Franchise law governs a business relationship in which one business entity receives payment for granting to another person or entity the right to use its trade name or trademark and for providing services to the other person or entity.
The franchise seller is the “franchisor,” and the buyer is the “franchisee.” What is sold is generally a limited right to use the franchisor’s trade name or trademark. This is typically done by a “license” agreement.
When many people hear the word “franchise,” they think of fast food chains. In reality, there are franchises in many lines of business including motels, hair salons, tax preparation services, janitorial services, and convenience stores, among others. According to the International Franchise Association, in 2007 franchised businesses in the United States provided 9.1 million jobs, $304.4 million in payroll, $802.2 billion of economic output, and added $468.5 billion to GDP.
Some of the reasons a business might choose to expand by franchising are that it can be done without diluting the equity ownership of the business or incurring substantial debt, most of the risks inherent in expansion are borne by the franchisee, it doesn’t require hiring day-to-day management personnel since the franchisee manages its own location, it generally provides more motivated management since the franchisee has a financial stake in how the franchise performs, and franchising permits rapid market saturation.
For the franchisee, some of the benefits of purchasing a franchise include that the operating procedures are in place, the franchisor generally provides initial training usually at it’s location and often provides on-site help for a short period of time to get the franchise started, the franchisor often provides the accounting software for the business and training in how to use it, the franchisee can evaluate the success of other franchisees before purchasing, brand identity is already established, operating procedures and quality control are standardized so customers know what they are getting and it doesn’t require time to build up the reputation of the business. As with any business, the single most important factor in determining the success of the franchisee is the business skill of the owner.
There is a natural tension between franchisor and franchisee as to whether the value of services received by the franchisee justifies the amount of the royalty payment. Some franchisors establish company sponsored franchisee associations so there is a forum to talk about issues that come up. Sometimes franchisees get together and form such an association on their own.
Franchising is highly regulated and an unwitting businessman or businesswoman may quickly fun afoul of franchise law. Franchising is regulated by the franchise law of both the federal government and the franchise laws of most states. The franchise law of some states requires that franchises be registered. Other states only have disclosure requirements. There are also laws dealing with the termination of a franchise. The Federal Trade Commission has the responsibility for the federal regulation of franchises. The Federal Trade Commission has adopted a Franchise Rule which governs the requirements for the franchisor to provide a franchise disclosure document to a potential franchisee before entering into a franchise.
A franchise has three elements: (1) the franchisor granting the franchisee the right to use its trade name or trademark, (2) payment of a fee by the franchisee to the franchisor, and (3) the rendering of “substantial” assistance by the franchisor to the franchisee.
The right to use a name or trademark is almost always a limited right granted by the franchisor to the franchisee to use trademarks or service marks of the franchisor that the franchisor has registered with the United States Patent and Trademark Office.
The franchise fee does not need to be a monthly payment, “royalty,” based upon the sales of the franchisee. It may be a small one-time payment. Usually there is an initial on-time fee as well as a royalty of between 4% and 8% of sales.
Substantial assistance may consist of providing training, providing guidance to the franchisee in how to operate the business including its business methods, marketing, purchasing, a proprietary computer program, and otherwise providing assistance to the franchisee.
Some businesses may enter into a business agreement in which one business entity grants another a license for some purpose and not understand that the transaction is a franchise requiring that it comply with the Franchise Rule of the Federal Trade Commission. Others may intentionally label the document by some other name thinking that if they don’t call the transaction a franchise, then it isn’t one. Labels don’t matter. If the transaction meets the three elements generally described above, it is a franchise and must comply with laws and regulations that apply to franchises.
The above comments are intended to illustrate general principles only. There are often exceptions to general rules which apply in certain circumstances. Laws change over time by subsequent enactment of legislation and by court decision. Legal principles can differ from one jurisdiction to another. Particular factual circumstances may result in a different legal conclusion. If you have a question about a particular factual situation you should consult with an attorney.
David G. Harrison has experience in franchise law practice. Harrison has conducted the due diligence investigation for a potential purchaser prior to the sale of an international franchisor. He has prepared franchise disclosure documents for franchisors and reviewed them for franchisees. He provides legal advice on business law matters for franchisors and franchisees. He has served as lead counsel in franchise litigation.