Franchise or License?
We recently talked with a business owner who was looking to expand his successful service business. He told me that he wanted to franchise his business, but that he didn’t want to call it a “franchise.” He wanted to sell the right to use his business’ name and systems and collect ongoing royalties, but he didn’t want to go through the hassle or cost of preparing the franchise disclosure documents (FDD).
I told this particular owner the same thing I’ve told many owners before: “You can call a duck an eagle, but that doesn’t make it true.” In other words, the name you choose to use doesn’t define a business arrangement. Rather, the arrangement determines what name is correct.
Franchise and license aren’t synonyms, and the distinctions are crucial. If your company creates a franchise but doesn’t provide the required disclosures, you could be personally liable for the buyer’s damages.
Yes. Under Florida law, if your company creates a franchise but fails to provide the required disclosures through an FDD, you can be held personally liable for the buyer’s damages.
This situation is more common than you might think, and often it starts out innocent enough. Customers and other people see the success of a business and “want in.” The owner wants to expand the business but doesn’t have the capital to pay for the attorney’s and accountant’s fees to prepare the FDD in advance.
So, when a prospective franchisee offers to pay the franchisee fee in advance, the owner sees it as a way to pay the costs of establishing the franchise: The franchise literally funds itself.
The problem is that franchise law prohibits it.
This means that the officers of the “licensing company” can be held personally liable for the buyer’s damages because the company created a franchise, but called it a license, and did not provide the required disclosures.
A Florida company, Relay Transportation, Inc., fell prey to this not too long ago. It decided not to provide the required franchise disclosures because it wanted to get an initial franchise fee of $50,000 before spending the money to create the FDD.
In this case Relay didn’t want to be completely exposed by selling vapor—collecting a franchise fee before having anything to sell. So, it decided to call the first arrangement a “license” and had its attorney prepare a license agreement.
Calling it a license wasn’t a magic potion that got Relay out of its requirements to provide the franchise disclosures.
The franchisee invested money to start the business and paid the “license” fee to Relay, but things didn’t work out. The franchisee lost its investment plus startup costs. (Like any other startup business, franchised businesses are not risk-free!)
When Relay refused to reimburse the franchisee for its losses, the franchisee sued both Relay and its officers for deceptive trade practices because Relay had failed to provide the required franchise disclosures.
Because it is a deceptive trade practice, the officers who participated in the franchise system development were personally liable to the franchisee.
FTC’s Definition of “Franchise”
The Federal Trade Commission regulates franchise disclosures through the Franchise Rule (“The Rule”). The Rule defines a “franchise” as a business arrangement that has the following broadly-interpreted elements:
- A common trademark or commercial symbol,
- Payment of $500 or more during the first six months of the relationship,
- Significant control or significant assistance.
Using a Common Trademark or Symbol
This element includes registered trademarks like names (e.g. McDonald’s or Nike) and logos (e.g. the Arches or the Swoosh), as well as trade names, service marks, and other symbols that indicate a common origin or enterprise. A common symbol could even exist where the phrase “Part of the Acme Business Group” is used in marketing materials.
Generally, if a name or logo is a part of the arrangement, the trademark element will be satisfied.
Payment of $500 or More in the First Six Months
A franchise fee of $500 or more is sufficient, but, because the elements are interpreted broadly, all of the following payments count toward the $500 threshold:
- Inventory and Equipment
- Marketing and Sales Materials
- Training and Training Materials
- Rent (equipment and real property)
In short, I assume this element will be satisfied in most cases.
Ability to Exercise Significant Control or Significant Assistance
This element is usually the determining factor. It broadly considers the power and dependency dynamic between the buyer and seller.
“Significant control” hinges on whether the seller has the right to direct the buyer in how to operate the business or provides services and components that are essential to the operation of the franchised business. Indicators include an operations manual, the use of financial reporting procedures, or mandatory sales or management training.
If a buyer wouldn’t be able to operate the business without the seller’s systems, training, or services, the reliance factor will likely be satisfied.
How Do I License My Business?
So now you know what constitutes a franchise. But what do you do if you just want to “license” a business?
Without trying to be cute, avoid creating a franchise by eliminating at least one of the franchise elements of a franchise (note: that there are other very limited exemptions to the Rule that I’m not describing in this article).
Remove the Trademark
The easiest franchise element to remove is the common trademark element. Rather than permitting licensees to use your company name, each licensee would select a separate name.
One client did this a few years back. He was operating a franchise system where franchisees would buy equipment, become trained and utilize the registered trademark in the operation of the business, all in exchange for an up-front franchise fee and ongoing royalty payments. In addition, franchisees purchased supplies and materials that were used in the business from the franchisor.
The client was frustrated, though, because franchisees were not paying the royalty payments or providing financial information. Based on their supplies and material purchases, he knew they were doing well. But, he couldn’t get them to do the paperwork for the business.
Rather than go after each franchisee, we suggested that the client convert the system into a license (business opportunity) by removing the right to use the trademark from the franchise. To collect the same amounts that were supposed to have been paid as franchise royalties, the client added a calculated royalty to the cost of the materials via a price increase. The client was able to increase collected revenues while simultaneously reducing the time he spent managing the franchisees (now licensees).
Significant Assistance or Control
An element that many business owners focus on removing is significant assistance or control.
Rather than require the buyer use specific systems, provide financial reporting, or meet requirements of any of the other things identified above, a business license can provide, but not require:
- Marketing plan,
- Initial supplies, and
- Trademark license and licensing royalties.
Of course, there cannot be any requirement that the licensee follow the training, use the equipment in a particular way, market in a particular way, or make any level of sales, attend meetings or do anything else.
There is, of course, a danger that a licensee will go astray and do business in a way that harms the goodwill associated with the trademark. Therefore, any trademark license should have protections for the mark, including the right to terminate the license if the license seller discovers the mark has been harmed by the licensee.
Business Opportunity Laws
The legal landscape isn’t all wide open green pastures when it comes to licensing a business though. Licensing arrangements can fall within the definition of “business opportunity.”
Business opportunities are also regulated by the FTC, as well as by many states, Florida included.
When is a License Arrangement a Business Opportunity?
The definition of Business Opportunity varies by state and by the FTC, and is generally broad. For example, the FTC definition has the following elements:
- New business,
- Buyer makes a payment to the seller, and
- Seller (itself or through another party) promises the buyer to:
- Provide locations, displays, or vending machines to the buyer, or
- Provide outlets, accounts, or customers to the buyer, or
- Purchase goods or services from the buyer.
The Florida law modifies the FTC definition. First, it limits the definition by adding a $500 threshold to the buyer’s payment. Next, it expands the definition by adding the seller promise of a sales or marketing program as one of the elements that makes an arrangement fall within the definition of business opportunity.
It is important to note that, even if an arrangement doesn’t meet the Florida definition of business opportunity, if it meets the FTC definition, then the FTC business opportunity rule must be satisfied.
Business Opportunity Disclosure Requirements
The good news, though, is that even if a business licensing arrangement falls within the definition of a business opportunity, the disclosure obligations are much less onerous than for a franchise. The disclosures are generally short, do not require financial statements, and are a lot less time-consuming (read: expensive) to prepare.
Business Opportunity Contract Requirements
One aspect of the business opportunity laws to be careful about is that they sometimes require specific provisions in the contract between the seller and the buyer. Florida has these requirements, and a buyer is able to rescind (undo) any contract that does not contain these provisions.
Stay Safe® Out There™
Franchising to expand your business must be accomplished carefully to avoid running afoul of franchise disclosure laws. At the end of the day, business owners must remember that whether or not a business arrangement is a franchise or a license depends on the arrangement, not the name. Once required disclosures are provided, a properly structured franchising arrangement can lead to successful growth of an already successful business.
Licensing and business opportunities are also a viable option for business owners. They, too, must be dealt with carefully as your business owners have to comply with both FTC and state laws.
How Can We Help You?
Here at Alexander Abramson, we focus exclusively on business-related legal matters. We have advised closely held businesses and business professionals for years on everything from raising startup equity and partnership arrangements to selling a business, and, yes, also franchising and business opportunities.
Our staff strives to create a wonderful client-experience by actively listening and maintaining open lines of communication, consistently meeting deadlines, and being upfront about our pricing and services. Don’t trust the legal needs of your business to an attorney that can’t or won’t offer you the best service possible.
We would love to speak with you directly about how we can help you start, grow, or sell your business.
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