Franchise or License?

Franchise or License?

Because Getting it Wrong Can Lead to Personal Liability

A couple of weeks ago I met with a business owner looking to expand his successful service business.

He told me that he wanted to sell the right to use his business’ name and business systems, to help buyers get up and running, and be successful, and to collect initial and ongoing royalties.

Then he said:

“I want to franchise my business, but don’t want to call it a franchise.  I don’t want to go through the hassle or cost of preparing franchise documents.”

As I’ve done with other business owners many times before, I told him that:

     Whether or not a business arrangement is a franchise or a license depends on the arrangement, not the name.

Understanding the difference in the arrangements is crucial because,

Under Florida law, if your company creates a franchise but fails to provide the required

disclosures through a Franchise Disclosure Document (FDD),

you can be held personally liable for the buyer’s damages.

 

This occurred recently in a Florida case.

The officers of the ‘licensing company’ were held personally liable for the buyer’s damages because the company created a franchise, but called it a license, and did not provide the required disclosures.

That company, Relay Transportation, Inc., decided not to provide the required franchise disclosures because it wanted to get an initial franchise fee of $50,000 before spending the money to create the FDD.

This is a common situation.  Customers and other people see the success of a business and “want in.”  The owner wants to expand her business, but doesn’t have the capital to pay for the attorney’s and accountant’s fees to prepare the FDD in advance.

So, when a prospective franchisee offers to pay the franchisee fee in advance, the owner sees it as a way to pay the costs of establishing the franchise.  It seems like a great process – the franchise funds itself.

The problem is that franchise law prohibits it.

In this case Relay didn’t want to be completely exposed by selling vapor – collecting a franchise fee before having anything to sell.  So it decided to call the first arrangement a “license” and had its attorney prepare a license agreement.

The problem was that the arrangement wasn’t a license; it was a franchise.  And calling it a license wasn’t a magic potion that got Relay out of its requirements to provide the franchise disclosures.

The franchisee invested money to start the business and paid the “license” fee to Relay.  Things didn’t work out.  The franchisee lost its investment plus startup costs.  When Relay refused to reimburse the franchisee for its losses, the franchisee sued both Relay and its officers for deceptive trade practices based on Relay’s failure to provide the required franchise disclosures.

And because it is a deceptive trade practice, the officers who participated in the franchise system development were personally liable to the franchisee.

When is an Arrangement a Franchise?

The Federal Trade Commission (FTC) regulates franchise disclosures through the Franchise Rule.

Three factors make a business arrangement a franchise:

  • Using a trademark or commercial symbol.
  • A payment of $500 or more during the first six months of the relationship.
  • Ability to Exercise Significant Control or Significant Assistance.

It is important to keep in mind that each element is broadly interpreted.

Side Note: Though many states require franchisors to file and secure approval of the Franchise Disclosure Document before making offers in their state, Florida is not one of them.  Florida does, however, have laws that a franchisee can use to sue a franchisor and its officers if the franchisor doesn’t properly provide the disclosure.

Using a Common Trademark or Symbol.

A trademark includes names, logos and other indications of common origin.  Examples include the Nike swoosh, the NBC tones, as well as business names.

The Franchise Rule includes in this element not only registered trademarks, but also trade names, service marks and other symbols that indicate a common origin or enterprise.

For example, a common symbol would also exist where, even though the member business names were different, each used the phrase “Part of the XYZ Business Group” in its marketing materials.

As a general rule, if the name or a logo is an essential element of the arrangement, the trademark element will be satisfied for purposes of the Franchise Rule.

Payment of $500 or More in the First Six Months.

Obviously, a franchise fee of $500 or more would satisfy this element.

Because the elements are viewed very broadly, all of the following purchases would be included in determining whether the $500 threshold had been met:

  • Inventory
  • Equipment
  • Marketing and Sales Materials
  • Training and Training Materials
  • Rent (equipment or real property)
  • Royalties

In short, if the buyer is paying the seller (or any related parties) $500 or more in the first six months, no matter the purpose, goods or services received, the payment element of the franchise definition will be satisfied.

Because the threshold is so low, when evaluating an arrangement to determine if it is a franchise, I always assume the payment threshold will be met.

Ability to Exercise Significant Control or Significant Assistance

This element of the definition focuses on the business of the buyer and whether:

  • the seller has the right to direct the buyer in how to operate the buyer’s business; or
  • the buyer is relying on the seller to be able to operate the buyer’s business.

Control.

Again, this is interpreted broadly.  Usually, the ability to exercise control is satisfied where the arrangement requires the buyer to operate using the seller’s systems, or in the seller’s “way” – often as a means to differentiate the ‘franchised’ business from its competition.-

I sometimes refer to this as the seller’s secret sauce – the thing that made the seller successful and that the seller usually wants the buyer to do in his business.

It is important to note that actual control is not required.  If the seller merely has the ability to control, this element will be satisfied.

Some of the things that indicate whether there is significant control by the seller include:

  • Location Selection and Design
  • Operational Requirements
  • Financial Reporting Requirements
  • Marketing Requirements
  • Sales or Management Training
  • Territory Restrictions
  • Systemwide Website
  • Operations Manual

Some of these things are sufficient alone.  Others are not.

As a general rule, though, if the seller is directing the buyer to operate material parts of the buyer’s business in a particular way, there will be significant control.

Reliance.

Instead of looking at the business operations, the reliance factor focuses on the buyer.  Reliance will usually be found where the buyer is inexperienced in the franchised business, or made a significant investment.

If a buyer wouldn’t be able to operate the business but for the seller’s systems, training and ongoing assistance, the reliance factor will likely be satisfied.

How Do I License My Business?

So now you know what constitutes a franchise.  But what do you do if you just want to “license” a business?

Without trying to be cute, avoid creating a franchise by eliminating at least one of the franchise elements of a franchise (note: that there are other very limited exemptions to the Franchise Rule that I’m not describing in this article).

Remove the Trademark.

The easiest franchise element to remove is the common trademark element.  Rather than permitting licensees to use your company name, each licensee would select a separate name.

One client did this a few years back.  He was operating a franchise system where franchisees would buy equipment, become trained and utilize the registered trademark in the operation of the business, all in exchange for an up-front franchise fee and ongoing royalty payments.  In addition, franchisees purchased supplies and materials that were used in the business from the franchisor.

The client was frustrated, though, because franchisees were not paying the royalty payments or providing financial information.  Based on their supplies and material purchases, he knew they were doing well.  But, he couldn’t get them to do the paperwork for the business.

Rather than go after each franchisee, we suggested that the client convert the system into a license (business opportunity) by removing the right to use the trademark from the franchise.  To collect same amounts that were supposed to have been paid as franchise royalties, the client added a calculated royalty to the cost of the materials via a price increase.  The client was able to increase collected revenues while simultaneously reducing the time he spent managing the franchisees (now licensees).

Reduce the Payment.

I have never had any business owner that was willing to eliminate the $500 or more in the first six months element because the payment is so broadly viewed.  So, I won’t focus on it here.

Significant Assistance or Control.

An element that many business owners focus on removing is significant assistance or control.

Rather than require the buyer use specific systems, provide financial reporting or meet requirements of any of the other things identified above, a business license can provide:

  • Training,
  • Equipment,
  • Marketing plan,
  • Initial supplies, and
  • Trademark License and licensing royalties.

Of course, there cannot be any requirement that the licensee follow the training, use the equipment in a particular way, market in a particular way or make any level of sales, attend meetings or do anything else.

There is, of course, a danger that a licensee will ‘go off the rails’ and do business in a way that harms the goodwill associated with the trademark.  Therefore, any trademark license should have protections for the mark, including the right to terminate the license if the license seller discovers the mark has been harmed by the licensee.

Business Opportunity Laws.

The legal landscape isn’t all wide open green pastures when it comes to licensing a business though.  Licensing arrangements can fall within the definition of “business opportunity.”

Business opportunities are also regulated by the FTC, as well as by many states, Florida included.

When is a License Arrangement a Business Opportunity?

The definition of Business Opportunity varies by state and by the FTC, and is generally broad.  For example, the FTC definition has the following elements:

  • New business,
  • Buyer makes a payment to the seller, and
  • Seller (itself or through another party) Promises the Buyer to:
    • Provide Locations, Displays or Vending Machines to the buyer, or
    • Provide Outlets, Accounts or Customers to the buyer, or
    • Purchase Goods or Services from the buyer.

The Florida law modifies FTC definition.  First, it limits the definition by adding a $500 threshold to the buyer’s payment.  Next, it expands the definition by adding the seller promise of a sales or marketing program as one of the elements that makes an arrangement fall within the definition of business opportunity.

It is important to note that, even if an arrangement doesn’t meet the Florida definition of business opportunity, if it meets the FTC definition, then the FTC business opportunity rule must be satisfied.

Business Opportunity Disclosure Requirements.

The good news, though, is that even if a business licensing arrangement falls within the definition of a business opportunity, the disclosure obligations are much less onerous than for a franchise.  The disclosures are generally short, do not require financial statements and are a lot less time consuming to prepare.

Business Opportunity Contract Requirements.

One aspect of the business opportunity laws to be careful about is that they sometimes require specific provisions in the contract between the seller and the buyer.  Florida has these requirements and a buyer is able to rescind (undo) any contract that does not contain these provisions.

Expanding a business through franchising or licensing must be accomplished carefully to avoid running afoul of franchise disclosure requirements and business opportunity laws.  Once required disclosures are provided, a properly structured franchising or licensing arrangement can lead to successful growth of an already successful business.

Please call me at 407-649-7777, if you would like to discuss how to expand your successful business the most profitable and cost-effective way possible.

 

Ed

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