The movies are replete with accidental relationships that entertain and amuse. Remember Geena Davis in The Accidental Tourist, or Jackie Chan’s The Accidental Spy? Unlike Hollywood stars, real life entrepreneurs can find themselves in the real life role of The Accidental Franchisor, with serious business and legal consequences. Like children on the sidewalk outside an ice cream shop on a summer’s day, entrepreneurs are hopeful folk.
Expansion of a business is the American dream in action. However, using licensing, dealership, or distribution deals to grow a business can be risky for well-intentioned but ill-advised business owners. Many an expansion-minded entrepreneur have followed the franchising road to remarkable success. Others, however, cobble together what they believe to be licensing, distribution or dealership systems, only to find that in the eyes of the law, the arrangements look and smell like government-regulated franchise arrangements.
Those who inadvertently cross the line may find themselves unhappily enmeshed in an intricate regulatory apparatus, filled with regulations that dictate virtually every aspect of the entrepreneur’s operations.
Franchising is not for the faint of heart. Why?
A fine line separates many ordinary business arrangements from government-regulated franchising operations. Those who inadvertently cross the line may find themselves unhappily enmeshed in an intricate regulatory apparatus, filled with regulations that dictate virtually every aspect of the entrepreneur’s operations. In a worst-case scenario, a misstep can drag the entrepreneur into court to fight state or federal regulators who are hoping to make the entrepreneur do some jail time. To be sure, doing hard time is not the typical punishment for the accidental franchisor. Jail time is typically reserved only for those who commit big-time franchise fraud. Still, there can be angry business associates suing to rescind their deals and collect damages.
The entrepreneur who thinks government regulates private industry with a heavy hand need look no further than franchise laws. While government doesn’t much care what companies do in forming ordinary business relationships, state and federal government care a great deal about the business dealings of franchisors. Government generally considers franchisors to be bad guys on the prowl for good guys, otherwise known as franchisees. Franchisors must prepare and register complex franchise disclosure documents before selling franchises, for example, and additional regulations govern the ongoing business activities thereafter.
The role of a good business lawyer is, where possible, to draft licensing, distribution or dealership agreements that do not cross the line and become franchisor-franchisee relationships requiring compliance with the state and federal regulatory schemes. Knowledgeable franchise law attorneys have attempted for decades, without much luck, to draft the “Not-A-Franchise” License Agreement even where the client’s business structure includes all of the elements of a franchise under the law. The hallmark of a good business franchise attorney includes knowing when to advise clients that avoiding compliance with franchise laws is just not always possible.
KNOW IT WHEN YOU SEE IT • The first step in avoiding franchisor status is to distinguish between a franchise and an unregulated licensing, distributorship, or dealer relationship. In a franchisor-franchisee relationship, one party, the franchisee, is dependent on the other, the franchisor, for many of the elements of a successful business enterprise. For example, the licensor provides the franchisee with access to a valuable and widely known trademarked product or service, an efficient and proven business system, expert advertising, marketplace dominance, and the like. These elements create value, and franchisees pay good money to make use of them in the form of franchise fees and royalties.
By way of contrast, ordinary licensing, distributorship or dealership arrangements do not make one party dependent on the other. Indeed, the hallmark of such relationships is that the parties come to the negotiating table as independent business operations and remain so, each with its own product or service, whether trademarked or not, and each with its own business systems, advertising and marketing strategies, and the like. The parties to such arrangements do business together, but they do so as separate and independent enterprises.
One or both of the parties may indeed make use of the other’s trademarked goods or services under such arrangements. They may collaborate in advertising and marketing campaigns, in training employees to make the most of the relationship, and even in developing business systems to keep track of successes and failures. To be sure, money will also change hands, but it will not take the form of royalties. Instead, when money changes hands among parties to licensing, distributorship or dealership agreements, it is usually payment at wholesale prices for goods or services for resale. Royalties are typically the regular payment by one party to the other of a specified percentage of gross sales.
The beginning point is the Federal Trade Commission’s definition of a franchising arrangement, which, boiled down, seems simple enough. A franchising arrangement, the FTC says:
Grants permission to use a trademarked good or service in the conduct of a business enterprise;
Requires the payment of royalties to the trademark owner;
Gives the trademark owner significant control over the operations of the business making use of the trademark; and
May obligate the trademark owner to provide significant assistance — for example, training — to the business making use of the trademark.
State laws are more, generally defining a franchisor-franchisee relationship as one in which:
The franchisee pays a franchise fee to the franchisor plus royalties and possibly payments for inventory, supplies, training, and assistance in order to gain the right to sell or distribute trademarked goods or services under a marketing plan “prescribed in substantial part” by the franchisor;
The franchisor exercises significant control over the franchisee’s business, grants the franchisee exclusive rights to operate in a given territory, and may require the franchisee to purchase or sell a specified quantity of the franchisor’s goods or services; and
The franchisee’s business is “substantially associated” with the franchisor such that, for example, the franchisee uses the franchisor’s trademark and advertising slogans to identify its business.
These points make clear why many entrepreneurs get into trouble when negotiating licensing, distribution, or dealership agreements. After all, if you don’t have the resources to expand by buying other companies outright, allowing others to buy into your business model, allowing them to use your trademark, granting them territorial rights, helping them with training and perhaps technical assistance, and keeping tabs on them to ensure that all of your work turns into dollars on your bottom line leads to a regulated franchise relationship. That brings us back to the lawyer’s job, which is to keep exactly that from happening, if you can.
In part 2, we will explore what the expert lawyer can do to guide you, and how to best establish a successful relationship that guides you to success.