Information About Franchising

Frequently Asked Questions

What do I need in order to franchise my business in the U.S.?

Experience

From a practical point of view a company should have substantial experience in operating its business before it starts franchising. Ideally, the company should have at least one or two company owned locations (in addition to the original company location) which it has been operating for some time. Such experience is important because the franchisor needs to understand what is involved in opening new locations.

Operations manual

One of the key items which a franchisor is “selling” is its know-how in operating the business. For this reason, a franchisor is expected to provide its franchisees with an operating manual. The operating manual should provide detailed guidance to the franchisee on how to operate the franchised business.

A valuable and protectable name

A franchisor is also “selling” the right to use the franchisor’s name. For this reason, the name should be valuable, in the sense that it will attract customers. In addition, the franchisor should take measures to make sure that it has the legal right to the use of the name.

Trademark rights in the United States are based on first usage. Whoever has been using the name first in a particular geographic area and a particular market will have superior “common law” rights to the use of the name. A franchisor should do a search to make sure that nobody else was using the name in the same line of business before the franchisor. In addition, a franchisor should register the trademark with the United States Patent and Trademark Office. Federal registration serves two purposes: 1) it puts the world “on notice” that the business is using the name, which should help deter other people from starting to use the name; and 2) it gives the franchisor additional legal remedies if somebody infringes on its rights to use the name, including additional monetary penalties and attorney’s fees.

Information about trademark registration requirements and searches can be obtained from the United States Patent and Trademark office.

Disclosure document

Before a business can sell franchises in the United States, a business must prepare and provide to potential franchisees a detailed written disclosure document, which provides, among other things, detailed information about the franchisor, the terms of the franchise agreement, the services which the franchisor will provide, the franchisor’s trademarks, the franchisee’s obligations, the expected start-up costs for the franchisee, the on-going royalties or payments to the franchisor, a detailed description of the training which the franchisor will provide, and a copy of the proposed franchise agreement. More information can be obtained from the Federal Trade Commission. Examples of franchise disclosure documents can be obtained from Franchise Help, FRANdata or the California and Minnesota Franchise Filings database.

State registration

In 13 states, including California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin, the franchisor must file the disclosure document with the state agency and obtain state agency approval of the disclosure document before the franchisor can start selling franchises in that state. (Michigan has a simple notice filing requirement. Oregon has a disclosure requirement, but no filing requirement). Separate registration may be required in some states under state business opportunity laws in certain circumstances.

In the remaining 37 other states, the franchisor does not have to file anything with any state agency, but the franchisor must still comply with the federal regulations which require the franchisor to provide the disclosure document to the potential franchisee, and get a receipt from the franchisee, even though the franchisor does not have to file anything with any state agency. (If the FTC becomes aware that the franchisor has failed to provide the disclosure document, the FTC can take legal action against the franchisor).

Audited financial statements

The federal regulations require that the franchisor must provide the potential franchisee with audited financial statements of the franchisor, as part of the disclosure document.

Audited financial statements are different than unaudited financial statements, because the accountant provides assurance that the financial statements are accurate by auditing the company’s records. As a result, the preparation of audited financial statements is more costly.

The requirement to provide audited financial statements can be financially burdensome for some established companies who want to start franchising if they do not have audited financial statements, because the accountants will have to go back through their books to prepare audited financial statements. In addition, this requirement can be problematic for foreign companies that want to franchise in the United States, because the financial statements must be prepared in accordance with U.S. accounting standards which are stricter than most countries.

In some cases, we may recommend that the owners of the franchisor establish a new affiliate to be the franchising entity. This structure may help to limit the potential liability of the original company. This structure may also lower the costs of preparing the audited financial statements, because audited financial statements may only be required of the new affiliate, rather than the original company.

Workable fee structure

The franchisor must establish a workable fee structure, including the initial fee, royalties, and advertising fund payments, which makes economic sense for both the franchisor and the franchisees. Franchisors can obtain information about the rates charged by other franchise systems by obtaining a copy of the disclosure documents of competitors from Franchise Help, FRANdata or the California Franchise Filings database.

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What laws govern franchising in the U.S.?

Federal Disclosure Requirements

The federal regulations promulgated by the Federal Trade Commission, which apply in all states, require that franchisors must provide prospective franchisees with a detailed disclosure document at least 14 calendar days before the franchisee signs or pays any money.

The disclosure document provides, among other things, detailed information about the franchisor, the terms of the franchise agreement, the services which the franchisor will provide, the franchisor’s trademarks, the franchisee’s obligations, the expected start-up costs for the franchisee, the on-going royalties or payments to the franchisor, a detailed description of the training which the franchisor will provide, a copy of the proposed franchise agreement, and audited financial statements. More information about the specific legal requirements can be obtained from the Federal Trade Commission

State Registration/Disclosure Requirements

In 13 states, including California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington, and Wisconsin, the franchisor must file the disclosure document with the state agency and obtain state agency approval of the disclosure document before the franchisor can start selling franchises in that state. (Michigan has a simple notice filing requirement. Oregon has a disclosure requirement, but no filing requirement). Separate registration may be required in some states under state business opportunity laws in certain circumstances.

In other states, the franchisor does not have to file anything with any state agency, but the franchisor must still comply with the federal regulations which require that the franchisor must provide the disclosure document to the potential franchisee, and get a receipt from the franchisee, even though the franchisor does not have to file anything with any state agency. (Compliance is important because the FTC can take legal action against a franchisor that fails to provide a disclosure document to prospective franchisees).

A few states have laws which govern the relationship between the franchisor and franchisee. For example, such laws may require that a franchisor must have “good cause” before terminating a franchisee, regardless of what the franchise agreement provides. A few states have laws which require that franchisors treat all franchisees in a similar fashion. A few states have laws which require that disputes must be resolved in the state where the franchisee resides.

Even if a system does not qualify as a franchise, it may qualify as a business opportunity.

If it qualifies as a business opportunity at the federal level, the seller must provide a disclosure document to a buyer. The definition of a business opportunity at the federal level is fairly narrow, and is mainly geared toward vending machine routes. Specifically, the federal definition of a business opportunity only covers arrangements in which the seller of the business opportunity secures for the buyer retail outlets or accounts for the products or services, or locations or sites for vending machines, rack displays, or other product sales displays, or provides to the buyer the services of another person able to secure such retail outlets, accounts, sites or locations.

If it qualifies as a business opportunity at the state level, the seller may be required to provide or register a disclosure document prior to selling the business opportunity in that state. At least 26 states, including Alabama, Alaska, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia, and Washington, have business opportunity laws. These laws are generally fairly broad, and generally cover any arrangement in which the seller provides goods or services to the buyer in return for a fee which enables the buyer to start a business, and the seller either makes promises to the buyer (such as how much money the buyer will make, that the seller will provide leads, or that there is no risk) or the seller provides a marketing program. These laws contain many exemptions, which differ in each state.

Almost all of these states with business opportunity laws require that the seller of a business opportunity must provide a disclosure document to a prospective buyer, and many require that the seller must register the disclosure document prior to offering them for sale.

For a discussion about the differences between franchises and business opportunities, see the section of this website, “Does the system qualify as a franchise?”

Recent Changes to the Federal Disclosure Requirements

Effective July 1, 2008, the Federal Trade Commission amended the federal franchise disclosure regulations. 16 CFR Part 436. The amendments changed some of the information which must be provided to prospective franchisees in the disclosure document, as well as the time and manner in which the disclosure document must be provided. The amendments also added new exemptions.

The primary changes in the new FTC Rule are as follows:

  1. Delivery requirements. Previously, the federal regulations required the franchisor to provide the disclosure document at the earlier of: 1) the first personal meeting or 2) 10 business days before the franchisee paid any money or signed anything. The new FTC rule gets rid of the first personal meeting requirement, and imposes a uniform 14 calendar day requirement. (A handful of states still require the disclosure document to be delivered at the earlier of the first personal meeting or 10 business days before the franchisee pays any money or signs anything).
  2. Financial performance representations (formerly known as “Earnings Claims”). Previously, the federal regulations provided that franchisors could not make any statements about the actual revenue or costs of other franchisees, or the projected revenue or costs for a new franchisee, unless the franchisor included such statements in the disclosure document and the franchisor had a reasonable basis for the statements. The new FTC Rule limits this prohibition to representations about revenue, and not costs.
  3. Disclosure of franchisor-initiated lawsuits. Previously, franchisors were not required to disclose lawsuits which they filed against franchisees to enforce non-compete agreements or to collect royalties. Under the new FTC Rule, franchisors must disclose such lawsuits.
  4. Disclosure of franchisee associations. The new FTC Rule requires that franchisors disclose the names and contact information for any formal franchisee associations.
  5. Financial statements. The new FTC Rule requires that a franchisor must provide the audited financial statements of a parent company if the parent company is obligated to perform obligations of the franchisor. Also, the new FTC Rule provides a phase-in of the audited financial statement requirement for new franchisors, so that they do not have to include the audited financial statements during the first year. In addition, the new FTC Rule allows for use of financial statements prepared by foreign accountants in very limited circumstances. (Some registration states have not yet adopted a phase-in of the audited financial statement requirement).
  6. Exemptions. The new FTC Rule adds two exemptions which are similar to exemptions under many of the registration state laws. First, the new FTC Rule adds an exemption for large investment franchises, if the franchisee’s investment is more than $1 million (not including vacant land). Second, the new FTC Rule adds an exemption for sophisticated franchisees, which have more than 5 years experience in the business and net worth of more than $5 million.

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What should I look for if I am buying a franchise?

  1. Decide whether you want to buy a franchise or open your own business. Before purchasing a franchise, you should consider whether buying a franchise is the best method to start a business. A franchise gives you the right to use the franchisor’s name and methods for a certain defined period of time (for example, ten years, or twenty years), but the rights end at the end of the agreement, and at that point, you have nothing you can sell or give to your heirs. In fact, franchise agreements typically contain a non-compete provision, which prohibits you from operating a similar type business under a different name for a certain number of years after the termination or expiration of the agreement at the same location or another location close to the franchisor’s other outlets. Instead of buying a franchise, you should consider the pros and cons of simply buying an existing business or opening up your own business. If you buy or open your own business, you do not get to use a well-known brand name and you do not get the training or support of a franchisor. At the same time, you do not have to pay a franchise fee or royalties, and you own the business.
  2. Compare systems. Assuming you decide that franchising is the right model for you, you should do homework to decide which is the best system to buy. The disclosure document provided by the franchisor will contain a tremendous amount of detailed information, particularly concerning the expected costs and the training. It will disclose lawsuits against the franchisor. It will also contain the names and telephone numbers of past and current franchisees. You should talk to many franchisors and compare systems and costs. Look at the franchisor’s experience and background to determine if it has operated this business for many years, and how successful is the business. Look at the franchisor’s history of litigation, using the information that is provided in the disclosure document and other public sources. Look at whether the franchisor has a federal trademark registration. Do your own calculations about how much money you might make and your expected expenses, taking into account the royalty and ad fund payments. Talk to as many former and current franchisees as possible. Ask them about how much money they make, how much training and support do they receive, how much advertising do they receive, and where do they get their products and supplies.
  3. Negotiate the franchise agreement. You should hire an attorney to review the franchise agreement, to help you understand the agreement and to attempt to negotiate changes with the franchisor. Even if the franchisor will not make any changes, at least you will have a better idea of your legal obligations. Here are the legal provisions which you should most carefully scrutinize:
    1. Deadlines for opening. Be careful that the deadlines for opening are not too short, because typically the franchisor can terminate the agreement and keep the franchise fee if you do not open on time.
    2. Refundability of franchisee fee. Some franchisors will give you back all or part of your franchise fee if you do not open on time or you fail to complete the initial training.
    3. Term and right to renew. Examine the provisions regarding the right to renew, and whether the franchisor has the right to raise the royalties in the renewal terms.
    4. Trademarks. Examine whether the franchisor has a federal trademark registration.
    5. Assignability. Look at how severe are the restrictions on selling the franchise.
    6. Default provisions. Examine whether the default provisions are reasonable. In particular, look at how much time the franchisor gives you to cure violations. Also, look at whether the franchisor has the right to terminate the entire agreement for minor breaches, even if they are cured.
    7. Renovation. Look at whether the franchisor has the right to require you to undertake an entire renovation of the business, and if so, how often.

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Does the system qualify as a franchise?

Federal Law

According to the federal definition of a franchise, a system is a “franchise” whenever:

  1. Trademark. The franchisor gives the franchisee the right to use the business’ name or trademark in the business;
  2. Payment. The franchisor charges the franchisee an initial fee of at least $500 in the first six months for the right to use the name or trademark; and
  3. Significant control or assistance. The franchisor exercises significant control over, or offers significant assistance in, the franchisee’s method of operation of the business.

The system must meet all three requirements. If it does not meet one of these elements, it will not qualify as a franchise at the federal level.

For example, in a sales representative arrangement, if the manufacturer does not charge the sales representative an initial fee to become a sales representative, then the arrangement would likely not be a franchise at the federal level because there is no initial fee requirement. In addition, if the buyer operates the business in its own name, then the arrangement may not be a franchise because the seller is not giving the buyer the right to use the name. But, the arrangement might qualify as a business opportunity.

In addition, there are a number of exemptions under the federal definition, which include the following:

  1. Fractional franchise. If the franchisee is adding a new product or service to an established business, the arrangement will be exempt if: 1) the parties reasonably anticipate that sales from the franchise will represent no more than 20% of the franchisee’s total sales for the first year; and 2) the franchisee or its officers have at least two years experience in the same type of business.
  2. Single trademark license exemption. The federal regulations exclude a single license of a trademark where it is the only one of its general nature and type to be granted by the licensor with respect to the mark in the United States.
  3. Employer and employee relationships. The federal regulations exclude employer-employee relationships.
  4. Large investment franchises. The federal regulations exclude sales to a franchisee which invests more than $1 million (not including purchase of vacant land).
  5. Sophisticated franchisees. The federal regulations exclude sales to a franchisee which has at least five years experience in the business and $5 million in net worth.
  6. Insiders. The federal regulations exclude sales to insiders.

State Law

With regard to the state law in the thirteen registration states, some states have slightly different definitions for a franchise. For example, some states have no $500 minimum for the initial fee requirement. As a result, any initial fee (even if it is less than $500) will meet the fee element.

In addition, some of the thirteen registration states have different exemptions. For example, some of the registration states have exemptions for large franchisors that have a certain net worth.

In addition to franchise laws, many states have business opportunity laws, which generally apply cover any arrangement in which the seller provides goods or services to the buyer in return for a fee which enables the buyer to start a business, and the seller either makes promises to the buyer (such as how much money the buyer will make, that the seller will provide leads, or that there is no risk) or the seller provides a marketing program. At least 26 states, including Alabama, Alaska, California, Connecticut, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maine, Maryland, Michigan, Minnesota, Nebraska, New Hampshire, North Carolina, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, Virginia, and Washington, have business opportunity laws.

Almost all of these states with business opportunity laws require that the seller of a business opportunity must provide a disclosure document to a prospective buyer with audited financial statements, and many require that the seller must register the disclosure document prior to offering them for sale.

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