South Dakota||Virginia|
|Washington||Wisconsin||US Virgin Islands||Puerto Rico|
Relationship laws can govern a variety of post-sale conduct by the franchisor.
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Many relationship laws prohibit a franchisor from terminating or refusing to renew a franchisee unless the franchisor either:
- Fulfills specific conditions; or
- Offers to compensate the franchisee for the termination or non-renewal.
These laws may:
- Prohibit discrimination (preferential treatment) between similarly situated franchisees;
- Prevent a franchisor from restricting the venue for legal disputes between the parties to locations outside the state;
- Prohibit franchisors from terminating franchisees’ contracts without giving the franchisees notice and a statutorily-mandated period to cure a default.
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To ensure that they comply with relationship requirements applicable to the parties’ relationship with one another, the parties must identify and evaluate any applicable and likely varying state relationship laws.
D. The accidental franchise
Many businesses around the country unknowingly operate franchises every year. The operation is extremely problematic in light of the above-referenced state and federal laws a franchisor must comply with. Any business that meets the franchise definition, but fails to comply the above regulations exposes itself to significant liability.
Trademark License + Marketing System + Fee = Franchise
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The most common method accidental franchise claims arise is a distribution or licensing arrangement falls short of the distributor’s or licensee’s expectations or the licensor terminates the contract without cause as permitted by the parties’ contract.
In some cases, accidental franchise claims are brought by unhappy licensees, distributors, or dealers to prevent a licensor or supplier from imposing network-wide changes. Accidental franchises are also exposed in the due diligence process that accompanies the sale of a company or strategic investment by private equity or venture capital firms.
So what are the dangers of not complying with applicable franchise laws?
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Franchise law violations carry significant penalties even when the inadvertent franchisor neither knew about the law nor intended to violate it. Not only is it a felony to sell a franchise without complying with franchise sales law, but federal and state agencies have broad powers to penalize franchise law violators, including by:
- Freezing their assets.
- Ordering restitution to the franchisee.
- Issuing cease and desist orders.
- Banning them from selling franchises.
- Assessing substantial fines.
Franchisees also have private remedies for state franchise law violations. Some laws permit franchisees to recover compensatory damages and also treble damages, lost profits, and attorneys’ fees.
An injured franchisee may also:
- Rescind a franchise agreement for disclosure and registration violations.
- Obtain an injunction to stop the wrongful termination or nonrenewal of a franchise.
- Recover damages or restitution.
State franchise laws impose joint and several personal liability on the franchisor’s management and owners even when the franchisor is a legal entity.
While the federal franchise law does not provide franchisees with a private right of action, injured franchisees can find remedies under many state unfair trade practices laws by relying on violation of the federal franchise law as the predicate unfair practice.
Counsel overlooking franchise laws may also be guilty of malpractice and potentially liable to victims of their clients’ wrongdoing.
II. Creating a Franchise – The Leg Work
A. The three pieces to the franchise puzzle
Trademark license + Marketing System + Fee = Franchise = you need an FDD.
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Examining the puzzle–
No formal license is required. A franchisor must simply grant to the franchisee the right to use the franchisor’s trademark or other commercial symbol. We’ll dig deeper in a moment.
The franchise seller will exert or have the authority to exert a significant degree of control over the franchisee’s operations or provide significant assistance in the franchisee’s method of operation. The marketing or operations piece is typically addressed by a franchise consultant that creates or solidifies an “Operations Manual” and marketing materials on behalf of the franchisee. (E.g. Franchise Creator, SMB Advisors, and iFranchise).
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The franchisee makes a required payment or commits to make a required payment, directly or indirectly for an amount greater than $570 during the first six months of operations.
B. Entity formation considerations
i. Sole proprietorships and general partnerships
Sole proprietorships are the worst legal structure for franchises. While sole proprietorships offer benefits for small businesses for their tax structure, they do not offer protection from individual liability.
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The reason for this is sole proprietorships and general partnerships are not separate from a franchisee’s personal legal identity.
Accordingly, any claims brought against the franchise would create enormous liability.
ii. Limited Liability Company
LLCs tend to be the best bet for startup franchisors. The entity form shields against individual liability while providing significant tax benefits. LLCs can be designated as flow-through entities, which means no corporate income tax returns need to be filed – all net income is taxed at the individual level.
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That said, LLCs offer somewhat limited flexibility as independent legal entities and have few statutory requirements governing them. They do not offer much for a franchise with equity investors. Franchises under LLCs run into challenges when issuing equity to investors because they are not distributed in the same structure as corporations. If a franchisee has multiple investors into a franchise, LLCs become more complex from a tax perspective.
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C-corps are more ideal for large, established franchisors, primarily for their equity distribution for investors. This legal structure is most commonly used for publicly traded companies with several equity investors and executive boards. They are also troublesome for startup franchisors because C-corps are taxed at both the corporate and individual levels. The goal of any C-corp structure is to position a business for future growth by soliciting additional capital investment from investors.
That said, if a startup franchisor anticipates rapid growth, C-corps could be an ideal structure to reduce tax costs. But for those just starting, this is not an ideal structure.
C. Intellectual Property considerations
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It is difficult to overstate the importance of trademarks to franchising given the FTC’s definition of a “franchise” under the Amended Rule. It comes as no surprise that franchisors need to protect their mark regardless at all times. Notwithstanding, this is an especially important consideration in formation. Ensuring that a franchisor’s marks are protected at the outset is great way to insure against future litigation issues.
(a) What Does Trademark Protect?
The Lanham Act purposefully describes the universe of things that can qualify as a trademark in the broadest sense to include “any word, name, symbol, or device, or any combination thereof.”
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Over the years the definition has expanded to include everything from a particular bottle shape to the scent of sewing thread. Even a particular identifying sound or jingle now qualifies as trademarks or service marks.
Trademarks are marks that are tied to a product, whereas “service marks” serve to identify the services a business provides.
(b) Eligibility for Trademark Protection under Applicable Law
The Lanham Act defines federal trademark protection and trademark registration rules. The Lanham Act grants the United States Patent and Trademark Office (“USPTO”) administrative authority over trademark registration.
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For a given Mark to be eligible for trademark protection in the United States, that Mark must be: (1) distinctive or capable of acquiring distinctiveness with respect to the goods and/or services that franchisor uses (or intends to use) the Mark in connection with; and (2) used in U.S. commerce in connection with those goods and services, except in very specific situations. Assuming a franchisor’s mark meets these criteria, the franchisor should register its trademark prior to sale.
The importance carries over to the FDD. Specifically, for each principal trademark, a franchisor must include information regarding its registration status with the United States Patent and Trademark Office (“USPTO”). A franchisor must also include any limitations on the franchisee’s use of the mark, whether the franchisor knows of any superior prior rights or infringing uses that could materially affect the franchisee’s use of the principal trademarks in the state where the franchised business will be located, and whether the marks have been contested (such as in any court action or administrative proceeding).
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Copyrights play a slightly less vital role in the franchising process. The U.S. Copyright Office, quoting the U.S. Copyright Act (the “Copyright Act”), sets forth the following as the primary categories of copyrightable works:
|Type||General Examples||Franchise-Specific Examples|
|Literary works||Book entitled “The Pelican Brief” by John Grisham||Operations Manual; source code to proprietary point-of-sale(“POS”) software|
|Musical works(and words thereto)||The hit song “Whatever It Takes” by ImagineDragons||Mister Softee Jingle|
|Dramatic Works||Shakespeare’s “Romeoand Juliet”||Taco Bell’s new “NachoFries” commercials.|
|Pantomines and other choreographic works||Ice Skating Routine Performed at the Winter Olympics||Fitness concept’s training instruction made available via online streaming|
|Pictorial, graphic and sculptural works||Painting entitled “Mona Lisa” by Leonardo da Vinci||Mascots; trade dress|
The Copyright Act does not have overly strict definitions regarding what falls within the scope of each “type” of copyrightable work, and the Copyright Office even advises applicants that these categories should be viewed broadly when filing a copyright application. For example, computer system programs franchisors develop for exclusive use in connection with their System (such as the POS System source code) might be registerable as a “literary work,” notwithstanding the fact that source code is not the next great American novel.
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Importantly in the franchising context, copyright law does not protect names, short phrases and slogans (such as “taglines”), product lettering and/or coloring and, perhaps most importantly, a mere listing of product ingredients or contents (which may apply to franchisor’s list of required purchases and/or approved suppliers).
Even if a franchisor client’s list of ingredients contained in a given menu item is not likely protectable, however, the proprietary recipe detailing how to make that menu item might be (assuming it is more than putting typical burger ingredients on a bun).
At the same time, brand names, slogans and phrases that most franchisors really rely upon to drive their brand are potentially protectable under trademark law, subject to the analysis discussed elsewhere in this paper.
iii. Patent Protection
Patent protection typically plays an even smaller role than copyright in the franchising process. Franchisors rarely rely on patent ownership as part of their IP arsenal as the core “trade secrets” and other “proprietary” information that comprise the System are typically licensed to their respective franchisee by way of trademark or copyright.
D. Drafting the franchise agreement and FDD
i. The Key Franchise Agreement Provisions
Profit and administrative fees:
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- Give companies the incentive to start and continue franchising.
- Set the franchisee’s expectation that the franchisor will likely share in the income of the individual franchised business.
- Help pay for the franchisor’s administrative infrastructure used to support its franchisees and franchise system.
There are three types of profit and administrative fees:
- Initial franchise fees
Prospective franchisees pay initial franchise fees to the franchisor for the privilege of entering into the franchise relationship. Typically made in a lump sum and disclosed in Item 5 of the FDD, the amount:
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- Is usually large enough to signify the franchisee’s commitment to build the business and learn the franchise system.
- May have some component of profit built in, but in most circumstances the franchisor uses the initial franchise fee to cover its costs to locate and train new franchisees.
- Usually helps new franchisors cover their significant start-up costs.
- Royalty fees
Royalty fees are typically ongoing fees that a franchisee must pay the franchisor during the life of the franchise relationship. They are usually expressed as either or a combination of:
- A percentage of the franchisee’s gross revenue.
- A flat fee.
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Royalty fees are usually paid weekly or monthly, but in rare instances are paid quarterly or annually. The amount of the royalty fee is disclosed in Item 6 of the FDD.
- Successor or transfer fees
Under the franchise agreement, the franchisor typically reserves the right to assess either or both:
- Successor fees. These fees compensate the franchisor if and when the franchisee decides, at the end of its term, to continue in the franchise relationship, typically by entering into a successor franchise agreement (also referred to as renewing and renewal fees).
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- Transfer fees. These fees compensate the franchisor if and when the franchisee transfers, sells, or assigns its rights under the franchise agreement to a third party.
- Successor and transfer fees are ordinarily charged as either:
- A fixed fee.
- A percentage of the initial franchise fee that the franchisor is charging new franchisees at the time that the franchisee obtains the successor franchise or transfers the franchise to a third party.
- Successor and transfer fees are ordinarily charged as either:
Successor franchise and transfer fee amounts are disclosed in Item 6 of the franchisor’s FDD.
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Depending on the franchise system used, franchisors charge franchisees service fees, including brand building fees, among others, for services provided.
- Brand Building Fees
Brand building fees are the most common of service fees. These fees are charged by a franchisor for the purpose of creating or increasing brand awareness. These fees have different names, including:
- National advertising fund.
- Marketing fund.
- Brand awareness fund.
- Brand fund.
Regardless of the name, the fee usually works the same way:
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- The franchisee pays the franchisor either or a combination of both:
- a percentage of its gross revenues; or
- a flat fee on a weekly or monthly basis.
- The franchisor:
- aggregates all of these payments across the franchise system into a common fund; and
- spends the money in the fund to advertise the franchise system locally, regionally, or nationally.
In most cases, the franchisor:
- Does not make any guarantees or promises to its franchisees that it will conduct advertising or brand awareness activities in a way that ensures that each individual franchisee will benefit directly or indirectly from the fund.
- Usually retains complete discretion over how the funds are spent, although some franchise systems use a council of franchisees to help direct advertising.
- Reserves the right to use a specified portion of the money paid into the advertising fund to pay its own internal administrative expenses that relate specifically to its advertising or brand-building activities.
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The amount of the required brand building fund payment is disclosed in Item 6 of the franchisor’s FDD. The specific ways that the franchisor uses or intends to use the brand building fund are disclosed in Item 11 of the franchisor’s FDD.
Other Service Fees:
Franchisors also charge a fairly wide variety of other service fees, including those that are related to a specific service that the franchisor requires its franchisees to pay for and use. These fees include:
- Technology fees
Typically, fees paid to license proprietary software or technology or to maintain and update a system-wide website.
- Customer relationship management fees
Paid for the franchisor to manage or administer a system-wide program for customer service.
- Fees paid for the franchisee to attend national meetings or conventions
These fees are disclosed in Item 6 of the franchisor’s FDD.
Expense Reimbursement and Cost Recovery Fees:
Expense reimbursement and cost recovery fees are designed to reimburse the franchisor for expenses and costs that it might incur over the life of the franchise relationship in supporting or focusing on the franchisee. These typically include:
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- Indemnification fees
The franchisee pays indemnification fees when the franchisor requires the franchisee to hold harmless or indemnify the franchisor for claims relating to franchisee’s operation of the franchised business.
- Attorneys’ fees and costs after dispute is resolved
Most franchise agreements have a “loser pays” attorneys’ fees provision. A minority of agreements have a non-reciprocal fee provision requiring the franchisee to pay the franchisor’s attorneys’ fees if the franchisee loses in a dispute.
- Audit fees
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The franchisor typically reserves the right to audit the franchisee to ensure the franchisee is accurately reporting gross revenue. If the franchisee underreports gross revenue, the franchisor often charges the franchisee for the audit costs.
- Legal fees and administrative costs
These are assessed if the franchisee does not timely pay the franchisor amounts owed or breaches another provision of the franchise agreement that requires the franchisor to take administrative action or use legal counsel to provide notice of the breach.
- Interest and late fees.
These fees are assessed if the franchisee’s payments owed to the franchisor are not paid in a timely manner.
- Management or step-in fees.
In most systems, the franchisor retains the right to step into the franchisee’s shoes and temporarily manage, operate, or terminate the franchised business if the franchisee:
- becomes temporarily or permanently incapacitated; or
- commits a material default that has remained uncured.
- Step-in or management rights typically last for a fixed duration and are charged in a specified dollar amount per day that the franchisor operates the franchised business.
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The franchisor typically has the right (but not the obligation) to obtain insurance on behalf of its franchisee if the franchisee fails to purchase insurance for itself. The franchisor typically charges a fee to cover its expenses of making these arrangements for the franchisee.
- Income tax reimbursement
An increasing number of states are now taking the position that if a franchisor has a franchisee located in the state, the franchisee’s presence in the state gives a sufficient economic nexus to charge income taxes to the franchisor based on the income earned from the franchisees in that state. Some franchisors in their franchise agreement retain the right to pass these income taxes to the franchisee, effectively requiring the franchisee to gross-up the amount paid to the franchisor, plus the amount of the income tax, so that the franchisee reimburses the franchisor for payments to the franchisee’s home state.
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This list of expense reimbursement and cost recovery fees is illustrative and non-exhaustive. These fees are disclosed in Item 6 of the franchisor’s FDD.
(b) Territorial Provisions
Most franchise agreements grant to the franchisee a protected territory (sometimes known as a protected area, exclusive territory, territory, or area of operations). The franchisor often reserves to itself the right to conduct certain types of activities within the territory, such as:
- The right to sell products or services under the franchisor’s trademarks within the territory through alternative channels of distribution (which are methods of sale that are dissimilar to the business being franchised), such as:
- internet sales;
- mail order sales; or
- branded product sales through unaffiliated retailers or wholesalers.
- The right to operate, directly or through franchisees, franchised units at non-traditional locations, such as:
- sport stadiums;
- military bases;
- hospitals; or
- The right to operate, directly or through franchisees, businesses under trademarks other than the marks being franchised that may sell products or services that are similar or dissimilar to the products or services that will be sold by the franchisee.
(c) Non-Compete Provisions
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Typically limited by geography and time, non-compete provisions prevent the franchisee from continuing to operate a similar business both before and after the franchise relationship ends. Some states have laws that prohibit or restrict the application of non-compete provisions after the termination, transfer, or expiration of the franchise agreement.
(d) Successor Franchise or Renewal Provisions
If a franchisee wishes to continue the franchise relationship after the end of the first term, the franchisor often requires the franchisee to:
- Sign the franchisor’s form of franchise agreement that it is then offering to new franchisees, which may include higher fees and a smaller territory, as well as other provisions that are materially different from those that are in the original franchise agreement.
- Remodel, update, or renovate the franchised business.
- Sign a general release of claims that the franchisee may have against the franchisor and its affiliates.
- Demonstrate that it has been in substantial compliance with the franchise agreement during the original term and that it has not been in default of the agreement more than a set number of times during the original term.
- Show that the franchisee has the right to continue at the same location under its lease or propose an alternative location.
- Demonstrate that the franchisee continues to meet the franchisor’s criteria for franchise operators.
- Pay a successor franchise fee that is charged as either:
- a fixed fee; or
- a percentage of the initial franchise fee that the franchisor is charging new franchisees at the time that the franchisee obtains the successor franchise or transfers the franchise to a third party.
Some state franchise relationship laws restrict a franchisor’s right to refuse to renew the franchise agreement, except under certain enumerated circumstances.
(e) Transfer Provisions
When a franchisee wishes to sell the franchised business to a third party, the franchisor often requires:
- The transferee (incoming franchisee) to sign the franchisor’s form of franchise agreement that it is then offering to new franchisees, which may include higher fees and a smaller territory, as well as other provisions that are materially different from those that are in the original franchise agreement.
- The transferee to remodel, update, or renovate the franchised business.
- The franchisee to sign a general release of claims that the franchisee may have against the franchisor and its affiliates.
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- The franchisee to demonstrate that it has been in substantial compliance with the franchise agreement during the original term and that it has not been in default of the agreement more than a set number of times during the original term.
- The transferee to demonstrate that the transferee meets the franchisor’s criteria for new franchise operators.
- Pay a transfer fee that is charged as either:
- a fixed fee; or
- a percentage of the initial franchise fee that the franchisor is charging new franchisees at the time that the franchisee obtains the successor franchise or transfers the franchise to a third party.
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Some state franchise relationship laws restrict a franchisor’s right to refuse a franchisee’s request to transfer the franchise agreement except under certain enumerated circumstances.
(f) Cooperative Advertising Provisions
These provisions require the franchisee, if it is within a geographic area where an advertising cooperative has been established, to contribute a fixed amount or percentage of the franchisee’s gross sales to the cooperative for the purpose of buying advertising that benefits all of the members of the cooperative.
(g) Automatic or Immediate Termination Provisions
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Franchisors often retain the right to terminate the franchise agreement immediately, with or without notice to the franchisee, for certain types of franchise agreement violations. Automatic or immediate termination rights often include the right to terminate the franchise agreement for the franchisee’s:
- Insolvency or bankruptcy.
- Abandoning the franchised business.
- Underreporting or otherwise falsely reporting income to the franchisor.
- Misusing the franchisor’s confidential information, trade secrets, or intellectual property.
- Misrepresenting facts to the franchisor.
- Making an unauthorized transfer of the franchised business or its assets.
- Committing a felony or misdemeanor that is likely to reflect materially unfavorably on the franchisor or the franchised business.
- Failing to comply with applicable laws.
- Repeatedly defaulting under the franchise agreement, even if the defaults can be cured.
- Violating restrictive covenants.
- Selling products or services that have not been approved for sale by the franchisor.
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Some state franchise relationship laws restrict a franchisor’s right to terminate the franchise agreement under certain enumerated circumstances.
(h) Termination with Opportunity to Cure
Franchisors usually have the right to terminate the franchise agreement if the franchisee commits a material default that remains uncured after a specified time, for example where the franchisee fails to:
- Make timely payments to the franchisor, its affiliates, or approved suppliers.
- Comply with the franchisor’s operations manual or other system standards.
(i) Dispute Resolution
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Many franchise agreements require the franchisee and franchisor to first attempt to mediate any dispute between them before proceeding to litigation or arbitration. The franchisee should expect the franchise agreement to:
- Require arbitration for any disputes, as is common in most franchise agreements.
- Except franchisor actions for emergency, injunctive, or other provisional relief from any mandatory arbitration or mediation proceedings.
- Have a forum selection clause requiring any litigation to occur in its home city and state.
- Apply the franchisor’s home state laws as the agreement’s governing laws.
- Include jury trial, punitive damages, and class actions waivers.
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The franchisee should note that any state franchise relationship laws limit the application of choice-of-law or forum-selection provisions, permitting the franchisee to litigate or arbitrate in the franchisee’s home state, under that state’s laws.
(j) Attorneys’ Fees Provisions
Most franchise agreements contain provisions for the unsuccessful party to pay the successful party’s attorneys’ fees after the arbitration or litigation proceedings conclude. A small minority of franchise agreements are non-reciprocal and do not require the franchisor to pay the franchisee’s attorneys’ fees if the franchisee is the successful party in dispute resolution proceedings.
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(k) Required Purchases
Franchisors typically require franchisees to purchase from the franchisor or its approved suppliers all, substantially all, or part of the products, inventory, equipment, items, or supplies used in or sold by the franchisee in the franchised business.
ii. The Key FDD Items and Disclosures
Each area of disclosure is referred to in the FDD as an “Item” and there are 23 different items in the FDD. Significant areas of disclosure in the FDD include (most of the provisions above include the FDD reference):
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- Fee disclosures (Item 6).
- an estimate of the initial investment that is required for the franchisee to build, open, and begin operating the franchise (Item 7).
- The prior business experience of the franchisor, its affiliates, and the officers, managers, directors, and other key employees who have management responsibility relating to the franchise (Item 2).
- The litigation and bankruptcy history of the franchisor and its officers, managers, directors, and other key employees who have management responsibility relating to the franchise (Item 3).
- Whether the franchisor offers the franchisee an exclusive territory and a description of any limitations on the scope of the franchisee’s territorial rights, including any rights the franchisor retains in the franchisee’s territory (Item 12).
- A description of the types of initial and ongoing assistance, including a summary of training, that the franchisor agrees to provide to the franchisee (Item 11).
- A list of any restrictions on the types of products, services, inventory items, equipment, real estate, or other items that the franchisee must purchase from the franchisor, its affiliates, or approved suppliers (Item 8).
- The franchisor’s financial statements, which must be audited by an independent certified public accountant (Item 21/Exhibit).
- A list of the existing franchised and company-owned units in the franchisor’s national system and information regarding the history of those locations over the franchisor’s previous three fiscal years (Item 20/Exhibit).
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Financial Performance Representations (Item 19 Disclosure)
- The most troublesome and commonly litigated disclosure point is the financial performance representation. Financial performance representations take a variety of forms and include any statement (express or implied) that promises that the prospective franchisee can achieve a specific financial goal under the franchise regarding:
- Potential sales.
- Gross profits.
- Net profits.
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The financial performance representations disclosure is the only disclosure that is optional for franchisors. A franchisor can choose not to make any financial performance representations, but if it does not, it:
- Must include a clear and conspicuous statement in the FDD that it has elected not to make that disclosure. The FTC included this requirement to help mitigate the common misstatement by franchisor salespeople that federal law prohibits franchisors from making financial performance representations.
- Is prohibited from making any statement, whether in the FDD or otherwise, about the sales, income, or profits that the franchisee can expect to achieve, including implied earnings claims, such as:
- “you will be able to replace your current income by working at your franchise”;
- “you will earn enough money to buy a new sports car”; or
- “100% return on investment within the first year of operation.”
- Mere puffery, however, like “earn big money” or “this is the opportunity of a lifetime” generally does not constitute a financial performance representation.
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If a franchisor does not make a financial performance representation in its FDD, prospective franchisees can ask existing and former franchisees in the system (listed under Item 20 of the FDD) for information regarding their own historical performance. Franchisees are generally not subject to the same restrictions against sharing their own financial information as the franchisor.