ALP: Is your business ready for franchising?
Over the last half of the 20th Century, franchising became one of the most popular methods of facilitating the growth of certain businesses. During this period, primarily due to the activities of a small number of bad actors, franchising received intense scrutiny from federal as well as state regulators.
If you are contemplating franchising your business, you should consider not only the legal requirements of offering franchises but also whether franchising is the right method of growth for your business. Fortunately, evaluating the legal requirements of franchising often helps determine if franchising is suitable for use in growing your type of business.
Franchising is regulated at both the federal and state level. The primary law which regulates the offering of a franchise is the Disclosure Requirements and Prohibitions Concerning Franchising and Business Opportunity Ventures rule promulgated in 1979 by the Federal Trade Commission under the authority of the Federal Trade Commission Act (the "FTC Franchise Rule"). The FTC Franchise Rule sets minimum standards for the offering of franchises and applies to offers in all states, unless a particular state sets higher standards, in which case that state's law applies. Fifteen states have franchise investment laws that require franchisors to provide pre-sale disclosures regarding the terms of offered franchises and the franchisor's business to potential franchisees. These states typically prohibit the offer or sale of a franchise within their state until a Uniform Franchise Offering Circular ("UFOC") has been filed as a public record with, and registered by, a designated state agency. Indiana is one of the fifteen states that has formally enacted its own franchise investment laws.
Kentucky, however, has not enacted its own franchise investment law but rather maintains statutes regulating the offering of business opportunities. Fortunately, franchisors that comply with the FTC Franchise Rule are exempt from Kentucky's business opportunity laws.
Gathering and organizing the information required to be disclosed in a UFOC forces
a would-be franchisor to analyze whether its business has the history, operating system, and trademarks or other intellectual property rights needed for a successful franchised business.
Generally the businesses most susceptible to successful franchising are those that have developed strong operating platforms and have successfully launched signature products or services at various franchisor-controlled operational units.
Significant profit should have been derived from these franchisor operations. Moreover, to entice prospective franchisees, franchisors need access to capital for organic growth of franchisor operations and dedicated management with industry-specific business experience. Involvement in material litigation or other disputes, especially those involving business dealings with affiliates, franchisees, or intellectual property rights, must be disclosed in the UFOC and would be viewed by potential franchisees as significant negatives.
Once a prospective franchisor has thoroughly analyzed its business model and determines it is fit for franchising, the next step is to develop the terms of the franchise itself. These terms are embodied in a franchise agreement or other development agreement. The material terms of these agreements must be summarized and disclosed in the UFOC. The terms of these agreements often include but certainly are not limited to:
- the fees the franchisor plans to charge the franchisee both initially and over the franchise term;
- the length of the franchise term and any available renewal terms;
- a summary of any required advertising expenditures to be made by the franchisee;
- any restrictions on the franchisee's offering and purchase of products to be used in the business;
- any restrictions on the franchisee's ability toown and/or otherwise operate competing businesses or franchises;
- a summary of any protected territory around the franchised business in which the franchisor covenants not to develop
- or allow the development of other similar franchised businesses; and
- a summary of the termination and transfer provisions applicable to the franchise.
The nature and extent of franchise agreement terms vary based on the business concept offered and the attractiveness of the offering. For example, franchisors with an established franchise track record can generally demand more franchisor favorable terms than a franchisor early in the franchise development process.
Accordingly, the proper balance needs to be struck between creating a franchise so restrictive and protective of the franchisor that no interest is generated among prospective franchisees and offering a franchise which is not restrictive enough and offers very little protection to the franchisor. In any event,new franchisors generally find it possible to develop franchise terms containing proper precautions while still providing attractive opportunities to franchisees.