Top 5 Legal Needs for Franchises

A franchise can be organized in three ways, each of which has advantages and disadvantages:

A. Sole proprietorship: A sole proprietorship is the easiest and simplest business structure to set-up. For this reason, it is the most popular option. The sole proprietor registers the business only in his or her name. This gives the business owner the right to all assets but also makes the business owner entirely responsible for all debts and financial liabilities. Any business owner that decides on a sole proprietorship should understand that if the franchise fails, the business owner is personally responsible for the debts. In the event that the franchise location cannot sustain itself, the owner is liable to pay off all debts that the individual location has accrued, and the owner’s personal assets are not protected.

B. Limited Liability Corporation: A limited liability company, or an LLC, limits the personal liability of the owner. The owner is only liable for the amount that he or she contributed to the start-up of the company. An LLC business structure allows for multiple owners or “members;” therefore, if a franchise owner wants to take on partners, he or she can do so if the business is organized under an LLC. If there are multiple members, each member is financially responsible for only the initial amount that he or she contributed to the business. An LLC also provides for “pass-through” taxation, which means that the members can register profits and losses on their personal returns, instead of having to complete a separate tax return for the business.

C. S Corporation: Most franchises are established as S Corporations, which is a variation of a standard corporation. An S Corporation is similar to an LLC in that it provides for “pass-through” taxation and limits the personal liability of the owners from the debts of the business. S Corporations also allow for other favorable tax incentives, including designating profits from the business as both income and dividends. However, franchises structured as S Corporations are required to meet more stringent filing requirements than an LLC.

As a franchisee, it is important to set up a partnership agreement prior to the start of the business. A partnership agreement is a written document that discusses and outlines the individual relationship, role, responsibilities and contributions between business partners. The Small Business Administration notes that there are six elements that every partnership agreement should include: (1) percentage of ownership; (2) allocation of profits and losses; (3) determinations of who can bind the partnership; (4) determinations of who makes decisions for the partnership; (5) determinations of what happens in the event of the death of a partner or if one partner wants to leave; (6) establishment of a dispute resolution process.

The Federal Trade Commission (FTC) requires franchisors to prove a Franchise Disclosure Document (FDD) to franchise candidates at least 14 days prior to a sale. The FDD’s purpose is to give candidates necessary information to make a wise decision on whether or not to buy a particular franchise. There are 23 categories of information that must be provided by the franchisor to the prospective franchisee. All of the information included in the FDD should be reviewed closely.

The FDD should discuss the franchisor’s intent to expand. If the franchisee is the first to open in a new market, the owner should consider whether to require a right of first refusal to buy additional franchised outlets in the market area before the franchisor considers other prospective franchisees. The obvious advantage to this is that the franchisee then has complete control of that market area. The disadvantage is that the franchisor may impose an expansion goal and if the franchisee does not meet this goal, then the owner might have to forfeit the area.

Franchising is a regulated industry. The Federal Trade Commission (FTC) regulates on the federal level, and while state level regulation varies, most states have a regulatory agency. When determining if a business is a true franchise, the FTC and state regulatory agencies focus on the substance of the relationship between the franchisor and the franchisee, and not necessarily how the franchisor and the franchisee characterize the relationship. Because there is not a uniform definition of a “franchise” at the federal and state levels, most states and local jurisdictions follow the Federal Trade Commission (FTC) definition of what defines a substantive franchise relationship. The FTC defines a franchise as any continuing commercial relationship or arrangement that contains three separate elements:

A. Trademark: The franchisor allows the franchisee to use the franchisor’s trademarks

B. Franchise Fee: The franchisor collects a fee from the franchisee within the first six months of the franchise starting

C. Control: The franchisor exercises significant control over the franchisee’s operation such as operating hours and techniques, accounting practices, employment policies, advertising, and business location.

If the FTC or a state regulatory authority determines that the franchise it not a true franchise, it can create issues of liability and also may invalidate terms within the FDD, such as a franchisee’s exclusive service areas or the imposition of covenants not to compete. Therefore, ensuring your franchise meets these elements is essential to protecting the franchised business from undue federal or state regulation issues.

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