A franchise is a very popular and attractive business relationship between an established company seeking to monetize on its brand reputation (the “Franchisor”) and a new player that wishes to enter a specific market (the “Franchisee”) leveraging on the expertise of the Franchisor.
Three elements generate a franchise relationship, whether the parties involved are aware or not:
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Franchisor’s trademark is used by Franchisee;
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Franchisor exercises a significant control on a certain aspect of Franchisee’s business – such as site location, restrictions and instructions on products/services and customers, design and techniques requirements, marketing campaigns – and provides assistance to Franchisee’s operations, such as training programs, sales advice, software systems;
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Franchisee makes one or more payments to Franchisor in exchange for the two previous elements.
The existence of these three items will trigger franchise laws, whether the parties intended to or are aware of them. The franchise relationship is heavily regulated both by the Federal Trade Commission and by the laws of each state to ensure that a potential purchaser of a franchise carefully evaluates the investment in Franchisor’s business.
The most significant requirement is the obligation of a prospective franchisor to provide a franchise disclosure document (FDD) to any potential franchisee at least 14 days after the execution of the franchise agreement.
The FDD will have to include extensive information about the Franchisor and its parent companies and/or affiliates’ operations, history, financial condition, together with a copy of the proposed franchise agreement and any other ancillary agreements. Failure to comply with the FDD requirements entitles franchisees to recover any fees paid and to rescind the franchise agreement.
A Unit Franchise Agreement will allow Franchisee to operate a single business, while in a Master Franchise Agreement (or Sub-Franchise Agreement) Franchisor grants to Master-Franchisee the right to sell Unit Franchisees within a pre-determined territory and quota, and therefore empowering Master Franchisee to collect fees from and to sub-license the trademarks and provide assistance to Unit Franchisees. Often Franchisor will require Master-Franchisee to operate at least one or more franchised businesses, but this is left to the negotiation between the parties.
Fourteen US states – among them, California and New York – require that FDD be registered with state authorities before a franchise agreement being executed or any payments being made to Franchisor. Typically, state regulators will conduct a thorough review to ensure accurate disclosures and compliance with state laws.
New York is arguably the most stringent state in terms of requirements on potential franchisors by concluding that a franchise relationship exists in the state – and therefore FDD registration is required – even when:
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there is no use of trademark or symbol, but there is a commonality of the marketing plan and payment of a fee;
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Franchisee operates in another state as long as Franchisor has a presence in New York, or the franchise offering occurs in New York.
There are a number of exemptions available to argue that the business transaction does not generate a franchise, thus not triggering disclosure and registration requirements. These exemptions will vary from state to state but some of the most significant are:
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Large Franchisor, with a net worth in excess of $5 million;
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Sophisticated Franchisee, with a net worth in excess of $3 million or a gross annual income exceeding $500,000;
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Franchisor Insider, when the proposed franchisee was an owner or director/officer of Franchisor;
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Fractional Franchisee, when the proposed franchisee is adding a new line of product or service and the sales generated by the franchise will not exceed 20% of the gross sales.