CLIENT UPDATE
Published for the Clients and Friends of Zegarelli Associates Professional Corporation

THANK YOU!

We must begin this issue by thanking you for your loyalty and patience during our period of transition and expansion, which is now complete. We did our very best to ensure that we continued to serve you in the highest-quality manner during the transition.

Like you, we understand the complexities, challenges and responsibilities of growing a business. Of course, if it were any other way, it just wouldn’t be fun.

Like you, we represent the entrepreneurial spirit.

FRANCHISING
Is It Right For Your Business?

Thinking about franchising in 1996? The following is a nutshell summary of points you need to consider in deciding whether a franchise is right for your business:

1. Franchises Generally. In short, franchising is essentially a contractual relationship for marketing and distributing the goods and services of a company (the "franchisor") through a network of distributors (the "franchisee"). The contractual relationship is embodied in a written franchise contract. Pursuant to the terms of the franchise contract, a franchisor grants the right and license to a franchisee to market a product, service, or both, by using the trademark and/or the business system developed by the franchisor.

2. Advantages vs. Disadvantages of Franchising.

Advantages:

• Expansion. Franchising provides a company the opportunity to expand its operations more quickly, especially in a capital intensive type of business by distributing risk among franchisees.

• Recognition. Franchising gives franchisees the opportunity to own their own business, and, at the same time, to have nationwide recognition, which is often important to the success of a business.

• Leverage. Franchising maximizes the franchisor’s rate of return on the development and replication of a system, while, at the same time, allowing the franchisee to leverage time and experience based upon implementation of a tested system.

Disadvantages:

• Control. The franchisor may lose the ability to change the business model once franchise agreements are in place, and may restrict the choices for business models available to the franchisee.

• Compliance. Franchising involves the costs and restrictions imposed upon the franchisor by federal and state franchise regulations. As explained below, these laws are generally for the protection of the would-be franchisee—basically, to ensure that the potential franchisee is provided with proper information relating to the nature of the particular franchise being considered.

3. What is a "Franchise."

The most commonly used definition of a "franchise" is provided by the Federal Trade Commission (the "FTC") in Rule 436. The FTC defines the term "franchise" to cover two types of commercial relationships:

• "package and product franchises"; and
• "business opportunity ventures"
(the "FTC Rule"). Under the FTC Rule, a continuing commercial relationship would be classified as a franchise, and subject to the requirements of the rule, if three central characteristics are present:

1. Trademark. The franchise distributes products or services associated with the franchisor’s trademark or identifying symbol;

2. Assistance. The franchise provides significant assistance and/or control over the franchisee’s method of operation; and

3. Payment. The franchisee is required to pay at least $500 in payments to the franchisor during the first 6 months of operation.

We note that, because acquiring strong trademark rights is so important and intertwined with growing a business, we consistently stress the importance of federal trademark registration and choosing "clean" business names, logos, etc. for new businesses. (See Trademarks and Eight Common Questions About Trademarks, Legal Links, Chain 1, Links 3 and 3A, respectively.) The "assistance" issue is why we stress that our clients develop business models and documented procedures that can be replicated, replicated, replicated. Replication is the cornerstone of growing a business.

4. State and Federal Laws.

Remember, the definition provided above is the federal definition of a franchise. In addition, most individual states have laws which regulate franchises. Since the definition of a "franchise" varies widely from state to state, it is imperative that a company seek professional assistance in examining the applicable state federal statutes to determine whether it is engaged in franchising or some other regulated activity. For example, many states have "business opportunity" laws which do not rise to the level of a franchise, but are nevertheless regulated. The state research is also the primary reason why franchising often requires a significant initial investment.

At least thirteen (13) states require annual registration of an offering circular prior to the offer or the sale of a franchise, two (2) additional state statutes require the delivery of an offering circular, but not registration thereof, and the FTC Rule mandates the delivery of an offering circular prior to the offer or sale of a franchise.

It is important to note that the mere fact that the parties identify their relationship as a "franchise" does not make the relationship a franchise. Conversely, an express disclaimer in an agreement stating that the relationship does not constitute a franchise will not negate coverage under the relevant laws, if all definitional elements are met.

5. Disclosure Requirements.

Franchises are required to make disclosures of business information to potential franchisees. The purpose of this requirement is similar to the requirement of disclosure for securities offerings (see Investors? Comply or Die, Client Update, April, 1995). Under the FTC Rule, the franchisor is required to disclose detailed information relating to at least twenty separate aspects of a franchise offering. Information to be disclosed includes all relevant facts about the identity, location, business experience and financial background of the franchisor, detailed descriptions of the franchise opportunity, including all initial and continuing fees and payments, and an explanation of all requirements in the franchise agreement.

The disclosure document is in addition to the franchise agreement. Therefore, when considering a franchise, there are generally always two primary documents: 1) the disclosure document, which describes the franchise and risks; and 2) the franchise agreement, which embodies the contractual relationship.

6. Alternative to a "Franchise."

Because your business model will be a franchise if it meets the definition of a franchise—like it or not—you must be careful. For example, if you license your business name, provide business assistance to the licensee and require a payment, you may have a franchise. If this happens, you must automatically comply with the FTC Rule and disclosure and registration requirements of all states having jurisdiction. Of course, by then it may be too late.

For this reason, sometimes you may want to structure your business intentionally to fall outside of the definition of "franchise." In such cases, you may want to consider distributorship agreements. Many types of distributorship agreements are not a "franchise" within the meaning of the FTC Rule or state laws for franchises. For example, if the only "fee" received by the franchisor is the bona fide wholesale price of merchandise purchased by the franchisee, such payments may not be considered to be a "fee" within the meaning of the FTC Rule. However, you should consult a qualified attorney before setting up a distributorship agreement, since you could be subject to substantial liabilities and penalties if your business fails to comply with applicable franchise registration and disclosure laws by inadvertence.

7. Conclusion.

So, all that being said, here’s the bottom line. Would-be franchisors should consider: a) whether they have developed a tested system; b) whether they can replicate the system efficiently; and c) whether they can afford the initial research and development investment into creating the business model. Would-be franchisees should consider: a) whether they have the requisite entrepreneurial spirit to own their own business; b) whether they need to leverage on a pre-tested business model (rather then create their own). If structured properly, franchising can be extremely profitable for both the franchisor and franchisee. (See also Franchising, Legal Links, Chain 2, Link 2, and the Client Update, April, 1995, for a more detailed analysis of franchising and business risks.)

Legal Links^TM and back issues of the Client Update are available upon request. As always, please call us if you have any questions or if we can be of assistance to you in any way.

Articles and information are for general information only, and often address issues, without expressly indicating, in generalizations. Laws vary between and among jurisdictions.  You should not rely upon any information provided by or on the website, including articles, as applicable to your particular situation. The law, filing fees, etc., change often, so the information in this document may not be current. The laws of various jurisdictions may be different than provided here.  Please contact us at info@zegarelli.com if you are interested in becoming our client--only then would this office be in the position to provide advise with regard to your particular situation.  It is important for you to review Terms of Use.

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