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In Franchise Your Business, author and franchise consultant Mark Siebert delivers the ultimate how-to guide to employing one of the greatest growth strategies ever: franchising. Siebert shares decades of experience, insights, and practical advice to help grow your business exponentially through franchising while avoiding the pitfalls. In this edited excerpt, Siebert offers a legal description of a franchise from both a federal and state perspective.
Everyone knows what a franchise is, right? It’s McDonald’s and Jiffy Lube. It’s Subway, Massage Envy and Holiday Inn.
But many people would be surprised to hear that some of the biggest companies in janitorial services are also franchises. The same holds true for carpet cleaning, wood restoration, lawn care and dozens of other industries. The largest providers of in-home, non-medical care for senior citizens are franchises. And so are many of the world’s largest hotel brands. You name it — and chances are, it’s been franchised.
Who is the franchisee?
Generally speaking, a franchisee is someone who pays a franchisor for the right to operate a business under the franchisor’s name and using the franchisor’s business model. The franchisee furnishes all the capital required for opening the business and assumes full financial and operational responsibility for running the business. Generally, the franchisee will also pay a continuing royalty (usually between four to 10 percent of gross sales or sometimes even higher) to the franchisor, and often the franchisee will buy products from the franchisor.
Who is the franchisor?
The franchisor, for its part, will allow the franchisee to use its trademark and will train the franchisee to run the business according to its standards. Typically, the franchisor will also assist the franchisee during the startup period and provide ongoing support and assistance to the franchisee.
The franchisor will allow the franchisee to use its trademark and will train the franchisee to run the business according to its standards.
The level, type and quality of this ongoing support will often differ, but for many franchisors, it will take the form of advertising assistance, purchasing power, brand maintenance, financial guidance and ongoing operational support.
Legally speaking, what are franchises?
The term “franchise” has a very specific legal definition within the U.S. and other countries where they are regulated. In the U.S., the Federal Trade Commission in FTC Rule 436 defines a franchise as a business relationship that has three definitional elements:
1. The use of a common name or trademark
2. The presence of “significant operating control” or “significant operating assistance”
3. A required payment of more than $500 in the first six months of operation by the franchisee (including initial fees, royalties, advertising fees, training fees, or fees for equipment)
The Franchise Disclosure Document
If a business relationship has the definitional elements of a franchise under the FTC rule, the franchisor must provide the prospective franchisee with a Franchise Disclosure Document (or FDD), which makes certain disclosures to the franchisees prior to the sale of a franchise. Along with these disclosure obligations, the franchisor’s sales process is also regulated by this rule.
An FDD must contain 23 specific items of disclosure in a specific format.
An FDD must contain 23 specific items of disclosure in a specific format. In addition, the FDD must include all contracts the prospective franchisee must sign (including the franchise agreement and other ancillary legal documents, such as any financing agreement or an area development agreement, for example) and a copy of the franchisor’s audited financial statements. (If you do not have audited financial statements, don’t worry. Almost all new franchisors will create a new corporation and simply disclose that corporation’s newly audited balance sheet to satisfy the requirement.)
Rules when selling a franchise
You must then follow a fairly simple set of rules governing the sale of franchises, including:
- You must present the FDD to the prospective franchisee at least 14 days prior to the sale of the franchise (not counting the day you present the FDD or the day on which the contract is signed), or within a reasonable time upon request of the prospective franchisee.
- You must provide the prospective franchisee with a fully filled-out franchise agreement at least seven days prior to the sale of a franchise. (This time can run concurrently with the 14 days discussed above if the agreement is filled out.)
- You must limit what you say on certain matters (financial performance representations, etc.) to only what you have included in your FDD. If you choose not to do a financial performance representation (previously called an earnings claim), you cannot provide the prospect with any information on sales or earnings. While you can provide them with information on expenses, you cannot do so in a format that would allow them to calculate sales or earnings (so percentages of revenues are not allowed).
- You must treat all similarly situated prospects in the same way. The material terms of the agreement cannot be negotiated unless you are willing to enter into those same negotiations with all similarly situated franchisees and fully disclose both your willingness to negotiate and the range within which you will negotiate (which, of course, is negotiating suicide).
While there are other compliance and documentation issues you will need to be aware of, the process is fairly simple.
States can make franchising more complicated
This is all made more fun by the fact that, at present, more than half of all states currently regulate either franchises or business opportunities. Many of these states have their own definition of just what constitutes a franchise under their laws.
For many, the legal definition involves the use of the trademark, a community of interest or a common marketing plan and the payment of a fee. But in some states (like New York), you can trigger franchise laws even without allowing someone to use your trademark. In others, like Illinois, the triggering element for the required payment is not $500 in the first six months of operation, but $500 throughout the lifetime of the relationship. Moreover, the disclosure exemptions that are recognized at the federal level may not be recognized at the state level as exemptions to registration or filing.
More than half of all states currently regulate either franchises or business opportunities. Many of these states have their own definition of just what constitutes a franchise under their laws.
The list of complexities goes on and on. Seven states require you to submit your franchise advertising for approval before you use it. While most of these states have similar language regarding the timing of disclosures (having adopted the new 14-day waiting period between disclosure and signing a franchise contract), others continue to operate under the old 10-business-day waiting rule that was originally promulgated under the 1979 version of FTC Rule 436. Likewise, while most no longer require broker registration, again adopting the standards of the new federal rule, some continue to hold on to this cumbersome requirement. Some states, in fact, require franchisors to disclose their prospective franchisees at the first personal meeting (another holdover from the previous version of the FTC rule).
Moreover, the situations that trigger the need to register or file your documents will vary from state to state. These include:
- If the franchisor is physically located in that state
- If the franchisor is incorporated in that state
- If the franchisee is a resident of that state If the franchisee’s territory will include territory in that state
- If the discussion of the sale of the franchise takes place in that state
Comply, comply, comply
There are plenty of legal definitions involved in the world of franchising. What is a franchise? How do you define the franchisor and franchisee? Then you have to take in all of the laws, such as what triggers a franchise, practices for selling and timelines regarding disclosures.
It can seem overwhelming, but you can work with franchising professionals (consultants and lawyers) to make the process simpler. At the end of the day, the key point to take away is that you must comply with both state and federal laws.