The Rules and Regulations of Being a Franchisor
In Franchise Your Business, author and franchise consultant Mark Siebert delivers the ultimate how-to guide to employing one of the greatest growth strategies ever: franchising. Siebert shares decades of experience, insights, and practical advice to help grow your business exponentially through franchising while avoiding the pitfalls. In this edited excerpt, Siebert offers a legal description of a franchise from both a federal and state perspective.
Everyone knows what a franchise is, right? It’s McDonald’s, Jiffy Lube and Century 21. It’s Subway, Massage Envy and Holiday Inn.
But many people would be surprised to hear that some of the biggest companies in janitorial services are also franchises. The same holds true for carpet cleaning, wood restoration, lawn care, and dozens of other industries. The largest providers of in-home, nonmedical care for senior citizens are franchises. And so are many of the world’s largest hotel brands. You name it, and chances are, it's been franchised.
Generally speaking, a franchisee is someone who pays a franchisor an initial franchise fee, averaging close to $30,000 in today’s market, for the right to operate a business under the franchisor’s name using the franchisor’s business model. The franchisee furnishes all the capital required for opening the business and assumes full financial and operational responsibility for running the business. The franchisee generally will also pay a continuing royalty (usually between 4 and 10 percent of gross sales, or even higher) to the franchisor, and often the franchisee will buy products from the franchisor.
The franchisor, for its part, will allow the franchisee to use its trademark. The franchisor trains the franchisee to run the business according to its standards. The franchisor will generally assist the franchisee during the startup period. And the franchisor will provide ongoing support and assistance to the franchisee. The level, type, and quality of this ongoing support will often differ, but for many franchisors it will take the form of advertising assistance, purchasing power, brand maintenance, financial guidance, and ongoing operational support.
The term “franchise” has a very specific legal definition within the U.S. and in other countries in which they are regulated. In the U.S., the Federal Trade Commission in FTC Rule 436 defines a franchise as a business relationship that has three definitional elements:
1. The use of a common name or trademark
2. The presence of “significant operating control” or “significant operating assistance”
3. A required payment of more than $500 in the first six months of operation by the franchisee (including initial fees, royalties, advertising fees, training fees, or fees for equipment)
If a business relationship has the definitional elements of a franchise under the FTC rule, the franchisor must provide the prospective franchisee with a Franchise Disclosure Document (or FDD), which makes certain disclosures to the franchisees prior to the sale of a franchise. Along with these disclosure obligations, the franchisor’s sales process is also regulated by this rule.
An FDD must contain 23 specific items of disclosure in a specific format. In addition, the FDD must include all contracts the prospective franchisee must sign (including the franchise agreement and other ancillary legal documents, such as any financing agreement or an area development agreement, for example) and a copy of the franchisor’s audited financial statements. (If you do not have audited financial statements, don’t worry. Almost all new franchisors will create a new corporation and simply disclose the newly audited balance sheet of that corporation to satisfy the requirement.)
You must then follow a fairly simple set of rules governing the sale of franchises, including:
You must present the FDD to the prospective franchisee at least 14 days prior to the sale of the franchise (not counting the day you present the FDD or the day on which the contract is signed), or within a reasonable time upon request of the prospective franchisee.
You must provide the prospective franchisee with a fully filled-out franchise agreement at least seven days prior to the sale of a franchise. (This time can run concurrently with the 14 days discussed above if the agreement is filled out.)
You must limit what you say on certain matters (financial performance representations, etc.) to only what you have included in your FDD. If you choose not to do a financial performance representation (previously called an earnings claim), you cannot provide the prospect with any information on sales or earnings. And while you can provide them with information on expenses, you cannot do so in a format that would allow them to calculate sales or earnings (so percentages of revenues are not allowed).
You must treat all similarly situated prospects in the same way -- so the material terms of the agreement cannot be negotiated unless you are willing to enter into those same negotiations with all similarly situated franchisees and fully disclose both your willingness to negotiate and the range within which you will negotiate (which, of course, is negotiating suicide).
While there are other compliance and documentation issues you will need to be aware of, the process is fairly simple.
Further Complications: State Definitions
This is all made more fun by the fact that, at present, 30 states currently regulate either franchises or business opportunities. Many of these states have their own definition of just what constitutes a franchise under their laws.
For many, the legal definition involves: a) the use of the trademark, b) a community of interest or a common marketing plan, and c) the payment of a fee. But in some states (like New York), you can trigger franchise laws even without allowing someone to use your trademark. In others, like Illinois, the triggering element for the required payment is not $500 in the first six months of operation, but $500 throughout the lifetime of the relationship. Moreover, the disclosure exemptions that are recognized at the federal level may not be recognized at the state level as exemptions to registration or filing.
The list of complexities goes on and on. Seven of these states require you to submit your franchise advertising for approval before you use it. While most of these states have similar language regarding timing of disclosures (having adopted the new 14-day waiting period between disclosure and signing a franchise contract), others continue to operate under the old 10-business-day waiting rule that was originally promulgated under the 1979 version of FTC Rule 436. Likewise, while most no longer require broker registration, again adopting the standards of the new federal rule, some continue to hold on to this cumbersome requirement. Some states, in fact, require franchisors to disclose their prospective franchisees at the first personal meeting -- another holdover from the previous version of the FTC rule.
Moreover, the situations that trigger the need to register or file your documents will vary from state to state. These include:
- If the franchisor is physically located in that state
- If the franchisor is incorporated in that state
- If the franchisee is a resident of that state If the franchisee’s territory will include territory in that state
- If the discussion of the sale of the franchise takes place in that state
The key point to take away is that in states that regulate franchises, you must comply with both the state and federal laws.