You are an entrepreneur. You created, founded and currently operate a successful and vibrant business. Perhaps customers, family members, or friends are loyal fans of your brand and are approaching you with a request to start their own location. How do you know when it is time to start franchising your business concept?
First, it is important to understand what it means to “franchise” a business from a legal perspective. Franchising is considered a business model, not an industry. Although it is often described as an industry, there are important distinctions. There are franchise concepts across all almost any industries, including: hotels and hospitality; restaurants, bars and grills; entertainment; health, fitness and wellness; and automotive, just to name a few. Franchising as a business relationship is an excellent way to grow a brand rapidly, penetrate new markets and leverage investment from the capital infusion and energy of franchisees.
The Accidental Franchise Issue
As a business model, franchising opens avenues for brand expansion. But franchising is also a high regulated endeavor. This means that launching a franchise system requires serious commitment. Some prefer to avoid the term ‘franchising’ by calling their business structure something else – a license, direct selling, joint venture, sales agency, distribution or partnership. At the end of the day, if a business meets the definition of a franchise, then it will be considered a franchise under state law and federal regulation. You may often hear the phrase “If it quacks like a duck . . . it’s a duck.” Simply put, the definition of a franchise hinges on having three components. If all three exist, then the business structure is a franchise for legal purposes.
Generally, a franchise has three components:
- FEE STRUCTURE. Requires payment of a minimal fee to the franchisor. This element is satisfied when the licensor charges any fee that exceeds a de-minimus threshold including initial upfront fees, on-going royalties, training fees, and software subscriptions.
- TRADEMARK. There is a licenses to the franchisee of the right to distribute goods or services under, or operate using, the franchisor’s trademark names, symbols, logos and slogans.
- CONTROL. The franchisor will or has authority to exert significant control over the licensee, provides a marketing plan or renders significant assistance to the franchisee in operating its business or the franchisee’s method of operation.
Some states define the “control” element even broader so it is possible to be deemed a franchise in California and New York, but not Arizona or Florida. Complicating matters further, New York has one of broadest definitions in the nation where you don’t even need all three elements! Why does the characterization of a business matter? Because the federal government and more than a dozen states regulate the offer and sale of franchises. Failure to comply with franchise laws can have dire legal consequences – asset freezes, monetary penalties, rescission obligations and even criminal liability.
Many companies fall into the “Accidental Franchise” trap, which requires curative measures if the proper legal strategy is not mapped out before the franchise offer. One legal strategy is to eliminate one of the three components (fee, trademark license or control), but this often diminishes business success. The most common element to eliminate is the “control” element. Eliminating this element can be problematic as it will not allow a licensor to take the necessary steps to ensure uniformity and standardization of the brand for customers. Because the fee element is met under the FTC Rule only if the payment occurs within the first 6 months of operation, some licensors will try to eliminate the fee element by delaying initial payments. This too can be problematic as certain states have a broader definition of “fee” where this strategy is not successful. Further, delaying collection of a fee could mean a franchisee does not have as much “skin in the game”. Strategizing with franchise legal counsel to determine the most logical path forward will ensure compliance with whatever decision you make. Come back for Part II when we discuss what steps a successful business owner should take to prepare for franchising.