Franchising or Licensing?
Franchising and Licensing as a means of expanding a business are often confused with one
another. However, franchising and licensing come from two distinct areas of the law.
Franchising is based on Securities Law and Licensing is a form of Contract Law.
What does this mean to the non-lawyer?
It means that if one takes up franchising as a means of expanding a business, then compliance
with the franchise laws, like the securities laws, requires registration of the franchise in the
applicable jurisdictions. On the other hand, licensing is merely a contract between two
independent parties.
Why Do Franchises Have To Be Registered?
In general, the primary difference between a license and franchise situation is the amount of
control that the franchisor or licensor exercises over its franchisees and licensees, respectably.
A franchise has to be registered, because the control by the franchiser over the franchisee is
what is supposed to make the money for the franchisee; i.e. if you do what the franchiser says,
then you will make money.
Buying a franchise is like buying a security; i.e. the control over whether or not the buyer of
the franchise or security makes money is in the hands of a third party; for the security situation
it is in the control of the people who operate the company that issues the security, and for the
franchise the control is in the franchiser who dictates how the franchise operates to make
money.
Thus, the government requires disclosure of the risks to the potential franchisees just like the
government requires a disclosure of the risks in buying a new stock issue. There are
government requirements of registration of both franchises and securities for the same reason;
i.e. to protect the public and give the public full disclosure of all risks before
purchasing.
One Thing You Better Know: There areTwo Types of Franchises and One is Very Bad
In practical terms there are two types of franchises:
(a) intentional franchises and
(b) unintentional franchises.
The first type is the situation where someone wants to expand their business and decides to use the franchising mechanism to do it.
The second type is the predicament where in the effort to expand the business; franchises are inadvertently created (sometime called Distributorships or Licenses). These hidden franchises are often spawned from a poorly advised and drawn distribution agreement, license agreement, and other marketing formats. These are the franchises that get people into trouble!
The problem is that both types of franchises have to be registered in the appropriate jurisdictions, and the consequences of failing to do so is often substantial civil penalties and/or criminal punishment.
So this area of the law is nothing to “trifle with”, so to speak.
Licensor’s beware! If you go the licensing route it is extremely easy for a licensing format to slip into an unintentional franchising structure either by poor draftsmanship of the licensing documents and/or the inappropriate use of business applications in company operations. If a licensor slips into the franchise arena, he needs to either (a) immediately comply with franchise laws or (b) re-adjust the operations to comply with the licensing laws and avoid the franchise laws.
THE THREE-LEGGED FRANCHISE STOOL
The Legal Definitions of a Franchise So Everyone Can Understand It
You have to know what franchising is to know how to lawfully avoid franchising, and you have to know how to avoid franchising to create a licensing or other mode of business expansion. Consequently since we have been talking about franchises and need to knowabout them, we better make it understood just what constitutes a “franchise”.
First, I have to tell you the various States and Federal definitions of a franchise are pretty clear, but the application of the facts to these definitions is highly mercurial. You may have trouble ever getting any two franchise lawyers to agree on whether or not franchise law compliance in various situations has been met.
Federal Definition of the Federal Trade Commission
THREE ELEMENTS. The FTC “Franchise” definition has three key elements:
(1) The Franchisee’s goods and/or services are to be offered and sold under the trademark of the Franchiser
(2) The Franchiser requires the franchisee to make a minimum payment of $500 or more, and
(3) The Franchiser maintains significant control of, or provides significant assistance to, the franchisee’s operation methods.
Common Name Leg. The element (or leg of the three- legged franchise stool) of the use of the trademark or common name is clear for the purposes of this discussion. You want your trademark or common name to be the rudder that moves your business expansion. “McDonalds” is the most famous example of the common trademark name of franchises.
Fee Leg. The element (or leg) of payment of a fee means that franchisee must pay the franchiser $500 or more as a condition of obtaining the franchise or of beginning initial operations. Any payments made at any time before or within six months after beginning operations shall be aggregated (combined) to determine if the $500 element is present.
These payments may be a requirement of the franchise agreement, or a secondary agreement (e.g. agreement to purchase goods only supplied by franchiser.).
Operations and Marketing Control Leg. As to the element (or leg) of “significant control or assistance in franchise operations or marketing”, the key word is “significant”. Franchiser actions that trigger the application of the concept of “significant control” are (for example): operations manuals, site approval, personnel policies, accounting procedures, co-op advertising, operations training, etc. If you are operating a Distributorship or License arrangement that falls into the above 3 “legs” then you are actually offering a Franchise without the proper documentation and registration.
The States’ Definitions of Franchise (The Three Categories)
The FTC basically sets a minimum standard of what a franchiser must disclose to a prospective franchisee. Then it leaves it up to each State to add any laws it deems necessary to protect the potential franchisee. Thus, each State has its own franchise laws which include the definition of franchise that must be followed.
I have used three categories to describe the various types of franchise laws of the States.
They are: Category I. In California, Illinois, Indiana, Maryland, Michigan, North Dakota, Oregon, Rhode Island, and Wisconsin, a franchise is defined as having three essential elements:
(a) A franchisee is granted the right to engage in the business of offering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchiser
(b) the operation of the franchisee’s business is substantially associated with the franchiser’s trademark or other commercial symbol designating the franchiser or its affiliate and
(c) the franchisee is required to pay a fee.
Category II. Hawaii, Minnesota, South Dakota, and Washington have a broader definition of franchise which include three primary elements:
(a) Franchisee is granted the right to engage in the business of offering or distributing goods or services using the franchiser’s trade name or other commercial symbol or related characteristic
(b) franchiser and franchisee have a common interest in the marketing of goods or services, and
(c) franchisee pays a fee.
Category III. Virginia and New York are different than other States. New York, for instance, the
(a) franchiser is paid a fee by the franchisee, and
(b) is either essentially associated with the franchiser’s trademark or the franchisee operates under a marketing plan or system prescribed is substantial part by the franchiser.
As you have probably determined, this type of situation can get sticky. It is often times not you that decides whether your arrangement is a franchise, but rather the law that decides. Many distributorships & licenses are in actuality operating as a franchise by the above-described definitions.
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