Franchise Law Basics

Franchise Law Basics 101

INTRODUCTION

Franchise law governs the complex relationship between franchisors and franchisees. This article delves into the key aspects of franchise law, including regulatory compliance, contractual obligations, and the rights and responsibilities that shape the franchising landscape. Whether you're a business owner considering franchising or a legal professional navigating this field, understanding these principles is crucial for success.

FRANCHISE DEFINED

  • A franchise can be explained as a licensing agreement in which one party (the “franchisor”) authorizes another (the “franchisee”) to use its business model, goods, services, and/or trademark.
  • In exchange for the franchisor agreeing to the initial franchise, the franchisee will provide the franchisor with an initial fee, in addition to ongoing fees, known as “royalty fees,” throughout the life of the franchise.

 

TYPES OF FRANCHISES

  • There are two kinds of franchises: (1) a “business format” franchise; and (2) a “product” franchise.
  • In a “business format” franchise, the franchisor will license the franchisee to use a particular business model or operation which is associated with the franchisor’s trademark.
  • Most franchises in the U.S. come within the business format type.
  • Examples of business format franchises include McDonald’s, Subway, Motel 6, Cinemark, and more.
  • A “product” franchise, also known as a “trade name” franchise, gives the franchisee the right to distribute the franchisor’s products.
  • While the franchisee may carry and distribute one franchisor’s products, they can also carry and distribute other brand’s products.
  • Examples of product franchises include, Coca-Cola, Ford Motor Company, Kellogg’s, and more

 

GOVERNING LAW

  • Franchises are predominantly governed under state law. However, franchising is also regulated by federal law—namely, federal rules and regulations promulgated and enforced by the Federal Trade Commission.
  • There are 24 states which have their own regulations regarding the franchise relationship and required disclosures.
  • Federal law essentially sets the minimum standards for franchising a business.

 

FRANCHISE COMPONENTS

Major components that are universal to the franchise process and play an essential role in forming a franchised business:

THE FRANCHISE APPLICATION

  • A franchise application is the beginning step in becoming a franchisee and is much like an employment application.
  • The franchise application is a mechanism by which a franchisor can get to know potential franchisees.
  • Franchise applications require much more information, including detailed personal information.
  • The most important section of a franchise application is the section covering the franchisee’s current financial situation, including the potential franchisee’s current assets and liabilities—and potentially even their spouse’s current assets and liabilities.
  • Many franchise brands have established partnerships with lenders who can assist franchisees in assessing and evaluating the cost of getting a franchised business up and running.
  • The SBA Franchise Directory provides a list of franchise brands approved for SBA-backed financing.
  • A franchise agreement sample template can be viewed for the McDonalds Franchise Application.

 

THE FRANCHISE DISCLOSURE DOCUMENT FDD

  • A Franchise Disclosure Document (“FDD”), also known as the “Franchise Rule” (16 CFR, 436 and 437) is a document which provides legal disclosures to individuals interested in purchasing a franchise.
  • The FDD is a required step in the due diligence pre-sale process, as prescribed by the FTC, and is the starting point of formally franchising a business.
  • There are 23 sections in an FDD.
  • The FDD at least two weeks prior to any agreement being signed, or any money being exchanged between the franchisor and the franchisee.
  • Many states have additional FDD requirements. These states are generally known as “registration states” and require that the FDD comply with certain state regulations prior to being approved; LIST REGISTRATION STATES.
  • An FDD must be updated each year. However, the FTC does not require that the FDD be re-reviewed and re-approved.
  • A sample FDD for McDonalds.

 

THE FRANCHISE AGREEMENT

  • Although the FDD and the franchise agreement share many commonalities, the franchise agreement will provide more particular information and details about the specific franchise, along with the roles, responsibilities, and obligations of the franchisor and franchisee.
  • The franchise agreement must be included as an exhibit in the FDD.
  • The franchise agreement is the governing legal document which establishes and defines the franchisor-franchisee relationship.
  • Some of the substantive legal rights and obligations contained in a franchise agreement include: (1) the grant of franchises rights and the designate term of the franchise; (2) the franchisee’s development obligations; (3) training; (4) territorial rights; (5) operating procedures; (6) initial fees; (7) ongoing fees; (8) marketing fees and obligations; (9) restrictive covenants and non-compete agreements/clauses; and (10) legal rights and jurisdiction.
  • The terms of a franchise agreement cannot be negotiated to be less favorable to the franchisee.

THE OPERATIONS MANUAL

  • The operations manual is a blueprint that sets out how the particular franchised business should run and operate.
  • It is important to note that operation manuals are generally confidential and are not disclosed to the public. Many times, operation manuals contain trade secrets.
  • Operation manuals are not stagnant and will evolve over time. As the franchise grows and develops, the operations manual will also grow and develop.
  • Although the operations manual serves as a how-to document, it also serves as a legal document that communicates the mandatory and/or minimum operating standards of the franchisor.
  • In general, there are approximately 6-7 sections in the average operations manual. These sections include: (1) confidentiality and legal notices; (2) brand introduction; (3) development of the franchised business; (4) training; (5) operating systems and requirements; and (6) marketing and business development.

 

ADVANTAGES AND DISADVANTAGES OF FRANCHISING

ADVANTAGES

  • There are some very simple advantages to franchising a business, such as brand recognition, an established business model, and limited to no decisions to be made about what products to sell.
  • Lower risk of failure with franchising because there is an established network, proven to attract a broad customer base.
  • The opportunity for rapid growth.

DISADVANTAGES

  • The startup costs required to franchise, in addition to royalty costs, can be hefty. The franchisee will be responsible for ongoing fees owed to the franchisor, which can range anywhere from 4.6% to 12.5%, depending on the franchise brand.
  • Another aspect to consider is the inflexibility in operating your business as you see fit. Franchising may not be the most conducive business model for someone who wants control or wants to be their own boss.

CONCLUSION

In conclusion, navigating the complexities of franchise law is essential for both franchisors and franchisees to ensure a successful and legally sound business relationship. By understanding the regulatory framework, adhering to contractual obligations, and protecting their respective rights, parties can foster a thriving and sustainable franchise system. Whether you're entering the franchise world or refining your legal strategy, a solid grasp of franchise law is indispensable.

 

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