Basic Franchising Law Information
Though it didn’t blossom until the 1950s and 1960s, franchising has been part of the American business landscape since the mid-1800s, when I.M. Singer of the Singer sewing machine company created the first identifiable franchise system. Early franchisors, like McDonalds and Midas Muffler, have proven the effectiveness of this business model by becoming undisputed leaders in their industries. The franchise business model allows companies to reach larger audiences while firmly establishing the identity of their trademarks, products and logos. Corporon & Katz are expert Colorado Franchise Lawyers and can help you understand the ins and outs of the laws for franchisors or franchisees.
About the Franchise System
Franchising is an important part of the American economy. Franchised businesses provide an estimated 11 million jobs and account for nearly 5% of the total payroll for America’s private sector of business. There are more than 900,000 franchised business establishments in the United States alone.
The franchise industry in the United States is regulated by the Federal Trade Commission (FTC). In general, a franchise can be defined as any business arrangement or relationship in which a franchisee purchases or otherwise obtains the right to run a business that uses trademarks owned by the franchisor. In a franchise system, the franchisor has considerable control over the business and/or offers a significant amount of direction to the franchisee. The franchisee must also make payment to the franchisor within a specified time period. Though these are the requirements set forth by the FTC, individual states may have different requirements for what is considered a franchise in that state and how a franchise must be operated.
Franchise Disclosure Document (FDD)
The Franchise Disclosure Document, or FDD, is prepared by the North American Securities Administration Association (NASAA). The format is accepted in all states and consists of 23 items and exhibits. Each item has to be accounted for and thoroughly discussed. The FDD must also be written in plain English and free from legal jargon, and it must be of uniform size and font.
Elements of the FDD
There are several specific items that make up the FDD. The cover page identifies the franchisor and advises franchisees to beware. The facing page describes the franchise being offered and lists risk factors. The 23 items included in the FDD are:
- Franchisor, affiliates, predecessors and parents
- Business experience
- Initial fees
- Other fees
- Estimated initial investment
- Limitations on sources of products
- Obligations of the franchisee
- Franchisor’s advertising, assistance, training and computer systems
- Obligation to participate
- Renewal and termination
- Public figures
- Financial performance representations (earnings claims)
- List of outlets
- Financial statement
A franchise agreement is required to conform to the language of the FDD and should be reviewed by the franchisee. This document is subject to state laws, rules and procedures and needs to be signed at the time of closing.
People who are ideal franchisees all share several common characteristics. Ideal franchise owners are intelligent and have business experience. They also work well with people. Individuals looking to purchase restaurant franchises should have restaurant experience as well. There are several qualifying traits to look for in a potential franchisee, including:
- Computer experience
- Financial ability
- Experience with franchises
- Ability to follow rules
- Able to work on own
- Willing to learn new skills
- Dedication and willingness to spend time on the project
When considering someone as a potential franchisee, there are several questions a franchisor may ask, such as name, address, phone number, education, business experience, financial status, credit and social security number. However, there are also several illegal questions that may not be asked, including color, race, creed, marital status, age, national origin, pregnancy status, gender, disability and living arrangements.
Selling a Franchise
When selling a franchise, you cannot say or write anything about the current or past financial status of any franchisee-owned, company-owned or affiliate-owned unit. This includes information regarding past, present or future income, profits or projected sales. The Franchise Disclosure Document provides enough financial data for the potential franchisee. You may, however, provide industry statistics from publications with general distribution. You can also feel free to invite prospective franchisees to visit the business at various times of day or talk with them about the franchising business model and why it may be right for that person.
Closing is best done face to face, but it may also be done by mail with a “closing” by phone. If there are no material changes to the franchise agreement included with the FDD, it does not need to be delivered to the prospect prior to closing. If, however, there is a material change, the FA must be presented to the prospect at least 7 days prior to closing so that he/she can review the change.
The closing process involves reviewing and signing or initialing several documents, beginning with the closing checklist. There must be two original sets of these documents; one set goes to the franchisor and the other to the franchisee.
Franchisor Responsibilities after Closing
Franchisors have several responsibilities after the closing. Federal law has strict record keeping requirements. Franchisors must keep an exact copy of the FDD, the original receipt and the original of the FA with signatures. These files must be kept for a minimum of 3 years, but it is advisable to maintain these records for no less than 7 years after a franchisee leaves the system. Franchisors must also maintain all correspondence, including email, audit reports and logs of conversations with franchisees.
Franchisors are required to have an organization dedicated to franchising. This department must include:
- Franchise compliance officer – Ensures complete compliance with the franchisors obligations to state government, federal government, franchisees, sales staff and training as needed. This person must know the FDD and FA completely and understand basic financials. The franchise compliance officer is in charge of all parts of franchising and requires computer experience and must be good at working with people and keeping detailed records.
- Financial person – Understands business finances and is in charge of all the financial components of franchising. This person should have computer experience, know the FDD and FA inside and out, be a good record keeper and be able to generate weekly, monthly and quarterly reports for an auditor.
- Administrator – Must be extremely organized and know the FDD and FA front to back. This person is in charge of record keeping and scheduling.
These roles may only be filled by current personnel if they are able to dedicate at least 20 hours per week to related tasks.
Franchisees are customers and, in most cases, the customer is usually right. Franchisors need to maintain frequent, positive communication with each franchisee and address any problems promptly. Franchisors should also encourage franchisee support groups and provide regular support and field visits. If possible, yearly meetings are encouraged. Reach out frequently with newsletters, updates and training opportunities.
If a franchise is not working out, do not be afraid to terminate that franchisee. After all, refunding the money is often less costly that keeping a bad franchisee in your system. Show franchisees that you care, but do not let that prevent you from enforcing the contract fairly and consistently. There are several instances in which you may need to terminate a franchisee, such as:
- Failure to pay on time
- Failure to report
- Hiding income
- Failure to follow the established franchise model
- Offering services that are not offered
- Fraudulent behavior
- Moral turpitude
When problems arise, it is best to first try discussing them with the franchisee. Make sure to carefully document violations. Send out warning letters if necessary, but do not take any further action without consulting with an attorney.
Franchise law is complicated for both franchisors and franchisees. Before making any business decisions relating to a franchise, consulting with an experienced Colorado Franchise Lawyer is advised. Michael J. Katz, Esq. of Corporon & Katz is an experienced franchise law attorney. We represent both franchisors and franchisees. For more information or to schedule a consultation, call 303-790-4103 or email Michael@BusinessLawyer.com.