The Accidental Franchise

Expanding your business is at once an exciting and daunting prospect. Exciting because after hard work and sacrifice, you are ready to take the next step. Daunting because choosing the right way to take the next step can be overwhelming with all the practical, business, legal, and financial considerations. From a legal perspective, a variety options exist to expand your business. You can choose to keep all operations in-house by hiring employees. If hiring employees and having to comply with labor regulations and tax implications is too much, then you can outsource certain tasks by entering into an agreement with an independent contractor. If you sell a product, you could license the use of your product and charge a fee for such use. Or, if have created a brand and a business model that could be replicated, you could franchise your business. While all of these options exist and are excellent choices for expansion, they are each unique and have there own legal implications and pitfalls for the unwary. This article will focus on the accidental franchise, which is inadvertently creating a franchise without following the rules for it, the consequences of doing so, and how to avoid it.

Starting a franchise business from the franchisor’s perspective is not an easy undertaking. Federal and state rules govern the issuance of a franchise, and a franchisor must strictly comply with those rules. The franchise regulations, promulgated and enforced by the Federal Trade Commission, require that a Franchise Disclosure Document must be prepared and given to a potential buyer a minimum of 14 calendar days before any money is paid or contracts are signed. This document is voluminous and contains 23 items of information, current financial statements and a copy of the actual contracts that will be used. The Disclosure Document is prepared to give prospective buyers enough information about the company prior to making the purchase to determine whether the opportunity is legitimate and a sound investment.

Problems arise when an individual seeking to expand their business enters into a contractual arrangement with another party that is called a licensing agreement (or any other type of agreement) and the test of what constitutes a franchise is met. In this type of case, you may have an agreement that says this is a license to use a brand and product, but if the three-prong franchise test is met, the relationship is really a franchise and therefore subject to franchise regulations. A commercial business arrangement is a franchise if it satisfies three definitional elements: the franchisor must (1) promise to provide a trademark or other commercial symbol, (2) promise to exercise significant control or provide significant assistance in the operation of the business, and (3) require a minimum payment of at least $500 during the first six months of operations. Despite the name of the agreement you have, if the relationship meets this three-part test, then you have what is known as an accidental franchise.

Having an accidental franchise can be incredibly costly. When someone has an accidental franchise, they have failed to comply with the disclosure rules and are subject to severe civil penalties (up $10,000 for each violation) in addition to an unwinding of the deal. These penalties and the litigation that comes along with it can prove to be very costly, particularly in cases where a party has many accidental franchises.

While preparing the documents necessary for a franchise can also be costly, it is far less expensive to do so than to pay the penalties for having an accidental franchise. If you are considering expanding your business, have counsel review your terms and discuss whether you would be a franchise or whether a licensing arrangement would be best. Years down the road and successfully doing business, you do not want find yourself having established an accidental franchise.