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Franchising vs. Licensing a Business


     By Franchise Foundations, APC - Kevin B. Murphy, B.S., M.B.A., J.D. Franchise Attorney and Expert Witness

PhoneCall Kevin B. Murphy, B.S, M.B.A., J.D. at (800) 942-4402


The starting point in the franchising vs. licensing a business analysis is to consider the legal aspects, then the business aspects. In considering the legal aspects, begin with the following premise that applies to both options. If you put someone into business (or allow them to use your business name/mark) this transaction will normally be a regulated activity, subject to substantial penalties for noncompliance.
This guiding principle, coupled with the business aspects of selling a franchise vs. a license (discussed below) will answer most franchise vs. license questions.

BACKGROUND OF FRANCHISE & BUSINESS OPPORTUNITY LAWS
Why does regulation exist? The government, due to documented past abuses where tens of thousands of individuals lost all of their net worth by investing in nonexistent or worthless business endeavors, has devised two principal consumer protection mechanisms:

(1) franchise disclosure-registration laws; and
(2) business opportunity laws.

The thrust of these laws is to require sellers to give potential buyers enough pre-sale information so informed investment decisions can be made before money changes hands, long-term contracts are signed and sizeable financial commitments are undertaken. Under federal regulations, a Franchise Disclosure Document (FDD) covering twenty-three individual chapters and a hundred or more pages in length must be prepared and given to every potential buyer at least 14 calendar days before any contract is signed or money paid.

It doesn't matter what terms are used by the parties in contracts or other documents to describe their relationship. For example, the contract may call the relationship a license, a distributorship, a joint venture, independent contractors, etc., or the parties may form a limited partnership or a corporation. This is entirely irrelevant in the eyes of governmental regulators, in particular the Enforcement Division of Federal Trade Commission (FTC). Their focus is not on semantics, but on whether a small number of defining elements are present or not. Today the industry is subject to a complex web of regulations that differ from the Federal level to the state level and differ widely from state to state.

Firms or individuals that say calling it a “license” dispenses with legal regulations are delusional and wrong for at least three reasons:

(1) common sense - if it was really that easy, everyone would have done it that way;

(2) if the relationship is not regulated under franchise law, business opportunity laws (discussed below) will apply, and complying with these will be a lot more expensive than going the franchise route; and

(3) any analysis must include federal as well as applicable state laws.

This all reminds me of some financial planners who still advise clients filing U.S. income tax returns is not required under their interpretation of the U.S. Constitution. It just doesn’t work that way. Actually it only works until the IRS catches up. The "licensing avoids franchise regulation" spin (which, not surprisingly, is not accepted in the legal community) also only works until the company gets caught. The logic (not) goes something like this: licensing arises under contract law, not franchise law and therefore franchise law doesn't apply. Sound's just like the "you don't have to file a tax return because tax laws don't apply" argument.

Here's a real life example. A "licensing attorney" prepared a dealer license agreement and ignored the FTC Franchise Rule disclosure requirements. The dealers became disgruntled and hired a litigation attorney who sued the company, not surprisingly, for selling illegal, disguised franchises. It cost the company $750,000 to go to trial in federal court to answer the question "Is this contract a franchise?" It's always a very expensive question to answer. Trying an end run around the franchise disclosure laws by calling it a "license" may be a cheaper way to go initially. But it's not a question of if you will be caught, the only question is when. Be prepared to spend mind-boggling amounts down the road when the disguised franchise is challenged for what it really is.

In a 2008 case, Otto Dental Supply, Inc. v. Kerr Corp., 2008 WL 410630 (E.D. Ark. 2/13/08) another disguised franchise vs. a license was at issue. The licensor claimed it sold just a license, not a franchise and the franchise laws didn't apply. It made a motion for summary judgment to have the case thrown out of court. The federal Eastern District Court ruled against the licensor and ordered the case onward. It said whether or not the license was really a franchise was up to a jury to decide. Juries apply common sense to the simple defining elements of a franchise. They are not swayed by semantic arguments like "licensing arises under contract law, not franchise law and therefore franchise law doesn't apply." Another expensive franchise vs. license learning lesson.

This is not to say licensing a business isn't a viable option in foreign (out of U.S.) transactions where U.S. laws don't apply - but these are a very small minority. Most transactions and contracts cover U.S. activities and residents, so the franchise vs. license question is an easy one to answer. Even inside the U.S. there are some cases where calling the relationship a "license" makes sense. Years ago, a company selling education franchises to university professionals called their contract a license. To comply with applicable laws, a full franchise disclosure document was prepared and registered. For strictly marketing reasons, the "franchise agreement" was called a license agreement within the franchise disclosure document.

The list of required defining elements is quite short, and although certain franchise exemptions and exclusions are available, the franchise statutory framework was designed to pigeonhole these relationships into either a franchise or business opportunity box. Normal license agreements contain certain "control" provisions (right to audit, require reports, mandate suppliers, etc.) and the presence of ANY control or assistance provision (operations manual, training, site or other assistance) is enough to satisfy these elements of the Rule. In fact, the title of the FTC Rule says it all: "Disclosure Requirements & Prohibitions Concerning Franchising and Business Opportunity Ventures." So, the focus must be on which box is better to use, not on how to avoid using either box.

THE FRANCHISE BOX - REGULATION BY THE FEDS
Let's consider the franchise box. Under FTC regulations that became effective in 1979 a thick document (now called a Franchise Disclosure Document) must be prepared and given to prospective buyers for a minimum of 14 calendar days before any money is paid or contracts are signed. This document now contains 23 items or chapters of information, as well as current financial statements and a copy of the actual contracts used.

As mentioned, this document is designed to give prospective buyers enough pre-sale information about the company, its financial condition, the proposed contract, investment requirements, trademark rights, exclusive territories, etc.,so informed decisions can be made before long-term contracts are signed. For companies that attempt to disregard federal law, the FTC Act authorizes the Commission to recover civil penalties of up to $10,000 for each violation of its Rule, plus injunctive relief, consumer redress (obtaining complete refunds, canceling contracts), etc. Because each sale can involve multiple violations of various regulatory provisions, these fines can be substantial and far outweigh the cost of doing it right the first time.

Selling a disguised franchise (an illegal franchise) as a "license" can be the most expensive mistake a company ever makes. One need only consult the franchise registration filings of various states to see the significant number of companies that fall into this trap. They started out selling "licenses," operating under misguided advice, in a vain attempt to save money. Then, they either get sued for selling an unregistered or illegal franchise. Or they finally get competent legal advice that what they've really sold are disguised franchises, even though they were called a "license." The governmental agencies require them to offer full rescission rights (cancel the license, refund all money that's changed hands) to all persons they've sold "licenses" to. Defenses that "we didn't sell a franchise - we just sold a license" are unavailing. In the end, they pay a lot more to have it done the way it should have from the very beginning. Not a pretty picture.

STATE REGULATION OF FRANCHISING
Because regulation of franchising is at the federal and state level, the effect of state regulation must also be considered. The FTC Rule sets minimum standards and applies in all states, unless a particular state sets higher standards, and then that state's law applies. In 1971, eight years before the FTC Rule went into effect, the State of California was the first to enact a franchise disclosure-registration law where a franchise registration process is required before franchises can be offered (i.e. advertised) or sold. The California Franchise Investment Law was in response to a wave of consumer franchise complaints. Other states soon followed California’s lead, leading to a situation where franchise companies had to follow different rules in each franchise registration state.

To alleviate these difficulties and achieve a uniform format, a group of Securities Commissioners from various states adopted a Uniform Franchise Regulation, effective in 1977, known as the Uniform Franchise Offering Circular (UFOC) format. All states requiring franchise registration followed the UFOC format, a thick document also containing 23 chapters of information. None of these states accepted what was then known as the FTC's Basic Disclosure Document. To ease the obvious predicament created by UFOC vs. FTC format, the FTC allowed companies to use the UFOC format as an alternate to its Basic Disclosure Document. In 2007, the FTC adopted its own version of the UFOC format, known as the Franchise Disclosure Document or FDD. The FDD format is the required format in all states beginning July 1, 2008.

FRANCHISE BOX SUMMARY
Bottom line on the franchise box: By preparing a single franchise disclosure document (at a cost of about $30,000), a company satisfies the federal requirement and is positioned to offer and sell franchises throughout the United States. Although certain state-specific information and disclosures may be required in the minority of states having a franchise registration-review process, this can normally be accomplished in a couple of extra hours per state.

THE BUSINESS OPPORTUNITY BOX
Now, let's consider the business opportunity box. At the state level, there are approximately 24 states that regulate and register business opportunities. Unlike the franchise box, there is no such thing as a uniform business opportunity disclosure format. Business opportunity rules and registration requirements differ in each business opportunity state. Many of these states also have a "cooling off" period, usually a couple days after the sale where buyers can change their mind for any reason and receive a full refund.

For a company that's going the business opportunity route two different documents may need to be prepared and provided: the FTC's Basic Disclosure Document (if the business opportunity fits the FTC’s definition of a business opportunity) and a state's more abbreviated business opportunity disclosure document. Also, different timelines may need to be observed: the FTC's 14 calendar days before, and a business opportunity state's cooling off period after.

Bottom line on the business opportunity box - if you're an attorney with a business opportunity or "licensing" client, get ready for hundreds of billable hours, you've just landed a big one. But, if you're the business paying the legal bills, it's going to be a lot less money to go the franchise route. Prepare a single, Franchise Disclosure Document, register in a state or two as expansion efforts begin, and you're essentially done.

There are also other factors to consider in the franchise vs. business opportunity analysis, including liability issues (definitely a greater risk in the franchise arena) but these are beyond the scope of this article, which is not intended to offer legal advice. Companies should consult with competent, informed legal counsel about the specifics of their particular situation before making any decision.

THE BUSINESS ASPECTS OF FRANCHISING VS. LICENSING A BUSINESS
The business aspects of the franchise vs. license and business opportunity options are relatively straightforward. It all boils down to image from a marketing standpoint. From a credibility standpoint, does your company want to stand toe to toe with the likes of McDonalds, Radio Shack, H & R Block and other franchised household names? These are the mental images formed in the mind when an average consumer hears the word franchise, along with familiar, highly advertised slogans like "being in business for yourself, but not by yourself," "complete training," "support where and when you need it," etc.

This, coupled with the complete package of training, start up and ongoing support services offered by franchise companies, makes a franchise a more attractive commodity in the eyes of the prospective buyer and an easier sale. The same applies to firms that sold "licenses" then switched to selling "franchises." These companies report they attracted considerable interest and far more inquiries when offering "franchises" compared to when they offered "licenses." So, even from a business standpoint, the franchising vs. licensing a business question is easy to answer. In addition, and as discussed above, a "license" is almost always a franchise in disguise, a ticking bomb creating significant legal issues if the FTC Rule (and corresponding state franchise registration laws) are not followed.

THE BUSINESS ASPECTS OF FRANCHISING VS. BUSINESS OPPORTUNITIES
Business opportunity ventures, when compared to franchises, suffer from definite image problems that translate into difficult marketing issues. If you ever need proof of this, just attend any business opportunity show or expo. You'll see a host of fly-by-night opportunities such as worm breeding in backyards, exotic plants raised in glass bowls, condom vending machines (not a bad idea these days) and the like all promoted by fast-talking, high pressure salespersons. Does your company really want to be associated with these companies and the reputation they project? Poor image, coupled with the fact that business opportunity ventures typically provide little training and no ongoing support, make them a much more difficult sale to prospective buyers. In a business opportunity, the buyer is just thrown a ball, and it's entirely up to them how to run with it.

Copyright 1990-2009, Kevin B. Murphy

ABOUT THE AUTHOR: Kevin B. Murphy, B.S, M.B.A., J.D.
Mr. Murphy, a San Francisco franchise attorney is an internationally-known franchise expert, author, and instructor - known in the industry as Mr. Franchise. For over two decades he has specialized exclusively in the franchise industry and owned a very successful franchise in the home improvement field. He has written over 30 publications, including four books on franchising and one book on trade secrets. He instructs franchise company personnel in best franchise practices and teaches franchise, licensing and intellectual property courses to attorneys. Mr. Franchise is a franchise attorney and Director of Operations for Franchise Foundations, a San Francisco-based professional law corporation.

Copyright Franchise Foundations, APC - Kevin B. Murphy, B.S., M.B.A., J.D.

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While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.

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