A Word to the Wise – Avoid the “Accidental Franchise”

Caution with licensing, distributorship agreements and the like can help you avoid the pitfalls of franchise law!

We like to think we know a franchise when we see one.  Among some of our favorites:  Krispy Kreme, Cold Stone Creamery, and Snap Fitness (after we’ve visited the first two).  What many fail to realize, however, is that your business relationships can create “franchises” under the law – with all the accompanying legal requirements – even though that wasn’t necessarily your plan.  Read on to avoid the “accidental franchise.”

The FTC (Federal Trade Commission) defines a “franchise” as any continuing business arrangement with the following elements:

  1. The right to use a common trademark in the operation of the business;
  2. The imposition of significant control, assistance, and/or support over the method of operating the business;
  3. The payment of a fee, including but not limited to initial fees, royalties, advertising fees, training fees, and fees for equipment.

If a business relationship has these three elements, it is a franchise – period.  That’s right, the intent of the contracting parties is irrelevant.

Why does it matter?  If a franchise relationship exists, a host of legal requirements kick in.  For example:  federal law requires that the franchisor provide a detailed franchise disclosure document to the prospective franchisee at least 14 days before signing any agreement or accepting any payment.  Some states have additional franchise laws, may require registration with a specific state agency… and more.  And failure to comply can be very costly.  For some scary examples of that cost – including a company that started out not charging a fee, but later triggered state franchise law (and ultimately a $1.5 million verdict!) by charging for some manuals – you can read more here.

As one expert puts it, the “accidental franchisor” has essentially given the franchisee a winning lottery ticket they never knew about.  The franchisee may be able to terminate the agreement, recoup amounts paid to the franchisor and additional damages, and recover any attorney fees paid along the way.  Even worse, some state laws also impose fines and categorize the sale of an unregistered franchise as a crime.  No thanks.

What types of business relationships can create “accidental franchises?”  The most common examples are trademark licensing agreements and distributorship agreements.

Trademark Licensing Agreements:  Here, you simply grant someone a license to use your trademark in the operation of their business.  You’re in business to make money, and were likely paid a fee.  Already, two franchise elements are met.  (Example:  a sports team that licenses the right to use its logo on t-shirts, and gets paid in return.)  If you go on to provide training or promotional assistance that constitutes a sufficient amount of control (e.g., you provide support in the operation of the business that sells the t-shirts), you’ve now become a franchisor!

Distributorship Agreements:  In this circumstance, you enter into an agreement with someone who will offer and sell your products for a profit, presumably using your trademark (Mary Kay cosmetics, for example).  Generally, distributorship arrangements do not constitute franchises because the definition of a “fee” is not met.  (A “fee” does not include payment for the purchase of a reasonable amount of initial and ongoing inventory at bona fide wholesale prices.  What a mouthful.)  However, once the distributor begins to sell displays, sales kits, advertising, etc. (items not intended for resale), the exception may not longer apply and the fee element may be triggered.  Finally, just as described above, some friendly marketing and training assistance could trigger the control element.  Poof . . . a franchise is born!

Maybe you want to create a franchise—even make the “Franchise 500” someday.  Good for you!  But if that’s not your plan, watch out:  franchise laws and all their requirements can apply to many business relationships that we may not think of as franchises.  In order to avoid creating an “accidental franchise,” create the business relationship so that at least one franchise element (common trademark, fee, control) is missing.   Better yet, let your lawyer watch for it!  (And always share your Krispy Kremes.  Please.)