Accidental Franchise = Potential Lawsuits, Fines + Other Penalties

by Lewitt Hackman
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Lewitt Hackman

Business owners looking to expand may leave themselves vulnerable to several obvious losses, including those related to finance, brand identity, and customer loyalty. Resources, including exemplary human resources, are sometimes spread too thin.

But there is another risk that should be considered, one that is not quite so obvious – that of accidentally franchising the business. This pitfall could lead to potential litigation, not to mention years of scrutiny and torment by government regulating agencies.

But how does a business owner inadvertently franchise a company, without specifically setting out to do so? It helps to first understand what a franchise is, and where the business operates.

For example, under California law a business relationship is a “franchise” if: 

  1. The business will be substantially associated with the franchisor’s trademark;
  1. The franchisee will directly or indirectly pay a fee to the franchisor for the right to engage in the business and use the franchisor’s trademark; and,
  1. The franchisee will operate the business under a marketing plan or system prescribed in substantial part by the franchisor.

The Federal Trade Commission and several other states use similar characteristics to determine the difference between franchises and other business opportunities.

Then there are states that incorporate different elements in their franchise definitions. In Hawaii for example, the three elements that constitute a franchise are trademark license, required fee, and “community of interest”, or the mutual interest of the franchise company and the purchasing business to market goods and services.

Franchise Trademarks

If a business uses another company’s trademark to identify itself, or uses it in its advertising, the business may likely be found to be “substantially associated” with the enterprise company’s, or franchisor’s, trademark.

Licensing agreements may be a bit challenging when trying to avoid becoming a franchise, as they usually grant rights to the purchaser to use intellectual property, and payments or royalties are definitely made in return. Pay particular attention to state and federal regulations to walk the line between franchising and licensing.

Franchise Fees

Just about any payment can be interpreted as satisfying the “fee” element, regardless of whether the parties call it something else. And fees are generally involved no matter which path to expansion a business owner chooses, because the goal of growth is profit.

Franchise Controls & Marketing

The third element, sometimes referred to as the “control” element, requires the franchisee to operate the business under a specific method or system – it’s the “recipe for success” so to speak: 

  • A franchisor will typically provide its franchisees with an operations manual containing a system of operations and closely monitor its franchisees for compliance to protect the integrity of its system.
  • Franchisors usually mandate the use of specific suppliers, and in some cases, act as the exclusive supplier of certain products or services sold by their franchisees.
  • Franchisees rely on their franchisors for advice, training, advertising, increased purchasing power and marketing assistance.

Differences Between Franchise, License and Distribution Agreements

Under a typical licensing arrangement, one company permits another to sell its products or services in exchange for a percentage of the proceeds without any other involvement on the part of the licensor.

In dealership and distributorship arrangements, independent businesses operate under their own trade names. The dealers or distributors usually buy products or services from the other party at wholesale prices and then resell them to the public. Neither party is substantially involved in the business affairs of the other. 

Franchises have many advantages for both franchisors and franchisees. Creating a franchise system allows franchisors to expand already successful business concepts, achieve greater brand recognition and diversify risk through the investments of its franchisees. Franchisees generally enjoy access to a proven business system and a wider customer base, greater brand name recognition, a stronger market presence, group purchasing discounts, professional marketing, research and development benefits, and continuing education and training. However, business owners and their advisors must be able to spot the telltale signs of a franchise to avoid unwittingly becoming or contracting with accidental franchisors.

Keeping with the California example, true licensing, distributorship and dealership arrangements lack at least one of the three elements of a franchise defined under state law.

But they also lack the level of scrutiny and regulation of a franchise. Business owners should decide if they’re ready for that level of commitment. The rewards are great, but franchising requires a certain “upping of the game”, if you will.

Business owners who suspect they may have inadvertently sold franchises when they really wanted to just expand operations, should seek legal counsel immediately.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Lewitt Hackman | Attorney Advertising

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