 |
|
|
Franchising Basics
The term "franchise" is used to describe many different kinds of business relationships. Specific definitions for the word "franchise" are included in the Federal Trade Commission (FTC) Franchise Rule. Differing definitions have been developed by 25 states, three U.S. territories and two Canadian Provinces which have formulated their own franchise laws.
The technical definition of a franchise will vary according to the applicable law. However, the typical elements of a franchise include:
- The transfer of products, know-how, and proprietary information by the franchisor, either as a product to be distributed by the franchisee or as a business format or marketing plan to be followed by the franchisee, that enables the franchisee to start its own business;
- The related licensing of trademarks or service marks owned by the franchisor that carry with them public acceptance and goodwill;
- Retention of a significant degree of control by the franchisor over the manner in which the franchisee conducts its business; and
- A one-time payment or continuing payments by the franchisee to the franchisor for the right to enter into the business. Payments are usually in the form of an initial fee and subsequent royalties based on the franchisee's sales.
The seller of a franchise is called the "Franchisor." The buyer is the "Franchisee."
State and federal law heavily regulate franchises and franchise sales.
Back to Top
FRANCHISE LEGAL DOCUMENTS
The FTC Rule is designed to serve two principal functions. First, it prevents the fraudulent misrepresentation of material facts. Second, it requires the presentation of material facts as a franchisor offers franchises to prospective franchisees.
A "prospective franchisee" is defined as any person who approaches or is approached by a franchisor or franchise broker for the purpose of discussing the possible establishment of a franchise relationship. The FTC Rule requires the franchisor to deliver the disclosure information to a prospective franchisee in writing. This must be done at the earlier of the first face-to-face meeting between the franchisor's sales representative and the prospective franchisee, or ten business days prior to the time the franchisee executes any contractual documents associated with the franchise or pays any consideration in connection with it.
The franchise contract and all related agreements (i.e. supply contracts, leases, and security agreements) must be delivered to the prospective franchisee in final form, ready for execution. This must be done at least five business days prior to the date on which they are to be executed.
To make the disclosures required by the FTC Rule, a franchisor must deliver a prospectus document to a prospective franchisee. The document is often called an offering circular. The offering circular must have a cover page bearing language specified by the FTC Rule and a table of contents. It must contain comments that either positively or negatively responds to each disclosure question required to be answered under the FTC Rule. The offering circular may be created in one of two designated formats. The first is prescribed by the FTC Rule itself. The second format is the Uniform Franchise Offering Circular (the "UFOC") as developed by the North American Securities Administrators Association.
A franchisor must use either the FTC Rule format or the UFOC format. The formats may not be commingled. A franchisor's choice between the formats might be prescribed by the choice of states in which the franchise is to be offered. The FTC Rule format is often shorter and more easily prepared than one following the UFOC format. However, it is accepted in only 42 states. The UFOC format is accepted in all 50 states and in the province of Alberta.
The substance of the disclosures required by the UFOC is similar to that required by the FTC Rule. The FTC Rule format includes 20 different items of information. The UFOC format contains 23 items. To properly prepare an offering circular, a franchisor must analyze the franchise in light of the disclosure information required by each item.
The FTC Rule and UFOC formats include the following items:
| 1. | Information as to the Franchisor and Any Predecessors. |
| 2. | The Identity and Business Experience of the Franchisor's Directors, Executive Officers, and Franchise Brokers. |
| 3. | Litigation History. Disclosure under this item pertains to three types of litigation (criminal, civil, and administrative) in which the franchisor or any of the persons identified in Item 2 may have been involved. |
| 4. | Bankruptcy History. |
| 5. | A Description of the Franchise. |
| 6. | Initial Funds Required to be Paid by a Franchisee. |
| 7. | Recurring Fees Required to be Paid by a Franchisee. |
| 8. | Obligations to Purchase from Designated or Approved Sources or Under Certain Specifications. |
| 9. | Financing Arrangements. |
| 10. | Supervision, Service and Assistance Obligations of the Franchisor. |
| 11. | Territory and Sales Restrictions. |
| 12. | Trademarks, Service Marks, Tradenames, Logotypes, and Other Commercial Symbols. |
| 13. | Patents and Copyrights. |
| 14. | Personal Participation Obligations of the Franchisee. |
| 15. | Modification, Termination, Cancellation, Repurchase, Renewal and Assignment of the Franchise. |
| 16. | Statistical Information Concerning the Franchises and Company-Owned Outlets. |
| 17. | Public Figure Involvement in the Franchise System. If a person whose name or identity is known to the general public is involved in the franchise, that involvement must be disclosed. |
| 18. | Financial Information Concerning the Franchisor. Audited financial statements for each of the past three fiscal years must be disclosed. These include balance sheets, income statements, and a statement of changes in financial position. The financial statements must be prepared by an independent accountant using generally accepted auditing standards. Unaudited financial statements may be used in limited circumstances under the FTC Rule. |
| 19. | Franchise Contractual Documents. A sample copy of the franchise agreement and all other related contracts must accompany the offering circular. All contractual documents, in final form ready to be executed by the parties, must be delivered to the prospective franchisee at least five business days prior to execution. |
| 20. | Acknowledgment of Receipt. Under the UFOC format, the last page of each offering circular is a detachable acknowledgment of receipt. The prospective franchisee signs the receipt and returns it to the franchisor as evidence of the date on which the offering circular was delivered. |
Perhaps the most sensitive area of franchise sales regulation involves financial claims. Some popular franchises have experienced rapid success. In fact, the term "franchising" to some people, is synonymous with "instant success." Unscrupulous franchise sales persons may use misleading, exaggerated, or fraudulent earnings claims to induce prospective franchisees to invest in a franchise.
A franchisor is not required to make any financial claims or disclosures of franchise sales, revenues or earnings. If claims are made they must comply with the FTC Rule or requirements of the UFOC. Oral, written, or visual representations of financial claims must be supported by disclosure information. There must be a reasonable basis to support the accuracy of any claims. Supporting documentation must be in the franchisor's possession.
In the past, most franchisors preferred not to include any earnings claims in their offering circular. While this is permitted by the FTC and Uniform Franchise Offering Circular rules, today many franchisors consider it to be safer to include some minimal, well-established earnings claims. This is because prospective franchisees always ask about earnings potential, and franchise salespeople and business brokers usually will make certain representations to close the sale, even though they have been expressly instructed otherwise. Such unauthorized statements may leave the franchisor liable to rescission or damages at a future date, whereas including a well-established earnings claim may prevent such statements being made.
Earnings disclosures and claims must be relevant to the location where the prospective franchisee anticipates operating the franchise. The franchisor should retain complete data to substantiate all claims. The data must be made available to prospective franchisees, the FTC, and relevant state administrators upon demand. Earnings claims and disclosures are to be current through the franchisor's most recent fiscal year.
The FTC Rule governs earning claims in advertising for the promotion of franchise sales. States requiring the registration of franchise offerings may prohibit a franchisor from advertising the franchise until the franchisor has registered.
Proposed advertising often must be reviewed by the state franchise administrators. State administrators may prohibit the use of franchise advertising or to require the franchisor to modify advertising content to comply with state requirements. A wise franchisor will submit all new advertisements and promotional materials for legal and administrative review in draft form before they are produced in final form for use. Since a franchisor will be liable for misrepresentations even given administrative approval, one should not rely upon approval alone to measure the acceptability of the contents of advertisements and promotional materials
The FTC Rule does not require registration or advance submission of any offering circular or franchise contract documents to the Federal Trade Commission. The franchise laws of 15 states do require advance registration.
Thirteen of these states require that the offering circular and contractual documents be submitted for review and approval before franchises can be offered in those states. The documents often must be modified to conform with the relevant state franchise laws. State laws describe the disclosures to be made and also may regulate the relationship between the franchisor and its instate franchisees.
Back to Top
Disclosure
A prospective franchisee must receive a full copy of the Uniform Franchise Offering Circular (UFOC) and all of its exhibits at the earlier of "the first personal meeting" or at least ten business days (14 days in Illinois) before any Franchise Agreements are signed or any money changes hands. Your prospective franchisee (including all partners if it is to be a partnership or authorized corporate officers if it is to be a corporation) should sign the duplicate Acknowledgments of Receipt at the end of the offering circular.
The Uniform Franchise Offering Circular includes:
| 1. | A disclosure document; |
| 2. | Audited Financial Statements; |
| 3. | A Franchise Agreement (including any addenda); |
| 4. | Other materials required for state registrations. |
Back to Top
State and Federal "Business Opportunity" Laws: Traps for the Unwary
A businessperson risks a great deal by violating, either inadvertently or purposefully, state or federal business opportunities laws. Careful attention to these laws is critical when preparing a distribution program.
The definition of a "business opportunity" generally follows this pattern:
- A seller furnishes (this is much broader than merely sells) goods or services;
- For a payment of $500 or more (in most states, payments for inventory as well as payments for fees or for the purchase of marketing rights are included in calculating the $500 limit; several states do not calculate bona fide wholesale inventory price payments as part of the $500 requirement);
- To enable the buyer to start (or in some states operate) a business; and
- The seller represents one or more of the following:
- The buyer will earn income that exceeds the cost paid (this can be a common representation in business deals and a real trap for the unwary);
- The seller will buy back all or part of the goods or services produced by the buyer;
- The seller will find or help find locations for vending machines, video games, merchandise racks, or the like;
- If the buyer is unhappy with his or her bargain, the seller will refund some or all of the initial payment or buy back the program; or
- The seller will provide a marketing or operating plan to enable the buyer to successfully enter into business operations. (This representation closely parallels the basis on which standard franchise programs operate.)
Almost half of the states in the United States have some form of business opportunities law. While many of the definitional elements stated above are found in each of these laws, there are many variant elements and differences in statutory language under a particular state law that can be significant in an individual situation. Therefore, while the pattern described above is useful to identify potential problem areas, counsel should always closely review the laws of each relevant state when determining how that state's business opportunities laws might be applied to a particular proposed business development program. For example, in Connecticut, state administrators have determined that a representation that a program would produce profits can be implied from the circumstances when no express representation is made.
In addition to state laws, the Federal Trade Commission has adopted a business opportunities regulation as part of its franchise rules. The FTC rule defines business opportunities as a specific kind of franchise. See 16 CFR §436.1. The rule requires presale disclosure and prohibits fraudulent claims (including a promise to make refunds when refunds are not forthcoming). 16 CFR §436.1. Under the federal rule, there is no registration, filing, or review of the disclosure documents, nor is there any requirement for the business opportunity seller to make financial assurances to its purchasers.
By contrast, state business opportunities laws often require that a seller register its offering with a specified state administrator before beginning to offer or sell the opportunity within the state. This is always coupled with a presale disclosure obligation. Most states also require business opportunity sellers to post specified bonds, establish escrow accounts, or otherwise give financial assurance to the buyer that the seller will deliver on the promises made. All of this can be burdensome and expensive. Many states have minimum contract content requirements and prohibit certain types of contractual provisions. Most state business opportunities laws provide private rights of action for purchasers or would- be purchasers to bring legal action against sellers for violations of the relevant state requirements. The federal law does not have a corresponding private right of action.
Like the FTC rule, some state franchise registration laws are drafted broadly enough to include some, if not all, business opportunity programs within their ambit. Some other states have real estate broker licensing laws that include the phrase "business opportunity" in the list of things for which a person must be a licensed broker to sell.
Each state has exemptions or exclusions for certain types of investment programs from coverage under the relevant business opportunities law. These exemptions or exclusions vary greatly from one state to another. Among the most common exemptions or exclusions are the following:
| (1) | The sale of an ongoing business by its owner; |
| (2) | A bona fide deposit or price paid for the cost of a sales demonstration kit (the result of lobbying efforts by the Direct Sellers Association); |
| (3) | Licensed real estate brokers; |
| (4) | Newspapers; |
| (5) | Buyers who are already actively involved in an ongoing business operation; |
| (6) | Securities issues that comply with applicable securities laws; |
| (7) | Licensors of federally registered trademarks; and |
| (8) | Business format franchisors who comply with the FTC disclosure rules or relevant state franchise registration or disclosure laws.
|
If counsel intends to rely on an exemption or exclusion from coverage under a state business opportunities law, counsel must carefully examine the law to determine how best to qualify.
While it is obvious that business opportunities laws were designed to protect start-up businesses from unscrupulous schemers, many common and legitimate programs can be caught in their extensive web. Franchises, subcontractor agreements, authorized manufacturer contracts, licenses, distributorships, and joint ventures can inadvertently fall into the business opportunities trap. The results of violation of these laws can include the following:
| (1) | Cease and desist orders; |
| (2) | Criminal prosecution; |
| (3) | Criminal fines; |
| (4) | Revocation of exemptions; |
| (5) | Felony criminal prosecution; |
| (6) | Asset seizures; |
| (7) | Unlawful trade practices actions (including punitive damages and attorney fees); and |
| (8) | Civil remedial law suits (rescission, damages, and punitive damages).
|
See generally 1 Bus Franchise Guide (CCH) 2001, 2014, 3000, 4000, 5000 (1984).
Back to Top
Franchise Purchasing
The chief advantage in purchasing a franchise is that the franchisee can begin its own business with a reasonably modest investment and a significantly higher chance of success than if the franchisee were to start a business alone. This occurs because the chief elements being purchased via the franchise-training, a proven, successful product or business format, and publicly recognized names and marks-permit the franchisee to start successful operations and win public acceptance in a relatively brief period.
It is absolutely essential for the franchisee to independently investigate the franchise before buying to be certain it has the promised level of public acceptance and potential success as a business. Careful market research by the franchisee, including conversations with the existing and past franchisees listed in the franchise offering circular delivered by the franchisor, can help a franchisee avoid a bad investment. When you speak with existing and past franchisees, among the questions that you should ask are the following:
(1) Is the franchisor fulfilling its training, support and other obligations?
(2) What is the franchisee's relationship with the franchisor like? Is the franchisor easy to work with?
(3) How long did it take the franchisee to break-even financially?
(4) What are the franchisees profit margins? (A franchisee may be motivated to give you inaccurate information about its financial status. For example, a franchisee that does not have an exclusive territory may understate profits to discourage you from locating a franchise nearby. Or, a franchisee that is struggling financially may be embarrassed and may overstate its financial status. In any event, if the franchisor does not make earnings claims in Item 19 of the UFOC, then talking to franchisees is the only way to find out about costs and profits.)
(5) If the franchisee could do it all over again, what would the franchisee do differently?
(6) Why were past franchisees terminated or why did they otherwise leave the system?
If the franchisor does not yet have any successful franchise outlets, presents incomplete offering circulars and franchising documents, or has not perfected the franchise system, even more market research and price negotiation are necessary.
Other advantages to a franchisee are greater independence than would be found in working for a company-owned store, an exclusive territory for the franchise business according to the terms of the franchise agreement, and broad assistance from the franchisor in training, accounting, quantity purchasing, product pricing, quality control, and personnel supervision.
Back to Top
Disadvantages of Purchasing a Franchise
Potential disadvantages to purchasing a franchise include the following:
(1) Significant and sometimes overpowering retention of control by the franchisor concerning conduct of the franchise business;
(2) Unfair provisions in the franchise agreement concerning transfers and renewals of the franchise business;
(3) The potential for excessive franchise fees; and
(4) The obligation of the franchisee to continue paying a percentage of gross monthly revenues to the franchisor long after the franchisor has ceased to provide any significant assistance to the franchisee and regardless of whether the franchisee is making a profit.
Many of these potential disadvantages are mitigated by the franchisor's strong interest in the financial success of the franchisee.
In addition, through over commitment, inadequate financing, or product or trademark disputes, the franchisor may be unable to fulfill its commitments to the franchisee, or may even lose its rights in the franchise system. This problem arises particularly when the franchisee purchases a franchise from a subfranchisor. The franchisee always should examine carefully the franchise agreement and offering circular to determine precisely who owns the rights to the franchise system and whether those rights can be terminated or altered to the detriment of the franchisee.
Back to Top
|
