Franchise Law Frequently Asked Questions:
Q: How do I know if I should franchise my business?
A: The basic elements to successfully franchising a business are as follows:
First, you need to have a successful company store that is capable of being copied and which produces, preferably, $60,000 – $100,000 in owner’s profit or a draw.
Second, it is helpful if you have had franchise inquiries, individuals asking about franchising your outlet in another location. That way, you already have an idea that your franchise concept will be in demand when it is taken to market.
Third, you will need a business concept that can be duplicated. A concept that relies on unique skills of its owner is not one that is well suited for franchising. On the other hand, a concept that is so easy that anyone can start and run it with little guidance, also does not make for the best franchise concept. Instead, the best franchise concept is one where the guidance of a franchisor will be of value, yet the concept is not tied to unique owner skills that would be hard to teach broadly.
Fourth, you will want a strong trademark that will have appeal in the areas of the country where you intend to franchise. The trademark should be registered with the United States Patent & Trademark Office (“USPTO”).
Fifth, you will need to put together an Operations Manual which explains to a franchisee the steps needed to set up and operate a franchised business.
Sixth, you will need to engage a franchise attorney to draft a Franchise Disclosure Document (“FDD”) which will contain the Franchise Agreement, 23 disclosure items required by the FTC Franchise Rule, and other material. In certain states, your franchise attorney will need to make certain filings or registrations before your company can offer or sell franchises in those states.
Seventh, you need time and energy. Either you or someone else on your team needs time and energy to make a franchise program work. And it is also helpful to have or engage someone on your team with franchise industry experience.
Eighth, you need capital. We recommend $75,000 – $150,000. You will need capital to prepare an Operations Manual, incur legal and accounting fees, pay any applicable state filing fees, generate franchise sales leads, sell franchises, train new franchisees, and offer marketing and support to franchisees.
Q: Can you please tell me more about what is in an FDD?
An FDD is a fairly complicated and lengthy document (normally 100+ pages) containing information on the franchisor, its management, its litigation history, initial fees that a franchisee will pay, ongoing fees, the initial investment to start a franchise, product sourcing restrictions, financing terms (if offered), training and support offered by the franchisor, territory rights being granted to a franchisee, trademarks owned by the franchisor, a summary of key terms of the franchise agreement, possibly a Financial Performance Representation, information on company owned and affiliate outlets, and other items.
A franchisor must also include a copy of the franchise agreement and other agreements related to the franchise in the FDD, a list of current franchisees, a list of franchisees who left the system in the prior year, financial statements on the franchisor, state specific addenda, and receipt pages. A franchisor must also include the table of contents to its Operations Manual in the FDD, or else make the Operations Manual available for viewing by prospective franchisees.
Q: How much does it cost to prepare an FDD?
The cost to prepare an FDD varies depending upon the complexity of the business concept at issue and in which states the franchisor would like to offer and sell franchises initially. For FDDs that our law firm prepares, the attorney fee will start at $7,500 for a simple concept that is not being filed in any states and reach $24,500 for more complicated concepts being filed in all states that require a franchise filing. For most concepts that are in the middle, and being filed in select states the first year, our typical fee will be in the $9,500 – $15,000 range and can be paid over 3-4 months.
Q: Can I prepare an FDD on my own?
Preparing an FDD on your own is like attempting a medical procedure after reading an article on the internet. It is simply unwise. To intelligently pursue franchising requires the assistance of a franchise attorney. If you do not have the capital yet to engage a franchise attorney, then we suggest continuing to work on the flagship company store and improve its profitability to the point that capital is available for franchising.
And we also do not believe it is wise to let a franchise consultant or other non-attorney prepare an FDD for your company.
Q: How long does it take to prepare an FDD?
It will typically take 45-60 days to prepare an FDD. However, if you want to offer or sell franchises in certain states that require a filing or registration with the state and state approval, then it will take additional time in those states.
Q: Do I have to file the FDD with the FTC for review and approval before I can sell franchises?
A: No. While the FTC has issued the FTC Franchise Rule, and it is the primary guide in how to prepare an FDD and what an FDD must contain, the FTC does not review or approve an FDD. However, there are franchise filing requirements with a number of states if a company wants to offer or sell franchises in those states.
Q: In which states can a franchisor make offers or sales of franchises without making any filing with the state?
Once franchise counsel sends to you a complete, final, issued FDD, your company can begin to offer and sell franchises in the 25 non-registration states, plus D.C.
Q: In which states must a franchisor make a filing in order to be able to offer and sell franchises?
States fall into various categories.
First, let us deal with what we call the business opportunity states.
In these states, the franchisor is exempt from any filing requirements if it has a federal trademark registration:
- Connecticut (a one time filing with no filing fee should still be made)
- Georgia (a state trademark registration will also suffice)
- Louisiana (a state trademark registration will also suffice)
- North Carolina
- South Carolina (a state trademark registration will also suffice)
Second, we have what we call the 1-time exemption states. These states require a filing one time, but then the franchisor can forevermore offer and sell franchises in those states on a current FDD:
Third, we have 3 annual filing states, which require an annual filing and payment of a fee, but no franchise regulator will review the FDD, as follows:
Fourth, we have the 13 franchise registration states which require an annual filing and in most cases a state franchise regulator will review the FDD and issue a comment letter, meaning edits they want to the FDD before they will approve the FDD in that state:
- California ($675 filing fee)
- Hawaii ($250 filing fee)
- Illinois ($500 filing fee)
- Indiana ($500 filing fee)
- Maryland ($500 filing fee)
- Minnesota ($400 filing fee)
- New York ($750 filing fee)
- North Dakota ($250 filing fee)
- Rhode Island ($600 filing fee)
- South Dakota ($250 filing fee)
- Virginia ($500 filing fee)
- Washington ($600 filing fee)
- Wisconsin ($400 filing fee)
Q: I hear the term “affiliate” a lot. What does that mean and how does it relate to franchising?
“Affiliate” means under common ownership or control.
Let’s say you have a successful flagship company store, Bob’s Subs, LLC. And Bob’s Subs, LLC has operated for 5 years very successfully. You now want to franchise it. We do NOT recommend that you franchise under Bob’s Subs, LLC. Instead, we recommend that you set up an affiliate called “Bob’s Subs Franchising, LLC.” So Bob’s Subs Franchising, LLC would be under common ownership or control as Bob’s Subs, LLC.
We recommend that you set up an affiliated franchising entity for two reasons: First, this way, liability within the company store LLC and within the franchising LLC will normally be contained. So if there are many claims under one LLC it would not normally impact the other LLC.
In addition, a franchisor will need at some point, depending upon which states it is going into, audited financial statements. We do not want an audit of many transactions at Bob’s Subs, LLC, as that will take a lot of time and cost a lot of money. Instead, we want you to make an opening deposit into a bank account of Bob’s Subs Franchising, LLC and have that audited. An audit of a single transaction will be quick and inexpensive.
Q: I have heard the terms “Unit” franchise, “Area Representative,” and “Master Franchise.” What is the difference?
A Unit franchise refers to someone who owns and operates an outlet, like a sandwich shop.
An Area Representative, which is also a franchise relation, refers to someone who purchases rights to a large territory, for example, an entire state, then recruits Unit franchisees within that territory, in exchange for a portion of the initial franchise fee and royalties paid by the Unit franchisee. However, the franchise agreement between the Unit franchisee is with the franchisor.
A Master Franchise, on the other hand, also purchases the rights to develop a large area, but does so whereby the Master functions as the franchisor, actually entering into the franchise agreement with the Unit franchisee. Master franchise relations are commonly used in international franchising so that a franchisor can simply appoint one person to function as the franchisor on their behalf in the other country.
Q: Instead of franchising, can I simply have License Agreements?
It is not unusual for a company to start out with License Agreements instead of franchising. However, License Agreements are commonly illegal franchises.
In general, a “franchise” is defined as-
*Payment of $615 or more in the first six months;
*Use of the name of the franchisor; and
*Substantial assistance or control by the franchisor
These elements are usually present in a License Agreement, and hence that is why they are commonly illegal franchises.
However, if each licensee uses their own name in the business, e.g., “Mary’s Subs,” “Bob’s Sub’s,” “Charlie’s Subs” etc. then, as a general rule, the business format is not an illegal franchise, so licensing would be permitted.
But there are two major drawbacks to such an arrangement:
First, the company is not building a brand. Outlets all over the country with each under its own name does not build much of a company.
Second, approximately 26 states and the FTC have varying “business opportunity” laws which can require registration and disclosure. We feel these laws are more burdensome to comply with, when dealt with on a large scale, than franchise laws. You can find more information here.
So, for both of those reasons, we counsel against License Agreements and in favor of franchise agreements.
And do not worry. If you already started licensing, we can convert your licensing program into a franchise system in full compliance with the franchise laws.
Q: I now have my FDD issued and am selling franchises. A prospect has asked me how much money they should expect to make. Can I tell them?
The laws on Financial Performance Representations (“FPRs”), previously called “earnings claims,” can be tricky.
Here are some of the general rules:
A “financial performance representation: is broadly defined as any oral, written, or visual representation to a prospective franchisee, including a representation in the general media, which states (expressly or by implication) a specific level or range of actual or potential sales, income, or gross or net profits.”
With respect to the FDD, if the Company makes an FPR in Item 19, the Company may repeat that claim in sales talk and in sales literature (except advertising in the states of Maryland and Minnesota).
However, the Company may make no FPR other than as disclosed in Item 19, except a franchisor may supplement the information provided in this Item 19, for example, by providing information about possible performance at a particular location or under particular circumstances.
If the Company does not make an FPR in Item 19, it may not make an FPR in sales talk or sales literature.
In addition, the Company may refer prospects to existing franchisees who may reveal their financial performance.
If the Company is selling an existing operation, the Company may reveal the past earnings of that operation to a prospect interested in buying it.
And the Company may give out a blank pro forma with revenue and expense categories, but give no suggestions on dollar amounts to fill in.
Q: What is the 14 day hold on an FDD and how does a franchisor count the required 14 day hold that a franchise prospect must have on an FDD?
Under federal law, and the law of most states which have franchise laws, in order to enter into a franchise agreement or receive funds from a prospective franchisee, the prospective franchisee must first hold the FDD For 14 calendar days.
The law makes clear that those 14 calendar days must have “book ends,” in other words, the day of disclosure on the FDD, and the day of the execution of the franchise agreement (or payment of money to the franchisor) must be outside the 14 day hold.
So, if a franchisor furnishes an FDD to a prospect on June 1, then on June 16, the franchisor can enter into a franchise agreement and receive funds from the prospective franchisee.
Oddly, even though that is a 14 day hold, plus 2 book ends, which equals 16, when one subtracts June 1 from June 16 (16-1 = 15) the result is 15.
Please also note these additional rules on the 14 day FDD hold:
- Iowa requires that a franchisor with a net worth of $1M or less give a prospect the Disclosure Document at the earlier of the first personal meeting or 14 calendar days before the prospect signs a binding agreement with, or make a payment to, the franchisor or an affiliate in connection with the proposed franchise sale.
- New York requires the Company to give a prospect the Disclosure Document at the earlier of the first personal meeting or 10 business days before the execution of the franchise or other agreement or the payment of any consideration that relates to the franchise relationship.
- Michigan requires the Company to give a prospect the Disclosure Document at least 10 business days before the execution of any binding franchise or other agreement or the payment of any consideration, whichever occurs first.
A franchisor must furnish a copy of the FDD to a prospective franchisee earlier in the sales process if the prospect makes a reasonable request for an FDD.
Q: Are there any rules related to franchise advertising material and, if so, what are the main rules?
Several of the franchise registration states have rules on franchise advertising material. Here is a summary of some of the main rules:
First, franchise advertising material must be submitted to the following states before it can be used in those states: California, Maryland, Minnesota, New York, North Dakota, and Washington State.
Second, the franchisor’s name and address must appear in the advertising.
Third, Maryland and Minnesota do not allow FPR’s to be used in franchise advertising.
Fourth, Minnesota and New York require certain disclosures in the franchise advertising,
Q: What is a Franchise Seller or Franchise Broker? Are there any laws that apply to them?
A Franchise Seller is someone who sells franchises for a franchisor, normally for a commission on each franchise sale.
A Franchise Seller needs to be listed on the Receipt pages of the FDD, at least on a transaction handled by the Franchise Seller.
In addition, a franchisor must file Franchise Seller Disclosure Forms with the following franchise registration states, disclosing certain biographical and legal information about each Franchise Seller: California, Hawaii, Illinois, Indiana, Maryland, Minnesota, New York, North Dakota, Rhode Island, and Washington State.
If a Franchise Seller is not an officer, director, or employee of the franchisor, then the Franchise Seller is considered a Franchise Broker.
Franchise Brokers are supposed to register in Illinois, New York, and Washington State.
And if a franchisor is using a Franchise Broker to assist with franchise sales in Washington State, then the franchisor is required to file a Washington Appointment of a Franchise Broker form with Washington State, identifying the Franchise Broker and supplying the Franchise Broker’s Washington Franchise Broker Registration number.
Q: I am an existing franchisor having trouble with one of our franchisees. What are the next steps?
As a general rule, we counsel a three step approach to dealing with a franchisee who is not in compliance with the Franchise Agreement or Operations Manual.
First, it is always best to try and resolve things in an amicable way through a phone call or email.
Second, if an amicable approval does not work, we recommend a Notice to Cure in most cases.
Most franchise agreements are structured such that a franchisor can terminate a franchisee who is not in compliance with the Franchise Agreement. For some grounds of termination, an immediate termination with no cure period is permitted. And for other grounds of termination, a notice and opportunity to cure for some time period must be provided.
Third, for those grounds that allow for immediate termination, or where a notice to cure has been issued but the franchisee did not come into compliance, we recommend a Notice of Termination, ending the franchisee’s franchise agreement and rights.
Please note, however, several states have franchise laws that govern the termination of the franchise agreement and these laws may over-ride the franchise agreement. Therefore, it is critical that you seek the advice of a franchise attorney before issuing a Notice to Cure or a Notice to Terminate.
Q: I am an existing franchisor and it is time to renew one of our franchise agreements. What is the process to renew a franchise agreement?
A: A franchisor has two options when renewing a franchise agreement at the end of its term. The easiest option, though not preferred, is to simply execute an agreement extending the term of the existing franchise agreement, normally accompanied by a Release. This is not preferred because over time a franchisor’s franchise agreement normally evolves and improves so merely extending the term of a 5 or 10 year old franchise agreement may be extending something which has become out of date in some ways.
However, this path is preferable if ease of administration is the goal or if the franchise is in a franchise registration state (CA, HI, IL, etc.) where the franchisor no longer has a current franchise registration.
The other option is to treat the renewal like the sale of a new franchise. This requires disclosure on a current FDD, which in some states means the FDD must be filed and approved or the franchisor otherwise has obtained any necessary franchise approval, waiting 14 calendar days, then entering into a new current franchise agreement, and typically taking a Release from the franchisee as well.
The advantage to this path is to get the franchisee on a new, current franchise agreement, which is up to date to the franchisor’s business model. But the disadvantage is that more work is involved, and, as noted, this type of renewal is treated like a new franchise sale so any needed state franchise approval must be in place first.