Franchising is an extremely popular form of business expansion. But, franchising is not easy, and it is not cheap. The franchise format of business expansion is subject to state and federal laws that regulate the franchise sales process and the franchise relationship. This complex legal environment typically means additional legal costs and administrative costs for franchise businesses compared to non-franchised businesses.
There are some alternatives to franchising that may be appropriate for your business, without the extra burdens imposed by franchise law. But, the suitability of these options depend on what business goals you are trying to accomplish and how you want to accomplish them.
Vinson Franchise Law Firm helps clients with non-franchise methods of business expansion on a nationwide basis. We assist clients with:
structuring business relationships to avoid classification as a franchise or business opportunity;
complying with business opportunity laws;
complying with state dealership laws.
Warning: If your business model falls within the legal definition of a franchise, then it IS a franchise -- regardless of what you call it.
Deciding to Franchise By Choice
Because of the complex set of franchise and business opportunity laws and exemptions, many businesses that might be in a "gray area" under the FTC Franchise Rule or under the franchise laws in a few states may choose to comply with federal and state franchise laws anyway.
This approach often ultimately saves money. A state-by-state legal analysis of the franchise and business opportunity laws and exemptions can be expensive. And, typically, a state-by-state analysis indicates that the planned business relationship would be a franchise or business opportunity in some states anyway. And, some non-franchise business relationships are still subject to a complex system of federal and state laws. Examples of these are business opportunities, distributorships, and multi-level marketing companies.
Even when it is possible to structure a business relationship to avoid the application of franchise laws, many business choose not to do this because some of the desirable characteristics of franchises would have to be sacrificed. For example, to structure the relationship as a license, the franchisor would have to give up the right to impose significant controls on the franchisees. Or, to take advantage of the federal exemption for minimal fees, the franchisor would have to give up the ability to collect fees from its franchisees for 6 months. It is often not possible to accomplish all of the franchisor’s business objectives and still avoid application of franchise laws.
General Approach to Avoiding Franchise Law
Franchise laws apply to any business relationship that falls within the legal definition of a "franchise" under applicable law and that is not subject to any exceptions under applicable law. There are 2 ways to avoid having to comply with franchise law:
Structure the relationship so that one or more of the elements of the legal definition of a franchise is missing; or
Structure the relationship so that it is subject to an exception under franchise law.
These methods depend on the particular wording and interpretation of the FTC Franchise Rule and the statutes and regulations in the relevant states. Federal franchise laws and state franchise laws are not uniform. The laws of more than one state may apply, and these laws are usually not uniform. It is entirely possible for a business relationship to be a franchise under state law in one state, but not be a franchise under the laws of another state or under the FTC Franchise Rule. Often, it is impossible to structure a business relationship to avoid franchise law.
The federal and state exemptions have limited usefulness. An exemption under one set of laws does not mean an exemption under the others. As a practical matter:
most federal exemptions are useful only to franchisors who will not offer or sell franchises in any state with franchise laws and/or business opportunity laws;
most state exemptions are useful only to franchisors who will offer and sell franchises only in a few states (and who qualify for a federal exemption);
many state exemptions allow the franchisor to not register the franchise with the state, but they still require the franchisor to provide a FDD to potential franchisees.
Another problem with exemptions is that they can be lost. When that happens, a non-franchise business relationship can be automatically transformed into a franchise. In an actual case, a forklift manufacturer was surprised to learn that its distributor in Illinois was really a franchisee because the distributor had paid more than US$500 to the manufacturer during the course of the 20-year relationship for things like sales manuals and service manuals. The distributor was awarded US$1.5 million from the manufacturer because of the manufacturer’s violation of state franchise relationship laws by improperly terminating the franchise.
Non-Franchise Forms of Business Expansion Which Negate an Element of the Franchise Definition
A simple trademark license is usually not a franchise under federal law or under the laws of most states because:
the licensee typically does not get the right operate a business that is substantially associated with the licensor’s marketing plan or business system,
the licensor typically does not have significant control over the licensee’s business, and
the licensor typically does not provide significant assistance to the licensee.
For example, if a large retailer of supplies for home repairs wants to offer its customers additional value by establishing a network of qualified contractors to provide repair services to the retailer’s customers, it could accomplish this through a trademark license arrangement instead of a franchise under federal law and under the laws of most states. Under this arrangement, the contractors could pay a fee to the retailer for the right to use the retailer’s trademarks in connection with their existing business – in the form of an initial fee, or an ongoing royalty, or both. And, the retailer could impose quality standards on the contractors. But, the retailer must not provide a marketing plan or other significant assistance to the licensees, or impose significant controls on them, or else this arrangement would probably be a franchise.
Caution: The dividing line is not always clear between acceptable types of control needed to protect the goodwill associated with the licensor’s trademarks and service marks and the types of control that might trigger application of franchise law.
Caution: Significant assistance can also trigger the application of franchise laws.
A distributorship is usually not a franchise under federal law or under the laws of most states because the distributor typically is not require to pay a fee for the right to distribute the product or services involved. For example, if a fork-lift manufacturer want to expand its business by helping local companies start up local distributorships that offer retail sales and service of forklifts, it could do this through a distributorship instead of a franchise under federal law and under the laws of most states. The manufacturer could providing the local distributors with training, an operations manual, marketing materials, and other significant assistance in setting up and running the business, and the distributors’ local businesses could be substantially associated with the manufacturer’s trademark. But, to keep from being a franchise, the manufacturer must not charge the distributors any fee (other than the real wholesale price for the forklifts).
Caution: The definition of "fee" is very broad and includes just about every type of payment – even payments for goods or services the manufacturer provides to the distributors.
Caution: Some state have laws that regulate certain aspects of the distributorship relationship.
Caution: Distributorships involving certain types of items are subject to additional laws in many states – examples include alcohol, gasoline, automobiles, motorcycles, boats, industrial equipment, farm equipment, lawn equipment, etc.
3. Business Opportunity
A business opportunity relationship is usually not a franchise under federal law or under the laws of most states because:
the people who buy business opportunities typically are not given the right to sell goods or services under the seller’s trademarks, and
the business is typically not substantially associated with the seller’s trademarks.
For example, if a company develops a method for operating a business involving transcribing medical records, and it wants to sells this information to others so that they can open their own businesses, it can accomplish this through a business opportunity arrangement. This will not be a franchise under federal law or under the laws of most states, so long as the buyers of the business methods do not have the right to use the seller’s trademarks or service marks.
Caution: Many states have business opportunity laws that impose registration and disclosure requirements similar to those required by franchise laws. So, often there is no real benefit to trying to structure a relationship as a business opportunity instead of a franchise – especially if it will be offered in more than a few states.
Caution: Federal law applies to certain types of business opportunities if: (a) the business opportunity seller (or designated suppliers) provide goods or services to the buyer for resale; and (b) the business opportunity seller secures retail outlets or accounts (or locations for vending machines or racks) for the business opportunity buyer; and (c) the business opportunity buyer pays a fee for the business opportunity.
4. Multi-Level Marketing
A multi-level marketing system is a form of business opportunity that involves incentives and rewards to existing participants for recruiting additional participants into the system. A multi-level marketing system is usually not a franchise under federal law or under the laws of most states because the participants typically pay only a small fee for the right to participate. There are exceptions under federal law and under the laws of many states for franchises and business opportunities that require only a small investment. See the federal franchise exceptions discussed below.
Caution: Many states have laws that make pyramid schemes illegal, and multi-level marketing systems that are not properly structured will easily violate these laws.
Caution: Some states have multi-level marketing laws that impose registration and other requirements on multi-level marketing companies.
Caution: The legal costs involved in properly setting up a multi-level marketing system can be much more than the fees for setting up a new franchise system.
5. Sales Agent
A sales agency is usually not a franchise under federal law or under the laws of most states because the sales agent typically does not pay a fee for the right to distribute the product or services involved. For example, most insurance companies use agents to offer and sell their policies, and to provide services to policy holders. These agents offers products and services under the insurance company’s trademarks, and the insurance company typically provides training and other assistance. This relationship will not be a franchise so long as the agents do not pay any fees to the insurance company.
Federal Franchise Exceptions
1. Fractional Franchise
Under the FTC Franchise Rule, "fractional franchises" are exempt from the federal disclosure requirements. A fractional franchise is the arrangement where an existing business adds a franchised product or service to its other lines of business. For example, if a department store wanted to offer franchised make-up sales and services to its customers, the franchise that would be granted to the department store would probably be a fractional franchise. To qualify for the exemption, 2 conditions must be met:
the franchisee or any of its current directors or executive officers must have been in the same type of business as the franchised business for at least 2 years in the past, and
both parties must anticipate in good faith that the sales from the franchise would represent no more than 20% of the franchisee’s projected total gross sales (based on dollar volume) for the reasonably foreseeable future.
Caution: Only 7 states with franchise laws have a similar exemption (California, Illinois, Indiana, Michigan, Minnesota, Virginia and Wisconsin), and some of these state have additional conditions for eligibility.
2. Leased Department
Under the FTC Franchise Rule, a "leased department" is exempt from the federal disclosure requirements. A leased department is a relationship in which an independent retailer sells its own goods or services from rented space within a larger retailer’s store. For example, if a department store wanted to offer optometry services to its customers under its own name, but did not want to offer those services directly, it could lease out space in its store to a third party who would be authorized to use the department store’s name. This arrangement would be exempt from federal franchise law so long as the independent retailer is not required to buy the goods or services it sells from the larger retailer (or from designated suppliers).
Caution: There are no specific exemptions under state franchise laws similar to this federal exemption, but a leased department relationship could fall outside the scope of state franchise laws if properly structured.
3. Minimal Investment
Under the FTC Franchise Rule, franchises involving only minimal investments by franchisees are exempt from the federal disclosure requirements. To qualify for this exemption, the franchisee must not be required to make any payments to the franchisor (or it affiliates) of US$500 or more at any time before the franchised business begins operations, or within 6 months after beginning operations.
Caution: Just about any payments the franchisee makes to the franchisor would be counted towards the US$500, except for bona fide wholesale prices for reasonable amounts of inventory for re-sale.
Caution: Six states with franchise laws have similar exclusions, but the dollar amounts and applicable time periods vary from US$100 on an annual basis, to US$500 during the life of the franchise.
Caution: In these states, a relationship that was exempt from the state franchise laws can lose its exemption if the franchisee’s payments exceed the limits during the applicable period.
Caution: State business opportunity laws have similar exclusions for business opportunities involving minimal payments ranging from US$200 to US$500.
4. Verbal Agreement
The FTC Franchise Rule does not apply to franchise agreements that are purely verbal.
Caution: If any material term of the relationship is in writing, this exemption will not apply.
Caution: The franchise laws and business opportunity laws of most states apply to written and verbal agreements.
The FTC Franchise Rule exempts from the federal franchise disclosure requirements pure employer-employee relationships. These relationships would not normally be governed by federal or state franchise laws anyway.
Caution: Franchise relationships that are attempted to be disguised as employment relationships will not qualify for this exemption.
6. General Partnership
The FTC Franchise Rule exempts from the federal franchise disclosure requirements general partnership relationships. So, it is possible for one partner to contribute know how and a trademark license to a partnership, and for other partners to contribute cash and services for setting up and running the partnership’s business, without having to comply with federal franchise law. But, to be entitled to this exemption, all partners must be general partners, and no partner must have any advantage over the other partners.
Caution: Limited partnerships and other forms for business entities (such as corporations or LLCs) do not qualify for this exemption.
Caution: Most states with franchise laws do not have a similar exemption.
7. Single License
Under the FTC Franchise Rule, a single trademark licenses is exempt from the federal disclosure requirements. To be entitled to this exemption, there must be only one licensee who is granted the right to use the licensor’s trademark. For example, if a power company wanted to establish local energy efficiency consultants that were owned and operated separately from the power company, it can accomplish this by issuing a single license to a separate company, which would own and operate the individual units. Under this arrangement, the power company could grant the separate company the right to use the power company’s service marks, it could provide significant assistance to the separate company, and it could charge a fee for all this, without having to comply with the federal franchise disclosure laws.
Caution: To be eligible for this exemption, the license must be exclusive and nationwide.
Caution: There is no corresponding exemption in those states with franchise laws; but see the state law exemption for limited offers discussed below.
State Franchise Exemptions
1. Large Franchisor
In 9 states, franchisors are exempt from the state registration laws (but not state disclosure laws), if they meet certain minimum net worth requirements (typically US$5 million to US$10 million) and if they have certain minimum levels of experience (typically at least 25 franchisees each year for the last 5 years). These states are: California, Illinois, Indiana, Maryland, New York, North Dakota, Rhode Island, South Dakota and Washington. Most of these states require the franchisor to file certain forms to qualify for this exemption.
2. Limited Offers
In Indiana, Minnesota, New York and Washington, certain limited franchise offers are exempt from the state franchise registration laws (but not the state disclosure laws). The requirements for these exemptions vary. For example, in Indiana, a franchisor does not have to register if it sells no more than 1 franchise in that state in any 24-month period. In Washington, on the other hand, the limited offer exception requires that: (1) the franchisor has no franchises outside the state; (2) only 3 or fewer franchises will be granted within Washington; (3) the franchisor does not publicly advertise the franchise offer; and (4) the franchisee is represented by a lawyer or CPA.
3. Other State Exemptions
Existing Franchisees – In California, Hawaii, Maryland, New York, Rhode Island, Washington and Wisconsin, the sale of an additional franchise to an existing franchisee is exempt from certain state franchise laws. Most of these states impose additional requirements for this exemption, such as substantially similarity between the new franchise and the existing franchise, and minimum periods of operation for the existing franchise.
Franchisor Insiders – California, Rhode Island and Washington have exemptions for the sale of a franchise to franchisor insiders. These exemptions typically apply to officers and directors of the franchisor, and to certain other individuals.
Wealthy Franchisees – In Rhode Island and Washington, sales to a franchisee with a net worth of more than US$1 million or annual income of US$200,000 are exempt.
Experienced Franchisees – California exempts from the state registration and disclosure laws sales to experienced franchisees. To qualify for this exemption, the franchisee’s owners must have had 2 years of experience (within the last 7 years) managing the financial and operational aspects of a similar business, and the franchisor must file an exemption form.
High-Cost Franchises – In Illinois, Maryland and Wisconsin, the sales of high-cost franchises are exempt from state registration laws (but not state disclosure laws). The applicable thresholds are minimum initial investments of US$1 million in Illinois, US$750,000 in Maryland, and US$100,000 in Washington. There are additional qualification criteria in Illinois and Washington.
Out of State Franchises – In 7 states, there are exemptions from state registration and disclosure laws for sales of franchises if the franchise location will be outside of the state. These states are: California, Hawaii, Maryland, Michigan, Rhode Island, Virginia and Wisconsin. Most of these states also require that the franchisee not be a resident of the state.
Sales by Franchisees – The sale of a franchise by an existing franchisee to a new franchisee will be exempt from state registration and disclosure laws (and from federal disclosure laws) in most cases. But, if the franchisor is involved in the sale, such as by requiring the new franchisee to enter into a new franchise agreement, the franchisor will probably have to comply with applicable registration and disclosure laws.
Administrative Orders – In 8 states, franchisors can request an exemption by order of the state agency that regulates franchising. This generally requires a showing that the proposed transaction is not similar to the type intended to be covered by the state laws. these states are: Hawaii, Indiana, Illinois, Maryland, Minnesota, New York, Rhode Island and Wisconsin.
Other Non-Franchise Methods of Expansion
Franchising, licensing and business opportunities are not the only methods for expanding businesses. Many businesses that would be appropriate for franchising choose to expand through company-owned units. For example, this technique has been successfully used by a well-known coffee shop with more than 5,000 locations. Funding for this type of expansion may be available through:
Debt financing; or
Other techniques for business expansion involve mergers and acquisitions or strategic alliances.
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