Franchising

Franchising is the practice of licensing a philosophy of business—and its associated brand names—by a franchisor to a franchisee, in exchange for a share in sales and a franchise royalty fee. Chain stores and chain restaurants are the franchises best known to the public, and McDonald's is the most successful franchise network in the world. In the United States, the rise of franchises paralleled the growth of the interstate highway system and the sense of America as a nationwide culture rather than a conglomeration of regional cultures. Though not uniquely American, franchising is a distinctly American practice, at once appealing to the small business owner and representing the success of the national or international corporation.

United States

In the United States, franchising is governed by both state and federal laws. The Federal Trade Commission requires that franchisors provide a Franchise Disclosure Document (FDD) to potential franchisees, at least 14 days before the franchisee signs a contract. The FDD replaces the Uniform Franchise Offering Circular, a similar document that was required until the FTC revised its franchising-related regulations; the new regulations went into effect in July of 2008. The FDD consists of 20 items, in addition to the franchisor's financial statements, the franchise contract, and a receipt; no government agency audits a franchisor's FDD to ensure its accuracy, and a potential franchisee is expected to perform due diligence in doing so, but a franchisor misrepresenting itself is certainly liable to fraud charges.

The 20 items of the FDD are as follows:

• 1.
  The franchisor and any parents, predecessors, or affiliates.
• 2.
  Business experience. In this section, the directors, trustees, general partners, and officers of the franchisor are listed, along with any previous employment in the past five years.
• 3.
  Litigation. This section discloses any pending litigation against the parties in (1), any litigation from the previous fiscal year, and any convictions, nolo contendere pleas, or civil suit liabilities from the previous ten years.
• 4.
  Bankruptcy. Discloses whether the franchisor has filed for bankruptcy in the previous 10 years.
• 5.
  Initial fees.
• 6.
  Other fees.
• 7.
  Estimated initial investment. This includes not simply the fees paid to the franchisor, but the expenses the franchisor anticipates the franchisee will need to make, such as purchasing or leasing real estate and equipment, training employees, and purchasing inventory. One of the benefits of becoming a franchisee is that you are pursuing a business model that has been successfully pursued before, and can learn from your fellow franchisees' experience; the information disclosed in item (7) ideally reflects that collective wisdom.
• 8.
  Restrictions on sources of products and services. Some franchises require that the franchisee purchase some or all of its inventory from the franchisor, which provides the franchisor with additional revenue streams; in some cases this is true even when the inventory provided by the franchisor is not distinctly different from that which [Page 712]the franchisee could purchase elsewhere (such as Heinz ketchup for a fast food franchise).
• 9.
  Franchisee's obligations. Types of obligation can include site selection and acquisition, pre-opening purchases, site development, employee training, opening, fees, standards/policies compliance, trademarks and proprietary information, product restrictions, warranties and customer service, territorial development, ongoing purchases, maintenance, insurance, advertising, indemnification, management and staffing, records and reports, inspections, transfer, renewal, post-termination obligations, non-competition convenants, and dispute resolution. The combination of post-termination and non-competition obligations are especially important to a potential franchisee, because a franchise contract is typically long term—five and 10 year contracts are common—with a penalty for early termination. A franchisee unhappy with his franchise may find that his only alternative is not simply a new business but a new industry.
• 10.
  Financing.
• 11.
  Franchisor's assistance, advertising, computer systems, and training. The complement to item (9), this section discloses the extent of the franchisor's participation.
• 12.
  Territory. Franchisees don't generally want to compete directly with fellow franchisees of the same franchise. This section discloses whether the franchise agreement grants exclusive territory, and other items related to the issue of territory.
• 13.
  Trademarks.
• 14.
  Patents, copyrights, and any proprietary information.
• 15.
  Obligation to participate in the actual operation of the franchise business. Some franchisor's require that if the franchisee is an individual, he must be on-premises for the operation of the franchise business; others let him hire a supervisor to run the business, as is common in franchises in which franchisees may own multiple locations. When supervisors are an option, there may be optional or mandatory training programs offered by the franchisor. The supervisor may also be bound by restrictions similar to those of the franchisee—such as non-competition or maintaining the integrity of trade secrets.
• 16.
  Restrictions on what the franchisee may sell. Franchisors generally want to preserve their brand identity, which may lead them to preclude a franchisee from selling anything not on a specific list of options. Or there may be some binding agreement with a third party, such as a fast food franchise's contract with Coca-Cola or PepsiCo to provide only the soft drinks from that company and not from its competitor.
• 17.
  Renewal, termination, transfer, and dispute resolution. This section lays out the franchise relationship—not only the length of the term of contract, but provisions for termination by the franchisee or franchisor, provisions for transfer of the franchise to another franchisee, provisions for death or disability, and an agreement pertaining to methods of dispute resolution should the need arise.
• 18.
  Public figures. Discloses any information about public figures' involvement with the franchise.
• 19.
  Financial performance representations.
• 20.
  Outlets and franchisee information.

The FDD offers as complete a picture as possible of the franchising experience, much like the prospectus given to potential investors in a new business. Although the FTC requires the FDD, there are no federal filing requirements; often, state laws will require franchisors to file or register at the state level, and in the 21st century there is an increasing likelihood of municipalities passing ordinances restricting franchise businesses, out of the fear that Big Business will arrive to displace mom-and-pop shops.

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