The definitions of a franchise differ under the federal and state franchise laws. This discussion will focus on the FTC trade regulation rule on franchising (the FTC Rule). The state franchise disclosure laws have similar definitions, but they are not identical, and the exemptions are different in each state.
The FTC Rule defines a franchise as a continuing commercial relationship in which three elements are present: (i) a trademark element, (ii) significant control or assistance and (iii) a payment. If these elements exist, the offer is within the scope of the FTC Rule, and disclosure is required unless the offer falls within a specific exemption or exclusion.
The trademark element is satisfied if the franchisor grants the franchisee a license to sell goods or services under the licensorâ€™s trademark. But a formal grant of a license is not necessary. A supplier can simply give a distributor the right to sell the supplierâ€™s products associated with the franchisorâ€™s trademark. Taken by itself, this sounds like any simple distribution arrangement.
The significant control or assistance element is satisfied if the franchisor â€świll exert or has the authority to exert a significant degree of control over the franchiseeâ€™s method of operation or provide significant assistance in the franchiseeâ€™s method of operationâ€ť:
- Significant control can mean requirements relating to the franchisorâ€™s approval of the site for the business, site design or appearance requirements, hours of operation, accounting practices, promotional campaigns that require the franchisee to participate or contribute financially, or restrictions on customers, location or sales area.
- Significant assistance can mean training programs, establishing accounting systems, providing advice relating to management or marketing, actually selecting the site (as opposed to approving it) or furnishing an operating manual.
The payment element is satisfied if the franchisee is required to make a payment to the franchisor (or its affiliate) as a condition of obtaining the franchise or commencing its operation. The payment must be at least $540 made at any time before to within six months after the franchised business starts operating. This payment does not have to be in the form of an initial franchise fee or royalties on sales. It may be a required payment, for example, for rent, equipment and supplies, or training. It can be required by the written contract or by practical necessity. It does not include payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale.
Whatâ€™s not a franchise?
Many sales arrangements fall outside the scope of this definition. These include:
- distributors who buy products at a bona fide wholesale price for resale;
- sales representatives who work on commission and do not pay a fee for this right;
- sales on consignment;
- leased department in retail stores;
- employer-employee relationships;
- general partnerships;
- cooperative organizations;
- testing or certification services;
- a single trademark license;
- any arrangement where no fee is paid to the licensor or grantor.
What arrangements are exempt?
Below are a few of the specific exemptions available under the FTC Rule. Remember that exemptions vary from state to state, and these exemptions may not be available under the franchise and business opportunity laws of some states.
Fractional franchise â€“ The FTC Rule exempts the offer if the franchisee or any of its directors or executive officers has had more than two years of management experience in the business represented by the franchise, and the parties anticipate at the time of entering into the agreement that sales under the agreement will represent no more than 20% of the dollar volume of the franchisee’s projected gross sales during the first year of operation.
Large investments â€“ This exemption applies under FTC Rule if: (1) the estimated investment exceeds $1,084,900, and (2) the franchisee signs an acknowledgment verifying the grounds for the exemption. The figure of $1,084,900 excludes (a) financing from the franchisor or its affiliate, and (b) real estate costs.
Large franchisee â€“ Under the FTC Rule, this exemption applies if the prospective franchisee has been in business for 5 years and has a net worth of at least $5,424,500.
Franchisor Insiders â€“ This exemption applies if one or more purchasers with combined ownership of at least 50% either (1) has two years of management responsibility for the sale of the franchisorâ€™s franchises or the administration of the franchised network, or (2) for two years has been an owner of at least 25% of the franchisor.
Whatâ€™s a business opportunity?
Half of the states in the U.S. have business opportunities laws. The state business opportunity laws vary in their definition of a business opportunity. But generally, a business opportunity does not include ongoing support. The grantor of a business opportunity sells to the grantee the means to engage in a business and makes certain representations to the prospective grantee. For example, the grantor may represent that it will find retail outlets or accounts for the granteeâ€™s products or services or sites for vending machines, or that the grantor will purchase the products made using the goods or services sold to the grantee. Or the grantor may simply guaranty that the grantee will derive income from the opportunity. A business opportunity need not include a trademark.
Most of the business opportunity laws exempt franchise offerings that comply with the FTC Rule. The grant of a right that includes a marketing plan under a registered trademark is also exempt in many states.