Avoiding Legal Troubles as a Franchisor

At least once a month, a prospective franchisor comes to us worried about the decision to franchise--worried not for business reasons, but because they're afraid of the litigation that they believe follows franchisors.

For the most part, this threat of litigation is overblown. The risks of litigation are, in fact, much lower than you'd expect--headlines make it seem much more prevalent that it really is. In fact, a recent study of franchise offering circulars indicated that only 27 percent of franchisors had any history of litigation. And, since some of these franchisors, despite their great size, have had only minor legal problems, it's fair to say that the threat of litigation may be much lower than many perceive.

The Great Trade Off

While there are certainly risks of increased litigation in franchising, it's also important to put them in perspective. In fact, franchising poses a much lower risk of litigation than other expansion alternatives.

Yes, as a franchisor, you take on incremental liability relative to the contract that you sign with your franchisee. But this contractual liability is largely limited to the commitments you make in your franchise agreement. And most franchise agreements are written by attorneys who are expert at limiting that liability. The fact of the matter is, most franchise agreements are decidedly one sided in favor of the franchisor--making successful litigation very difficult in most cases.

Compare this risk of litigation with the alternative of company-owned expansion. If, instead of franchising, you were to open an equal number of company operations, you would avoid that contractual liability. But that contractual liability would be replaced by several other areas of potential exposure.

First of all, as a franchisor, you avoid the "slip and fall" liability associated with anything that happens in your place of business. As a business owner, you are responsible for everything that happens there. But as a franchisor, that responsibility rests with the business owner--the franchisee.

As a franchisor, you also avoid most of the potential "employment liability" that someone who owns multiple company-owned operations can face. Sexual harassment. Wrongful termination. On-the-job injuries. Again, in a franchised unit, the responsibility for proper conduct and workplace safety is shifted to your franchisee.

Moreover, as a franchisor, you also avoid several areas of contractual liability. Your franchisee signs the leases for property and equipment. In fact, as long as you ensure your franchisee acts as an independent contractor and not in an "agency" role, your franchisee has the responsibility for virtually everything that happens in that unit.

In America, nothing is absolute proof against the threat of a lawsuit. But there are things you can do to minimize that risk.

The Inadvertent Franchisor

One completely unnecessary risk we often see is companies that inadvertently violate franchise laws by offering franchises without proper disclosure. In virtually every case, these companies simply did not know that they were actually franchising--or their lawyers didn't.

The federal definition of a franchise includes a business relationship that has three elements:

1. The use of a common trademark (such as "McDonald's");
2. The provision of operational support or assistance, training or the exercise of significant operating control;
3. The payment of a fee of over $500 in the first six months of operation. This definition includes initial fees, royalties, advertising fees, training fees or fees for equipment. In fact, the lone exception is for goods sold to the franchisee at a bona fide wholesale price for resale to their customers.

If a company has those three elements, it is a franchise. It doesn't matter what you call it. It doesn't matter how you try to disguise it. If it looks like a duck and quacks like a duck ...

In addition to the federal law, franchisors must be aware that 24 states have laws governing the sale of franchises. Fourteen of those states (California, Washington, North Dakota, South Dakota, Minnesota, Wisconsin, Illinois, Indiana, Michigan, Virginia, Maryland, New York, Rhode Island and Hawaii), require the registration of the franchise with various state agencies, and, in some cases, their definition of a franchise might differ somewhat from the federal definition. In addition, some of these states require you to submit your franchise advertising approval before you use it--so make sure you do so before you print brochures, fliers or other franchise marketing materials.

While generally less cumbersome than registration states, another 10 states (Utah, Texas, Nebraska, Kentucky, Florida, Georgia, North Carolina, South Carolina, Connecticut and Maine) have business opportunity laws. As a franchisor licensing the use of a federally registered trademark, the paperwork required for these "biz opp" states in relatively minimal. The paperwork required of those franchisors that do not yet have an effective trademark registration, however, may be somewhat more cumbersome, illustrating in small part the importance of this vital step. (The importance of your trademark can hardly be overstated, but that is a different article.)

So Now You're an Official Franchisor...

The first rule of successful franchising is to realize that the best contracts are the ones you put in a drawer and never look at again. Simply stated, avoiding litigation as a franchisor is all about maintaining good relations with your franchisees.

First and foremost, create a "win-win" relationship with your franchisees. Communicate openly and honestly with them, and be as concerned with their profitability as you are with your own.

Be absolutely sure that you and your salespeople always tell the truth in the sales process--and state only what is contained in your Uniform Franchise Offering Circular. If you are not making an earnings claim in your UFOC, be sure that your salespeople are not saying anything about revenues, expenses or earnings in the sales process.

How do you ensure that your franchise salespeople are playing within the rules? First, hire veteran franchise salespeople, and train anyone involved in the franchise sales process on what they're allowed to say and what they're required to do (and when). Second, audit and mystery shop your sales force on a regular basis--it demonstrates your good faith in keeping your sales process clean.

Last, and perhaps most important, hire an attorney who specializes in nothing but franchising. There is nothing quite so expensive as a cheap lawyer. Yes, franchise specialists are more expensive. But if franchising is a part-time endeavor for your attorney, he or she won't be doing the things necessary to stay on top of the laws that govern your future. Ask your attorney point blank how long he or she has been practicing franchise law. Hire a franchise specialist with at least a decade of experience.

Business is all about risk. And the best businessmen are those that know how to best manage that risk. Like any expansion activity, franchising carries its own risks. But properly managed, these risks can be minimal when compared to the rewards.