STRUCTURING A FRANCHISE NETWORK. Speakers: Dean T. Fournaris, Esq. Wiggin and Dana LLP. Max Schott II, Esq. Gray Plant Mooty.

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1 STRUCTURING A FRANCHISE NETWORK Speakers: Dean T. Fournaris, Esq. Wiggin and Dana LLP Max Schott II, Esq. Gray Plant Mooty Moderator: Perry McGuire, Esq. Smith, Gambrell & Russell, LLP

2 TABLE OF CONTENTS Page I. INTRODUCTION... 1 II. INITIAL CONSIDERATIONS / BASIC DISTRIBUTION PRINCIPLES... 1 A. Direct Sales... 2 B. Distributorships... 2 C. Dealerships... 3 D. Sales Agents/Representatives... 3 E. Licensing... 4 F. Franchising Franchising as a System of Business Expansion Definition of a Franchise... 5 III. PERCEIVED ADVANTAGES OF FRANCHISING... 8 A. Rapid Business Expansion... 8 B. Decreased Capital Needs for Franchisor... 8 C. Decreased On-Going Supervisory Requirements... 8 D. Enhanced Unit Financial and Operational Performance... 8 E. Increased Purchasing Power... 8 F. Strong Franchise Contracts... 8 G. Increased Judicial and Regulatory Understanding of Franchise Relationships... 9 H. Avoid Unnecessary Disputes By Lowering Regulatory Red Flags... 9 I. Enhanced Corporate Message and Opportunities... 9 J. Less Liability at Unit Level IV. PERCEIVED DISADVANTAGES OF FRANCHISING A. Complicated Regulatory Environment B. Effect on a Company's Ability to Enter into New Relationships C. Creation of Long-Term Relationships D. Could Earn Less Than if Expanding Through Company-Owned Locations E. Effect on a Company's Ability to End Franchise Relationships F. Conflict Between Franchisees Developing Their Own Market and Franchisor Seeking to Develop Brand Equity/Product Dominance G. Lack of Comfort with the Franchising Model H. More Difficult to Make System Changes i

3 I. Despite Model and Precautions, Company May Still Face Liability Claims Based on the Action or Inaction of its Franchisees V. INITIAL CONSULTATION VI. EVALUATING THE FRANCHISE CONCEPT A. Profitability B. Narrow, Well-Defined Product or Service Offering C. Replicable Business Concept D. Uniform Product or Service Standards E. Uniform Operational Standards F. Intellectual Property Rights G. Talented and Experienced Franchise Personnel H. Adequate Capitalization VII. STRUCTURING THE FRANCHISE SYSTEM A. Single Unit Franchises B. Area Development Franchises Advantages Disadvantages Disclosure/Registration Issues C. Subfranchise Arrangements (Master Franchising) Advantages Disadvantages Disclosure/Registration Issues D. Area Representative Franchises Advantages Disadvantages Disclosure/Registration Issues VIII. DEVELOPING A FRANCHISE PROGRAM A. Business Plan B. Product and Service Development C. Selection and Protection of the System s Marks D. Structure the Offering (What Single Unit and Multi-Unit Franchises Will the System Utilize?) E. Determine the Details of the Franchise Offering(s), Including Fee Structure and Other Costs of Opening and Operating the Franchise(s) ii

4 F. Consider the Real Estate G. Prepare FDD, Unit Franchise Agreement and Other Relevant Agreements H. Prepare the Operations Manual I. Establish Training Program J. Develop Appropriate Compliance Programs IX. ALTERNATIVE METHODS OF EXPANSION A. Direct Development (potentially with Third-Party Management Arrangements) B. Licensing C. Distributorships/Dealerships D. Sales Agents E. Partnerships/Joint Ventures F. Exemption-Based Franchising X. CONCLUSION iii

5 I. INTRODUCTION. Distribution arrangements can take any number of forms from direct sales, to independent sales representatives, to distributorships, to dealerships, to franchises. As discussed below, the consequences of choosing voluntarily or, worse yet, being deemed involuntarily to have adopted, a particular distribution strategy can be substantial. Determining the preferred form and structure of a supplier's distribution scheme should be centered on whether a trademark license and supplier controls are necessary and desirable to satisfy the supplier's needs. The needs for trademark association and the need for some level of control over the distribution arrangement vary across a wide spectrum and are dependent in large measure on the industry, product and competitive environment. In the end, manufacturers and suppliers are interested in selling as much product, directly or indirectly, as efficiently as possible and in a manner which fosters or, at a minimum, protects the reputation and goodwill of the manufacturer or supplier and its product. Through various alternative models, franchising can provide an attractive opportunity to radically expand a company's distribution platform. II. INITIAL CONSIDERATIONS / BASIC DISTRIBUTION PRINCIPLES. Arrangements for the distribution of products or services frequently involve relationships with employees, distributors, dealers and sales representatives. These arrangements, which are often historical in nature having evolved over the course of years from oral understandings and abbreviated written agreements, are described below. Distribution agreements vary across industry, product and geographic lines. Nevertheless, there are some common terms and conditions that each distribution agreement typically addresses in some manner. The following list of material concepts is intended neither as a comprehensive list of all potential material terms of a distribution arrangement, nor as a list of all material contract provisions generally. At the same time, a written agreement memorializing a distribution relationship should set forth, at a minimum: (1) the performance agreed upon (i.e., to supply, or to purchase for resale; or to solicit sales for commissions) and the criteria for evaluating such criteria (i.e., sales quotas or goals, reporting obligations and minimum inventories); (2) the market or territory involved and whether the agreement is exclusive or not; (3) exceptions to the territory or appointment (i.e., rights reserved to the licensing party); 1

6 (4) whether there is a right or license to use or display the supplier's trademark(s) in the performance of the distribution duties; (5) whether the relationship has a definite duration or term; (6) the grounds for termination of the agreement; (7) a list of the obligations of each party (with reference to some measurable performance obligations for the distribution party); (8) an explanation of any limitations or special conditions that may affect performance; (9) a description of the nature of the relationship; (10) reference to price, commission, payment and terms, warranties and end of product or line life cycles; (11) designation of which state's law will govern in the event of a dispute, and how (mediation, arbitration, litigation) and where (venue) the dispute will be resolved; (12) any limitation on either party's remedies; a description of what must happen for the agreement to be amended or modified; and (13) and a statement that the agreement is the entire agreement between the parties and supersedes any prior agreements or understandings. A. Direct Sales. Direct sales, as the term describes, relies on employees and does not utilize third parties to assist in the distribution process. Selling direct provides the highest level of control to a manufacturer or other supplier. Because there is no ability to leverage a third party s resources and shift a portion of the expenses to a third party, however, it comes at a high cost. It is also difficult to incentivize employees to achieve the same motivation that inspires business owners. As a result, the performance of a non-vested employee will likely not match that of an engaged third party entrepreneur franchisee. B. Distributorships. The term "distributor" typically refers to a wholesaler of product that is eventually resold to the consuming public at retail. Distributorships are frequently memorialized in writing as supply agreements that include the appointment of a wholesale purchaser as either an exclusive or non-exclusive retail distributor of one or more product(s) or product channels in a certain geographic territory. A manufacturer or other supplier will often require that the distributor maintain specific levels of 2

7 inventory to meet anticipated demand. Finally, as a condition to appointment, the distributor may be required to exercise its "best efforts" to promote the product and/or to meet specific sales criteria in order to avoid termination of its status as an exclusive distributor or the distribution contract itself. Unlike franchises, a distributorship typically does not include either a trademark license or a requirement that the distributor pay a fee for the right to resell the supplier's product. The distributor also does not receive access to the manufacturer's or supplier's marketing systems or plans in the normal course. However, some manufacturers and suppliers do provide assistance in the promotion of the product by making available financial or educational resources, which are built into the wholesale price charged to the distributor for the product. C. Dealerships. Like a distributorship, a dealership involves a formal supplier-reseller relationship in which a dealer acting as a reseller promises to purchase and maintain an inventory of product and to observe certain standards of sale. However, a dealer typically receives at least a limited amount of production or promotional assistance from its supplier. Such "marketing" assistance may not approach the volume and comprehensiveness of support that a franchisee would receive, but it is likely to be greater than the resources offered under a distributorship. Additionally, a dealer may obtain some right or license to use or display the supplier's trademark(s) in the performance of its distribution duties. For these reasons, a dealership is closer to being considered a franchise than a distributorship and, in some instances, may be all but indistinguishable from a franchise. More on this in Section IX below. It is also important to note that there are various laws in the United States and foreign countries that offer protection to distributors and dealerships, particularly in the area of termination/nonrenewal. D. Sales Agents/Representatives. A sales agent or representative typically is authorized or appointed by a manufacturer to sell or distribute the manufacturer s products within a given territory. However, the sales agent or representative is in business for him or herself, typically does not take title to (or purchase) the goods being sold, does not set prices, and does not act as an agent for the manufacturer. Sales agents and representatives can be a very effective method for reaching and selling to end-use customers. An established sales agent or representative can grant a manufacturer immediate access to target markets and customers without the need to build and maintain its own force. A sales agent or representative model can also be particularly useful for a company that is trying to break into a new market or market segment including international markets where the company does not have prior experience or expertise. 3

8 Legal structure and contractual arrangements are an important consideration in any sales agent or representative agreement. Companies that use a sales agent or representative model may be liable for the sales agent s or representative s actions and may have legal obligations towards them, particularly if the sales agents or representatives are self-employed rather than part of larger corporate sales agencies. Additionally, sales agents and representatives have specific legal rights under U.S. law and the laws of many other countries, including with regard to termination and territorial rights. Finally, agreements with sales agents and representatives must comply with all applicable competition laws and price-fixing rules. E. Licensing. Licensing is another common distribution model. In its more simple form, a license provides an individual or company with the legal right to do something with licensed material that would otherwise be considered illegal absent the license. The use of licenses is particularly common with intellectual property. In a franchise model, the franchisee is licensed to use another company s proprietary marks and a system of operation as part of the franchisee s independent business in exchange for a fee. In contrast, a company grants licenses to one or more licensees to use the company s intellectual property (IP), brand, designs or business programs in exchange for a fee. The license is usually non-exclusive and, while the licensor may monitor and control how its licensed property is used, the licensor does not typically provide a business system or method or monitor or control the business operations or methods of the licensee. As described in Section II.F below, franchising is regulated under both federal law and the laws of approximately half the states. Unless an exemption exists, a franchisor must bear significant compliance expenses and adopt robust compliance procedures. For branded businesses interested in increasing distribution, a common reaction when faced with the prospect of complying with the franchise laws is to say that they will just license, rather than franchise. After all, the franchise laws apply only if all of the required elements of the franchise definition are present. One way to attempt to defeat coverage is to eliminate one of the required elements from the distribution program - (1) trademark license, (2) control/assistance/marketing plan/community of interest, and (3) a fee. Another way is to look for an exemption from coverage, with great care exercised in determining if the exemption is from state registration, disclosure and/or franchise relationship provisions. Disclosure is often required, even if the transaction is exempt under a state registration law. In short, while the goal of franchise avoidance may be simple, the execution is not. The use of licensing and exemptionbased franchising is further discussed in Section IX below. F. Franchising. A franchise is a form of licensing arrangement whereby one party licenses another to use its business system and trademark(s). Franchisees typically pay to the franchisor an initial franchise fee and ongoing royalty payments throughout the 4

9 franchise term. In consideration for these payments, a franchisor permits its franchisees to operate a franchised business under the franchisor's principal trademark and typically provides the franchisee a package of initial and ongoing assistance and training. Such assistance and training typically includes: site selection assistance; physical or electronic access to the franchisor's operations manuals (on loan) during the term; training; opening assistance; advertising materials; participation in buying and advertising programs; and accounting, business, and operating system assistance. Franchising is a vehicle for: (i) marketing and distributing a company's goods or services; (ii) rapid business expansion; and (iii) raising investment capital indirectly for expansion. It enables rapid expansion of a successful retail concept more quickly than through company-owned expansion. Franchising provides an alternate means to stock or bond offerings for companies to raise capital indirectly for expansion. Each franchisee utilizes its own capital and not that of the franchisor in expanding the franchised business. 1. Franchising as a System of Business Expansion. Companies are turning to franchising as a vehicle for expansion and distribution. Such companies range from large, established multi-national corporations to small start-up companies that have only one or two retail outlets. There are a host of reasons that so many companies franchise. As expanded on below, these reasons include: the enormous flexibility it offers; the potential for rapid expansion; overcoming limited capital resources; the greater motivation it provides to middle-managers; the potential it has as a means of acquiring and consolidating competitors' businesses; alternative means of distribution; and its use as a means of privatization. For a host of companies, franchising has proven to be a remarkably adaptable and effective growth vehicle. 2. Definition of a Franchise. A relationship is deemed a franchise if its meets the definitional elements of a franchise under applicable federal or state law. The federal definition of this term is contained in the Federal Trade Commission's "Trade Regulation Rule: Disclosure Requirements and Prohibitions Concerning Franchising," 1 which is generally referred to as the "FTC Franchise Rule" (also sometimes referred to as the Amended FTC Rule following an amendment effective July 1, 2007), which defines a franchise as any arrangement whereby the franchisor: Renders significant assistance to the franchisee in operating its business or significantly controls the franchisee's method of operation; Licenses the franchisee to distribute goods or services under, or operate using, the franchisor's trademark; and 1 16 C.F.R

10 Requires payment of a minimal fee to the franchisor. The FTC Franchise Rule imposes disclosure requirements but no registration requirement. Many states have also enacted disclosure laws (usually also requiring registration or some other filing) and relationship laws with respect to franchising. In doing so, various states have adopted their own definitions of a franchise which are different than the federal law definition of the term. The most prevalent state approach is distinguished from the FTC Franchise Rule definition by substituting for the significant assistance/significant control element a requirement that there be a "marketing plan or system" in which the franchisee is required to take part. The other common state approach requires that a "community of interest" exist between the franchisor and the franchisee in place of the significant assistance/significant control element. While the requisite nature of the relationship necessary to find a franchise under these two variations of the federal significant assistance/significant control element differ, the state definitions are substantially similar with regard to the two other necessary elements of a franchise included in the FTC Franchise Rule (a trademark element and a fee element). The "marketing plan or system" element in the definition of a franchise has been adopted in fifteen states, including franchise relationship states. 2 Under the California Franchise Investment Law, which is typical of state franchise laws which have adopted the "marketing plan or system" approach, the term "franchise" means a contract or agreement, either expressed or implied, whether oral or written, between two or more persons by which: A franchisee is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system3 prescribed in substantial part by a franchisor; The operation of the franchisee's business pursuant to such plan or system is substantially associated with the franchisor's trademark, service mark, trade name, logotype, advertising or other commercial symbol designating the franchisor or its affiliate; and 2 California, Connecticut, Iowa, Illinois, Indiana, Maryland, Michigan, New York, North Dakota, Oregon, South Dakota, Rhode Island, Virginia, Washington and Wisconsin (Wisconsin Franchise Investment Law). 3 Various courts have considered what constitutes a "marketing plan or system prescribed in substantial part" by the franchisor. Generally, the more control the franchisor exerts over the franchisee's operations, the more likely there will be found to exist "a marketing plan or system prescribed in substantial part by the franchisor." Factors that may indicate a franchisor's control over a franchisee include: (a) whether an operations manual, training, advertising, promotion or other support is provided to the putative franchisee; (b) whether there are standard operating procedures with which the putative franchisee is expected to comply; and (c) the extent to which the franchisee is required to engage in certain marketing activities. 6

11 The franchisee is required to pay, directly or indirectly, a franchise fee. 4 The alternative "community of interest" element of the definition of a franchise has been adopted in seven other states. 5 Under the Minnesota definition, the term "franchise" means a contract or agreement, either express or implied, whether oral or written, for a definite or indefinite period, between two or more persons: by which a franchisee is granted the right to engage in the business of offering or distributing goods or services using the franchisor's trade name, trademark, service mark, logotype, advertising, or other commercial symbol or related characteristics; in which the franchisor and the franchisee have a community of interest 6 in the marketing of goods at wholesale, retail, by lease, agreement, or otherwise; and for which the franchisee pays, directly or indirectly, a franchise fee. A common element to most definitions of a "franchise" (including the "marketing plan or system" and "community of interest" approaches discussed above) is the requirement that the franchisee pay a fee, directly or indirectly, to the franchisor for the right to enter into the business. State franchise sales laws are substantially similar as to their definition of the "fee" element of a franchise. Two franchise relationship law states, Connecticut and New Jersey, for example, do not require any fee, however. 7 New York s franchise definition only requires two elements, a fee combined with either a marketing plan or system or substantial association with a trademark. 8 A number of non-uniform exceptions do exist, however, under state franchise sales laws (e.g., a minimum payment may not constitute a franchise fee). Moreover, payments to a franchisor or its affiliate for certain items (e.g., for advertising materials, training, or a set-up fee) or to others may be deemed to be franchise fees, even if they are not labeled as such Cal. Bus. & Prof. Code Hawaii, Minnesota, Mississippi, Missouri, Nebraska, New Jersey and Wisconsin (Wisconsin Fair Dealership Law). 6 The "community of interest" prong of this statute, which gives this definition its name and its distinctive characteristics, is ambiguous, and subject to interpretation. The necessary element to find a "community of interest" is that the franchisor and franchisee share a continuing interest in the operation of the franchise. If a franchisor controls the franchisee's conduct of business to the point of the franchisee being subject to the whim and discretion of the franchisor, it is likely that a "community of interest" will be found. The mere fact that a seller may generate goodwill for a product, however, is not enough to indicate that a community of interest exists Conn. Gen. Stat e(b); N.J. Stat. Ann. 56:10-3.a. N.Y. Gen. Bus. Law Disclosure and/or registration requirements may also apply under state business opportunity laws 7

12 III. PERCEIVED ADVANTAGES OF FRANCHISING. A. Rapid Business Expansion. A principal advantage of franchising is that it frequently enables rapid expansion of a successful retail concept at a quicker pace than through companyowned expansion. Franchisors take advantage of each franchisee's desire to be in business for him or herself. B. Decreased Capital Needs for Franchisor. Franchisees use their own capital and personnel and not those of the franchisor for expansion of the concept. If multi-unit expansion is utilized (which is expanded on in Section VII below), many franchisees can be developing large territories simultaneously with relatively little capital expenditure on the part of the franchisor. C. Decreased On-Going Supervisory Requirements. As the franchisee gains experience in operating the franchised business during the term of the franchise relationship, the franchisee's need for operating supervision decreases. Conversely, royalty fees (which are often calculated as a percentage of gross revenue) typically increase as gross revenue increases. D. Enhanced Unit Financial and Operational Performance. Generally, a distribution system's best franchisees will achieve a higher level of unit financial and operational performance than the same distribution system's best managers of company-owned and operated units. Franchising provides an ownership and profit incentive to a unit supervisor to raise and maintain a high level of financial and operational performance. E. Increased Purchasing Power. The rapid expansion that franchising affords allows a distribution system to reach critical mass sooner, increasing leverage in supply negotiations and achievement of volume discounts and other concessions. F. Strong Franchise Contracts. The franchise arrangement shifts to the franchisee some of the business risks in the expansion process. Franchise contracts typically contain indemnification which often contain the existence of a marketing plan as one element of the definition of a business opportunity. State business opportunity laws and the Federal Trade Commission Business Opportunity Rule are outside the scope of this paper but must also be considered when evaluating a relationship for franchise requirements. See, e.g. Beata Krakus & Alexander Tuneski, Caught in the Web of Federal and State Opportunity Laws: Managing and Avoiding the Entanglement of Regulations, in ABA 36 th ANNUAL FORUM ON FRANCHISING, W7 (2013). 8

13 provisions that require the franchisee to indemnify the franchisor against any damages which result from the franchisee's operation of the franchised business. Most franchise contracts also require the franchisee to purchase and maintain a certain level of insurance, and to have the franchisor an additional insured on its policies. G. Increased Judicial and Regulatory Understanding of Franchise Relationships. By fully embracing the franchise model, companies engaged in alternative methods of distribution can enjoy the legal benefits and certainty of franchise law in a more substantial and predictable manner. Today, judges, jurors, regulators and customers generally understand franchising as a method of doing business. In recognition of franchising's unique characteristics and its benefits to the overall economy, franchise systems have generally been afforded a degree of understanding by courts and regulators with respect to certain labor, employment, tax and agency liability issues. Additionally, a fairly well-reasoned and predictable body of franchise law has developed to help define and frame the industry. A new challenge is continuing to develop, however, as the franchise model is coming under increasing attack. This is evidenced by the National Labor Relations Board (NLRB) charging McDonald's as a joint employer in several labor complaints in late 2014, and by a pair of cases in August 2014 where the Ninth Circuit panel reversed summary judgment for Federal Express and granted summary judgment for its drivers, finding that despite the crafting of the driver s contracts with Federal Express specifying the relationship as an independent contractor relationship, under the right to control test the relationship involved employment under California and Oregon law. 10 H. Avoid Unnecessary Disputes By Lowering Regulatory Red Flags. It appears that the intuitive reaction of courts and regulators to certain alternative, "non-franchise" arrangements (i.e., systems using "licensing," "independent contractor" and "operator" terminology) is to assume that the purported "non-franchise" company is attempting to circumvent applicable labor, employment and tax laws by cloaking its "employees" as "independent contractors." In other words, by avoiding the "franchise" label, companies can actually create otherwise avoidable labor, employment and tax disputes. The adoption of "franchise" terminology in the past has helped to eliminate the confusion caused by "non-franchise" terminology, which often serves as a red flag for certain courts and regulators with respect to labor, employment and tax issues, but as noted immediately above, the franchise label is increasingly attracting attention related to employment and vicarious liability issues. I. Enhanced Corporate Message and Opportunities. Regardless of the listener, the adoption of a clearly enumerated "franchise" program can increase the clarity of a company's messages regarding corporate purpose and available business and employment opportunities. Rather than 10 Alexander v. FedEx Ground Package Sys., Inc., 765 F. 3d 981 (9 th Cir. 2014) and Slayman v. FedEx Ground Package Sys. Inc., 765 F.3d 1033 (9th Cir. 2014). 9

14 attempting to offer an explanation why an opportunity does not constitute a franchise, a company is able to explain clearly and assertively what opportunity is being offered in terms that the public has grown to know and understand. Furthermore, the adoption of a franchise program may assist a company in attracting and retaining qualified franchise and employment candidates. J. Less Liability at Unit Level. A benefit of not operating the unit itself and instead licensing an independent contractor franchisee to conduct the business, is that the franchisee is the party in direct contact with the consumers of the business at the location, and that will have the most direct liability to the consumer and the public at large. The franchise agreement typically will require that the franchisee obtain insurance and name the franchisor as an additional insured and that the franchisee indemnify the franchisor for all liability arising from the operation of the business. IV. PERCEIVED DISADVANTAGES OF FRANCHISING. A. Complicated Regulatory Environment. The sale of franchises is regulated at both the federal and state level. Federal law requires that franchisors give prospective franchisees a franchise disclosure document (FDD) at least 14 calendar days before the prospect signs a binding agreement or makes a payment under the FTC Franchise Rule. Franchise sales and franchise relationships are regulated under a variety of state laws, and many aspects of the relationship are also regulated by federal law. Fourteen states, the so-called registration states (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin) require that franchisors (subject to the availability of an exemption from coverage under the state's laws) register the franchise offering or make a filing before they engage in any sales activity subject to the jurisdiction of the state in question. Generally, these state laws apply to the sale of a franchise to be located in the state, the sale of a franchise to a resident of the state (except in Virginia), even if the business is to be located in a different state, and, in some states, where the offer was made or accepted. These registration states also require that franchisors give prospective franchisees an FDD. Registrations or filings in these states must be renewed on an annual basis either by the anniversary date of effective date of the filing or some other registration states require that franchisors submit an annual report within a certain number of days following their fiscal year end. Most of these states also require that the registration or filing be updated in the event of a "material change" in any information previously provided to the state administrator. Oregon requires that franchisors give prospective franchisees a disclosure document, but does not require any filing with the state. Additional states have "business opportunity laws" which may apply to the offer or sale of a franchise if the franchisor does not have a federally registered 10

15 trademark, does not file the appropriate exemption notice, does not comply with FTC Franchise Rule requirements in offering or selling a franchise, or if the franchisor makes certain promises or representations in connection with the sale of franchises. Once a franchise is sold, a different set of state specific laws and regulations may apply. Approximately twenty-one states, Puerto Rico and the U.S. Virgin Islands have laws governing at least a portion of the ongoing franchise relationship. These laws may include provisions affecting the termination and renewal rights of a franchisee, including the franchisee's right to cure a default under the franchise agreement. The laws also affect other franchise agreement provisions such as: governing law, jurisdiction and venue of litigation, discrimination, the franchisor's right to injunctive relief, general releases upon renewal and transfer of the franchise agreement, and the franchisor's right to vary the terms of the franchise by amending the operations manual for the franchise system. 11 The franchise relationship is also subject to Section 5 of the Federal Trade Commission Act, 12 which prohibits unfair or deceptive trade practices in commerce or competition. Many states have also enacted "Little FTC" or "Baby FTC" Acts which prohibit unfair and deceptive practices and which often provide the franchisee a private right of action against the franchisor. 13 On balance, the regulatory burdens of being deemed a franchisor must be kept in perspective. Numerous franchisors operating in the United States comply with franchise laws every day, while growing successful and substantial businesses. B. Effect on a Company's Ability to Enter into New Relationships. Given the regulatory environment described above, companies perceive that complying with franchise registration and disclosure laws is difficult and acts as a barrier to their unit development and system profitability. While the initial cost of complying with franchise registration and disclosure laws is not insubstantial for most start-up companies, federal and state registration and disclosure laws apply regardless of whether the parties intended to create a franchise relationship or whether the parties term their relationship a "franchise." Moreover, knowing that the penalties for noncompliance are high, most companies engaged in franchising have already made the appropriate business/legal decision to comply fully with all applicable franchise registration and disclosure laws. C. Creation of Long-Term Relationships. Franchise agreements are typically for a minimum term of several years and usually for a longer duration in order to enable the franchisee to amortize its investment over a sufficient period of time and earn a profit. Franchise relationships, like other relationships, tend to have a predictable life cycle for a certain segment of any 11 See, e.g. Shelly Weatherbie, Jonathan Solish and Emma Harker, Basics Track: Navigating State Relationship Laws, in IFA 46 th ANNUAL LEGAL SYMPOSIUM (2013) U.S.C See, e.g. Robert M. Einhorn, Paula J. Morency & Altresha Burchett-Williams, Claims Under the Little FTC Acts, in ABA 33 rd ANNUAL FORUM ON FRANCHISING, W6 (2010). 11

16 franchise system's franchise community. As the relationship matures, a franchisee may become disenchanted with the franchisor as his or her need for the franchisor's services decreases. The franchisee may begin to resent what he or she perceives to be the franchisor's intrusion into the operation of the franchised business and may resent the ongoing obligation to pay royalty fees. D. Could Earn Less Than if Expanding Through Company-Owned Locations. The company, in exchange for transferring the investment cost, risk and liability for the unit operation to the franchisee, is also transferring to the franchisee the upside reward if the business is successful. The company s revenue stream from the business is usually principally just the royalty fees, most often calculated as a percentage of gross revenue, and the remaining profits inure to the benefit of the franchisee. Because the royalty fee is based on gross revenue and not profits, the company will receive its payment even if the business is not profitable, which is another justification to the franchisee to retain the upside potential if the business is profitable. E. Effect on a Company's Ability to End Franchise Relationships. As noted above, franchise relationship laws in a number of states affect a franchisor s ability to terminate, requiring good cause, a prescribed minimum advance notice or cure period, for example. The applicable franchise relationship and termination laws apply regardless of whether the parties intended to create a franchise relationship or the parties' relationship is called a "franchise" if the definitional requirements of a franchise are met. In such instances, the third-parties will already be entitled to the protections of any applicable franchise relationship and termination laws even if they are described as only a "licensee" or "distributor" in the agreement. F. Conflict Between Franchisees Developing Their Own Market and Franchisor Seeking to Develop Brand Equity/Product Dominance. As the franchise market matures, franchisors are increasingly turning to alternate channels of product distribution (e.g., e-commerce, direct distribution, cobranding, etc.) as a way to develop brand equity and/or product dominance. Franchise agreements that provide the franchisee a protected territory may restrict the franchisor's rights to engage in these activities within the franchisee's area. Even in the absence of express territorial protection, the implied covenant of good faith and fair dealing may provide a basis for an encroachment claim if the franchisor does not expressly reserve in each of its agreements the right to establish additional franchised units or to engage in such alternate channels of distribution within the franchisee's area. G. Lack of Comfort with the Franchising Model. All things considered, franchising is a relatively new method of doing business. As a result, many companies have not been comfortable enough to embrace "franchising." Today, there are over 770,000 franchised businesses in the United States 12

17 that generate more than $840 billion in sales. 14 Sales by franchised businesses now total more than one-third of the U.S. retail market. 15 Predictably, the uncertainty attributable to franchising's novelty has diminished substantially over time. Judges, jurors, regulators, prospective and existing employees and franchisees, and customers generally understand franchising as a method of doing business. H. More Difficult to Make System Changes. The larger an enterprise is, and the greater number of stakeholders, the harder it is to effectuate change. A company with only its own units can effect change on its own by taking the measures needed. A franchise system, with long-term contracts and numerous franchisees, must follow a careful path to implement changes. An analysis must be performed to determine if the change is permitted unilaterally by the company under the franchise agreement in conjunction with changes to the operations manual. Franchise agreement and disclosure document changes may be needed going forward. Franchisee input should be obtained through a franchise advisory council or other formal or informal group of franchisees in order to insure franchisee buy-in to the change and its supporting rationale. A change to existing franchise agreements in California may require adherence to California s procedures for amending existing franchise agreements. 16 I. Despite Model and Precautions, Company May Still Face Liability Claims Based on the Action or Inaction of its Franchisees. Vicarious liability exposure has been a reality for franchisors for a long time. As is true in other relationships, such as employer-employee, landlord-tenant, principal-agent, injured parties will seek a deep pocket to enhance their chances of receiving a recovery and will not feel bound to sue only the party with which they had direct contact. The law concerning vicarious liability has been fairly stable for a number of years, centering on tests such as the franchisor s control of the instrumentality that caused the alleged harm. 17 The vicarious liability area may be due for a major change increasing franchisor risk in conjunction with the attack on the franchisor model in the employer and joint employer area. V. INITIAL CONSULTATION. When meeting a prospective start-up franchisor client for the first time, a skilled franchise and distribution attorney will keep an open mind. It may turn out that franchising is in fact not the best expansion method given the client s industry, product 14 See The Franchise Business Economic Outlook: 2015 released by the International Franchise Association (IFA) Educational Foundation and IHS Economics, available at (accessed February 26, 2015). 15 See Small Business Trends, U.S. Small Business Administration, available at (accessed February 26, 2015). 16 Cal. Corp. Code 31125; Cal. Regs See, e.g., Patterson v. Domino s Pizza, LLC, 60 Cal.4 th 474, 177 Cal. Rptr. 3d 539, 333 P.3d 723 (2014). 13

18 or service offering, capital, skill-set, stage of development, and short and long-term goals. The attorney s role at the initial consultation should be that of an objective factgatherer, with more of an emphasis on listening than talking. The attorney should also will be well-versed in the actual and perceived advantages and disadvantages of the franchise model and be prepared to discuss them in a frank manner with the client. Although not meant to be exhaustive, the following is a list of some questions an attorney should consider asking a prospective franchisor at an initial meeting: What is driving your desire to consider a franchise growth model? Do you want to expand your business? Build a national brand? Expand rapidly? Drive revenue? Service national accounts? Or, is your desire to expand through franchising based on franchise inquiries or the offer of a large sum of money for a particular territory? Have you considered expanding through the establishment and operation of company-owned outlets? What are the relative strengths and drawbacks of such an approach versus franchising? Could management arrangements be utilized to lessen some of these drawbacks? Are you using a sufficiently strong trademark to identify your brand? Have you obtained, or are you in the process of obtaining, registration of a trademark with the United States Patent and Trademark Office (USPTO)? Any related issues or concerns? What is the unit level profitability for the prototype? Would you make more profit on a store-by-store basis by franchising or establishing and operating company-owned outlets? Is there enough of a profit margin in the business prototype so that franchisees can pay franchise fees and still make a profit? How will you determine relevant franchise agreement terms, like initial and ongoing fees, initial and renewal terms, protected territory, if any, etc.? Do you plan to use a consultant? Is the concept replicable or franchiseable? Who is the ideal franchise candidate? What will a successful franchisee s operation look like? Do you have the ability and temperament to teach other people how to establish and operate the business? Does the concept present a win-win scenario? 14

19 VI. EVALUATING THE FRANCHISE CONCEPT. Clients are often unsure themselves whether their concept can be franchised. Successful franchise companies are predicated typically upon the following guiding principles. A. Profitability. The franchised business must be sufficiently profitable to present an attractive rate of return for the franchisee and to allow for the payment of royalties and fees to the franchisor. B. Narrow, Well-Defined Product or Service Offering. Most successful franchises start with a narrow, well-defined product or service offering that satisfies the demands of an existing market segment. C. Replicable Business Concept. and easily. The franchised business must be capable of being replicated efficiently D. Uniform Product or Service Standards. and quality. The product or service to be delivered must be uniform in terms of quantity E. Uniform Operational Standards. The product or service must be delivered by franchised businesses operated uniformly through strict adherence to developed operational standards. F. Intellectual Property Rights. The franchise system, including its trademarks, service marks, trade secrets, operating systems and other intellectual property, must be capable of being legally protected and fully developed. G. Talented and Experienced Franchise Personnel. The franchisor must possess or develop in a fairly short time personnel that are capable of making sales, leading the various constituencies of the franchise system, operating the franchisor, directing the training and support functions of the franchisor, and developing and implementing system advertising and marketing programs. As an alternative or supplement to in-house development, a franchisor also may be able to consider outsourcing some of these functions to the right third-party provider, either temporarily or on a permanent basis. 15

20 H. Adequate Capitalization. A franchisor must be adequately capitalized in order to develop and launch its franchise program, and then sustain the franchisor s on-going operation. While none of the foregoing may be outcome determinative, counsel should be mindful of these basic principles in evaluating the particular needs and circumstances of a client and its business. In addition, depending on the sophistication and experience level of the client and their management team, it may be wise to encourage the client to seek outside assistance from a franchise consultant or other professional to help them assess the potential viability of the franchise concept. VII. STRUCTURING THE FRANCHISE SYSTEM. Once a company makes the decision to franchise, it must then decide how it will structure its system and what franchise offerings will be a part of that system. This Section VII first describes the single unit franchise, which is at the core of all franchise systems. Next, this Section VII describes the three most-common forms of multi-unit franchise area development, subfranchise arrangements, and area representation the advantages and disadvantages of each, and the related disclosure and registration obligations that accompany them. While the franchise community has used many different terms to describe these multi-unit franchises over the years, the terms above are the ones recommended by the North American Securities Administrators Association, Inc. ( NASAA ) in its Franchise Multi-Unit Commentary, adopted on September 16, 2014 ( Multi-Unit Commentary ). 18 To provide additional clarity, however, this Section also notes some of the other terms franchisors have used to refer to these structures and their recipients. A. Single Unit Franchises. The most basic franchise structure is that of a unit franchise. Under a unit franchise agreement, a franchisee is granted the right to operate a single unit franchise (or franchised business), using the franchisor s trademarks, system and other IP, at a location or within a territory agreed upon by the parties. While unit franchise agreements vary in length and level of complexity, most of them contain the same general type of terms described in Section II above for distribution agreements. Some franchise systems, especially those in the early stages of development, choose to expand only through single unit franchising. This approach is beneficial for franchisors seeking deliberate growth of their franchise systems. Slowerpaced growth enables the franchisor to test its business concept on a smaller scale. This allows it time to adjust and refine system standards and specifications to create a 18 Adopted-Sept pdf, Definitions, A-C [hereinafter Multi-Unit Commentary]. NASAA recommends that franchisors use the terms adopted or, if they continue to use other terms, that they identify in state cover letters how these terms correlate to the adopted terms. Id., Introduction. 16

21 successful business model, and identify the training practices and ongoing support necessary to develop and grow a strong franchise system. While the methodical single unit approach has its advantages, at a certain point a franchisor may turn to multi-unit franchising in an attempt to further accelerate system growth. It should be noted, however, that even in systems that embrace the multi-unit franchises described below, it is still typically the unit franchise agreement (or unit subfranchisee agreement in the case of a unit subfranchise granted by a subfranchisor) that forms the foundation of the franchise system and governs the actual operation of each unit. Because the single unit franchise represents the vast majority of all franchises granted, it is the focus of most federal and state franchise regulation. Consequently, the disclosure and registration requirements described in Section IV.A above apply to single unit franchises. B. Area Development Franchises. One of the three most-common multi-unit franchises is the area development franchise. Under an area development arrangement, a franchisor enters into an area development agreement with an area developer for the development and operation of two or more unit franchises within a defined development area in accordance with a development schedule. 19 Typically, for each unit an area developer develops under the development agreement, the area developer (or in some cases its affiliate) must enter into a separate unit franchise agreement with the franchisor. An area developer may receive some level of territorial protection within its development area, although, in some cases, territorial protection, if any, is only granted through the unit franchise agreement. Most often an area developer will pay a nonrefundable development fee to the franchisor under the development agreement, some of which may be credited against the initial franchise fees due under the unit franchise agreements it enters into pursuant to the area development agreement. 1. Advantages. Area development structures create potential for rapid and self-sustaining growth. Unlike single unit systems, franchise systems with area development franchises consist of fewer unrelated franchisees, providing the franchisor with the potential to simplify the franchise sales process and contract administration. After receiving training as part of opening its first unit, an area developer will likely need less training and support for the opening of subsequent units. In addition, area development franchisees tend to be more sophisticated in terms of economic stability and business acumen, and may not have been interested in a brand only offering single unit franchises. This fact, coupled with a lower number of overall franchisees, enables the 19 An area development agreement also may be referred to as a development agreement or multi-unit development agreement. In addition, an area developer also may be referred to as an area franchisee or operator, multi-unit developer or operator, regional developer or operator, and master franchisee. See Multi-Unit Commentary, supra note 18, Definitions, A. 17