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What is Franchising?

Franchising vs. Licensing

A license is an agreement under which a licensor of property (which may be the property owner itself or another party licensed to use and further sublicense the subject property) grants to another party (the licensee or sublicensee) rights to use the subject property. Not all licensing arrangements are franchises; but all franchising relationships do include a license to use a trademark and other intellectual property. For purposes of this discussion, the subject property of the license is intellectual property: that is, a business format and a brand. However, license agreements may also involve licenses to use tangible personal property or real property.

A licensing relationship generally satisfies the legal definition of a franchise, and thereby triggers the application of federal and state franchise laws, when the following three elements exist together:

1. The licensed right or contractual requirement to use another party’s trademark to offer, sell or distribute goods or services;

2. The requirement to pay a fee for that right (either initial, ongoing or in-kind); and

3. The imposition of controls or the provision of significant assistance (which may be in the form of a marketing plan).

These elements are outlined and further defined in a federal rule entitled Disclosure Requirements and Prohibitions Concerning Franchising (16 C.F.R. Part 436), often referred to as the “FTC Franchise Rule” or just the “FTC Rule”. Once a business relationship satisfies the definition of a franchise as set forth in 16.C.F.R. 436.1(h), the FTC Rule prescribes a series of required pre-sale disclosures the franchisor must provide to a prospective franchisee before the franchisee signs a binding agreement or makes any payment to the franchisor or its affiliates. (16 C.F.R. 436.5). The FTC Rule also imposes requirements and limitations on the franchise sales process itself. Because of these legal requirements and restrictions, some companies go to great lengths to avoid falling within the definition of a franchise under the FTC Rule. These attempts to avoid the reach of the FTC Rule include companies structuring their business relationships so that they do not meet the three-element definition or so that they may take advantage of regulatory exemptions or exclusions that may be available. (Note: state franchise law definitions vary and there are numerous exceptions and exemptions available under those laws and regulations.)

Reasons to Franchise

A company may be motivated to franchise its business for a variety of reasons, including, to establish a rapid market presence, to obtain off-balance sheet financing using franchisee capital, to leverage its trademarks and goodwill to build brand loyalty, to obtain operating efficiencies, to create a dedicated distribution network, and to shift operating responsibility from company employees to independent owner/operators who may be more highly incentivized to succeed. At the same time for numerous reasons, business operators may benefit from becoming franchisees rather than operating independently. Some of these benefits may include access to the franchisor’s know-how, methods, and operating systems, access to training and guidance, leveraging cooperative advertising, leveraging the strength of the franchisor’s brand to drive sales, as well as to locate and secure store sites, negotiate leases, and obtain favorable pricing on equipment purchases.

The Decision to Franchise

The business of operating a company that sells products or services is considerably different than the business of operating a company that offers and operates franchises. While a non-franchised company must deal with the typical long-term and day-to-day financial and operational concerns that arise, franchising adds another layer of complexity to the business. Some of the requirements for a company to succeed at franchising its concept include:

• a proven prototype and a business concept that can be replicated (successful replication in turn requires a distinctive set of proprietary trademarks and a brand identity, and a well-developed set of business methods and systems that are scalable);

• a management team with the skills necessary to handle growing and managing a network of independently owned and operated franchised businesses; and

• financial capital and human resources to develop a successful franchise system.

In addition to these business related factors, establishing a franchise network requires a significant commitment of legal resources to comply with federal disclosure and sales requirements.

This blog post is not intended to consist of legal advice and you should always consult with a lawyer before acting on anything you find on the Internet.  If you have questions or comments about this post, about the topic, or if you need legal assistance, you should feel free to give us a call or send us an email.  Let us know how a New York City corporations lawyer can assist you.

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