To license or franchise? What’s the difference and what’s best for my business?

January 25, 2017Blog, Legal Advise

We have had a few clients lately express interest in creating a franchise like relationship, but without the headache of creating a franchise.  CrossFit ® has done this successfully with a license agreement, whereby affiliates license the trademarks and the headquarters take a hands off approach with its affiliates.  While this model has numerous advantages, it also has significant downsides.  The most significant of which is the potential risk of loss of control over the use of your brand.  The more control provisions that a business puts in its license agreements, the more likely a franchise relationship is established.

Under the right circumstances, franchises can be a great option for business expansion. Franchise arrangements allow a business to leverage an already successful business model, process and brand to rapidly expand without expending the sort of capital necessary to open multiple corporate-owned locations.  In a franchise arrangement, the franchisor shares the “secret sauce” of its business success, including its brand, with a franchisee, and in exchange, the franchisee permits the franchisor considerable control over the business operations and pays certain fees (typically an up-front fee and an on-going royalty).

However, the bad news for franchisors is that franchises are regulated at both the federal and (often) state level and can come with considerable legal and business fees at the front end to put together quality disclosure documents that are legally required of all franchisors. With these sometimes overwhelming obligations, many small businesses shy away from franchising without fully understanding its benefits.  This article is intended to compare the two models, explain the positive and negatives of each, and help business owners understand what model may work best for them in light of their unique business goals.

Franchise Business Model:

Franchises are regulated by the Federal Trade Commission and by many state regulatory bodies.  Colorado does not regulate franchises directly (but does enforce other consumer protection laws).  The FTC rule governing franchises covers the offer and sale of franchises, with a commercial business arrangement is a “franchise” if it satisfies three definitional elements. Specifically, a business arrangement becomes a franchise if the following elements are part of the transaction: (1) provide a trademark or other commercial symbol; (2) 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.

To determine whether an arrangement would likely rise to the level of a franchise, there are certain hallmarks of a franchise agreement, which include requiring the franchisee (a) to follow site design or appearance requirements; (b) to adopt specific hours of operation, production techniques, accounting practices, personnel policies and practices; or (c) to undertake specific promotional or marketing campaigns for those products using the licensed trademark.  In addition, providing significant assistance, such as training programs for personnel, sales or business methods and procedures, selecting site locations or sources for materials (e.g. the bicycles), and furnishing detailed operating or employee manuals, all point to a franchise relationship.

Given that Colorado doesn’t regulate or require registration of franchises, a business seeking to franchise in Colorado need only comply with the FTC disclosure requirements (see https://www.ftc.gov/system/files/documents/plain-language/bus70-franchise-rule-compliance-guide.pdf).  The FTC requires that a franchisor prepare and provide a detailed 23 point disclosure document covering very particular business information, including financial statements (which eventually will need to be audited and GAAP compliant).  This process can be tedious and time consuming, and we recommend an attorney involved in this process, as a failure to properly comply with the FTC rules can result in potentially serious consequences.

There are considerable advantages to a franchise.  The franchisee is able to take advantage of a proven business model, so as not to have to deal with costs, headache, and stress of a startup.  The franchisor maintains a considerable degree of control over the operations and processes used by the franchisee, which ensures the franchisee does not do anything to dilute or hurt the brand.  The franchisor also helps with things like branding and marketing which supports franchisee. The franchiser also typically ensures that branches do not cannibalize other franchisee’s revenues.  On the flip side, to create disclosure documents is a time consuming and sometimes expensive endeavor and must be disclosed to the potential franchisor before you can enter into the actual franchise agreement.

License Agreements:

Instead of entering into a full fledge franchise arrangement, an alternative option is a license agreement. Under a licensing model, a business licenses to other businesses the right to use intellectual property (IP), brand, design or business programs. These licenses are usually non-exclusive, which means they can be sold to multiple competing companies serving the same market. In this arrangement, the licensing entity may exercise control over how its IP is used but does not control the business operations of the licensee.

License agreements do not carry the same level of regulation as a franchise and thus are easier to set up on the front end.  However, the licensor can only exercise control over its IP (which is actually necessary so that the licensor does not lose its right to the IP), but cannot exercise control over the operation of the business.

While a license agreement may seem more appealing initially, there are a lot of opportunities to accidentally create a franchise.  It is a thin line between exercising control over IP and exercising control over the business.   And if your business crosses that line, and meets the definition of a franchise, even if you don’t call it that, you can face considerable repercussions, including, but not limited to rescission of the agreement, refund of fees, payment of damages, and FTC fines up to $11,000/violation.  Furthermore, being party to non-compliant franchise agreements could have a negative impact on a potential investor or acquiror’s value of the business.

Conclusion

Ultimately, deciding whether to license or franchise your business comes down to your business objectives.  The biggest decision our clients in the health and wellness industry face is how much control they want to exercise over the entity and how that control impacts their own business model.  Additionally, sometimes finding ways to avoid a franchise can ultimately be more costly and expensive and run a higher risk than just buckling down and creating quality disclosure documents.  If you are considering what option is best for you, we recommend you think about your objectives, what model works best for your business, and talk to an attorney so you can make an informed decisions on how to move forward with expanding your business.

 

About Sarah April

Sarah knew she wanted to return to her roots to practice law and start a family. She began her career as a judicial clerk and then a commercial litigator at large firms in the Denver area. She transitioned to a transactional based practice as in-house counsel at a Fortune 500 company, where her practice focused on commercial contracts, real estate transactions, and providing practical legal counsel to her clients.

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