What’s required to begin franchising a business?

Raising Cane's

Photo: Flickr Creative Commons 2.0, photo by Mr. Blue MauMau -Raising Cane’s

The United States is filled with successful franchises, ranging from small businesses slowly spreading their reach to Fortune 500 conglomerates with a global empire.  Many times, the average consumer is oblivious to whether an establishment is operated by a franchisee, which is the business that receives proprietary knowledge and rights from the larger business, or by a franchisor, which is the larger business that provides a franchisee with proprietary knowledge and rights. 

The benefits that a franchise agreement can bring to each party are apparent.  For the franchisee, the business receives the knowledge, experience, and branding of a known and established company.  This can save the franchisee significant cost and time in developing its business model and consumer recognition.  For the franchisor, the obvious benefit is to collect franchise fees, royalties, or other forms of capital.  Furthermore, by adding franchisees, a franchisor can expand the reach of its brand recognition.  While franchise agreements are governed by contracts, both federal and state law impact who can enter into such agreements and the terms allowed.  This article will address the federal regulations for franchisors and state laws which are particularly likely to impact California-based franchisors.

The primary federal rule for franchisors is to develop, maintain, register, and disclose a Federal Disclosure Document, or FDD. An FDD must be renewed after its expiration in order to remain valid. The Federal Trade Commission mandates a franchisor create an FDD to be used for any states in which it operates, while state laws govern where it must be filed within each state. Generally speaking, FDDs must be registered in every state where there is a potential franchisee.  At the federal level, an FDD has 23 mandatory requirements (states may require more).  These disclosures include audited financial statements, the franchisor’s history, legal information, and more.

Beyond an FDD, the Federal Trade Commission continues to provide a series of regulations.  Most notable is that at least fourteen days prior to the offer or sale of a franchise, the franchisor must submit an updated FDD.  Federally, franchisors are largely self-regulated, with little involvement from the federal government.  However, a number of federal laws may be implicated if a franchisor acts improperly in its relationship with franchisees.

For California franchisors, California law has more of an impact than federal law in their actions.  To begin, California requires a franchisor to file its FDD with the California Department of Business Oversight.  This franchisor must also provide a $675 registration fee ($450 for renewals) and comply with additional provisions of an FDD.  Without following these protocols, a franchisor could face significant liability.  The California Franchise Investment Law provides additional regulations regarding franchising within the state.  This law requires that the FDD and final franchise agreements be provided to prospective franchisees at least fourteen days before the sale of a franchise. Its purpose is to ensure that franchisors honestly provide all material information to any potential franchisee before a transaction is completed, including in advertisements for franchise opportunities.  This law also provides penalties and enforcement details for fraudulent operation involving franchising.

The states immediately surrounding California – Oregon, Nevada, and Arizona – do not require FDD registration and have no laws which directly address franchisors.  Each state has its own sets or regulations regarding registry and operations of franchisors, so a franchisor must conduct a proper investigation of state regulations before expanding its franchises into any additional states.

In any opportunity to franchise a business, a franchisor must primarily remember to be forthcoming and honest in any negotiations.  Beyond registration requirements, franchisee-franchisor relationship will largely be governed by contract law.  Therefore, both the franchisor and franchisee have the ability to bargain for the exact terms of the agreement.  The franchisor may demand initial payments, recurring payments, or royalties as it wants.  Furthermore, a franchisor may restrict the franchisee’s freedoms on any number of issues, including products offered, advertising, décor, use of proprietary information and marketing materials, and more.  Additionally, a franchisor may require minimum performance standards to prevent poor performing franchisees from continuing to operate under the franchisor’s branding.

In considering whether to enter into franchise agreements, a business ought to consider federal law, laws from its own state and any state in which a franchisee will operate, legal costs, and business considerations.  With these factors in mind, franchising may be the first step in turning a mom and pop

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Photo: Flickr Creative Commons 2.0, photo by Mr. Blue MauMau -Raising Cane’s

About William Adams

Attorney at Norton, Moore, & Adams, LLP.
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