Accidental Franchise = Potential Lawsuits, Fines + Other Penalties

by Lewitt Hackman

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

Written by:

Lewitt Hackman

Lewitt Hackman on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Custom Email Digest
Privacy Policy (Updated: October 8, 2015):

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.


JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at:

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.