When Does Your License Become a Franchise and What Can You Do About It?

In response to my earlier post about franchising as a business model came the following:  "but my business is not a franchise, it is just a licensing arrangement where I use distributors to sell my product".  This is where bells start ringing, red flags are raised, and whatever other metaphorical warnings you like pop up. Many successful businesses license the right to use software, technology, a trademark or name, copyrighted information, or other intellectual property to other businesses or individuals.  However, when it becomes tied to a business model or you use dealers, distributors, or other licensees to sell your product, you face an increased risk of liability.  Here's why.

That three-pronged franchise test is definitional, not chosen - once you meet each of the three criteria, you are deemed a franchise under federal law and under certain state laws.  That automatically subjects the company to an entire scheme of regulatory requirements for which there are penalties for failing to comply (ignorance of your status is not a defense).  Here's a common example:  a business (1) contracts with distributors to sell products using its trademark to create a brand awareness, (2) takes payments from the distributor in the form of a fee or royalties, and (3) exerts control over where the the distributor located and how it operates its business and sells the product.  That business just became a franchise regardless of what it calls its arrangement.

Can you Avoid Being a Franchise?

So what can companies do to grow their businesses while avoiding the cost and expense of the franchise regulations?  Some companies will try to contract around the franchise laws.  Since the test is a definitional one, you can eliminate one of the criteria to remove yourself from the franchise model.  Some will complain (WARNING: more metaphors ahead) that lawyers - particularly franchise lawyers - see everything through franchise-colored glasses, or that when holding a franchise hammer, everything looks like a nail.  But there are practical steps that you can take to reduce the risk of falling into the franchise scheme.  For example:

  1. Remove the trademark.  If you don't license a trademark and allow your distributors to sell product with your assistance but without using your name, you might be able to avoid the franchise regulatory scheme.  However, you still have to be mindful of the related business opportunity laws that play a similar but more flexible role.  These are often associated with the vending machine business and similar systems of product placement, but can be triggered in elsewhere.
  2. Don't charge a fee.  Eliminating the fee is not as easy as it sounds because most licenses include some form of payment.  Not charging an upfront fee is not enough here; the fee component can be satisfied by a variety of payments made to your business in the first six months, including royalties and the like.
  3. Don't exert control or provide assistance.  Licensors can often maintain their contracted relationships, even with the use of a trademark and payment of a fee, if they do not control how the distributors operate.  The licensor is always able to control, for example, how a trademark is utilized.  Control over the use and image associated with a mark is important not only from a business branding perspective but also from a legal perspective in that trademark owners have a responsibility to control its use.  So a license agreement can impose quality control standards over use of the mark, such as submitting products bearing the mark for testing and monitoring or inspections.  But there is a hazy line across which a licensor steps into the franchise world.  The more that quality control extends to the business operations of the licensee, the closer it comes to franchising.

Do You Need to Avoid Being a Franchise? (or, can't I learn to embrace the system?)

As I mentioned before, franchising can be a very successful business model and is responsible for a sizable percentage of this country's economy.  The vast majority of the people in the United States (if not everyone) has purchased products or services at some point from a franchised business.  But creating and maintaining a franchise system is an expensive and time consuming endeavor.  I always tell business owners who are thinking of franchising that starting a franchise system is not an extension of their business, it is a new business that requires a full-time effort.

Franchise regulation is a creature of consumer protection.  The excesses and fraud of franchise schemes in the early to mid-20th century led the FTC to enact regulations in the late 1970s that treat franchises like the sale of securities.  Each franchisor is required to provide a detailed disclosure document called the Federal Disclosure Document (NOTE: until 2007, this document was called the Uniform Franchise Offering Circular or UFOC) which provides prospective franchisees with information about the system and the people involved in it to make an educated decision on purchasing the franchise rights.  I will save the details of the FDD and the other requirements for a subsequent post, but very generally speaking, you are looking at spending somewhere between $20,000 and $50,000 in legal costs for the first year alone to meet your regulatory obligations.

Risks of Noncompliance

The risk of failing to register a deemed franchise does not necessarily come from government.  While the federal government can enforce through the FTC Rule and some states have specific powers to penalize through their own state laws, the real risk of liability comes when your distributors become dissatisfied for whatever reason and decide to sue you for selling illegal franchises.  You could be subject to fines and other penalties (in addition to exorbitant legal fees and court costs), including offering rescission to each of your licensees.  So businesses that try to take the relatively inexpensive route of trying to contract around franchise laws may end up spending much more money in the end.

So what is the moral of this story?  Licensing can be an effective method for rapidly building your brand awareness and product sales.  However, exercise caution before you jump in and consult a qualified attorney who can counsel you on the specifics of your model to help you avoid major headaches and costs down the road.