FRANCHISE LAW WHAT THE GENERAL PRACTITIONER NEEDS TO KNOW

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2 About the Authors About the Author, Carl Khalil, Esq.: Carl Khalil is a Partner in the Law Offices of Carl Khalil and Sada Sheldon, PLC. He has 17 years of franchise law experience and previously worked as Corporate Counsel for Jackson Hewitt and Liberty Tax Service. During his tenure at Liberty Tax Service, it grew from 35 offices and zero Area Developers to offices and 100+ Area Developers, with over $200M in franchise fees earned. He may be contacted at carl@khalilsheldon.com and his firm s website is located at. About the Author, Sada Sheldon, Esq.: Sada Sheldon is a Partner of Carl Khalil & Sada Sheldon, PLC in Virginia Beach, Virginia, a nationwide franchise and trademark practice. She is admitted to the State Bar of both California and Virginia. She is a member of the ABA Forum on Franchising. Previously, she worked as an in-house attorney for Liberty Tax Service, which grew to over 4000 offices in its first fifteen years of operation. She can be reached at sada@khalilsheldon.com and her firm website is at. 2

3 What is a franchise? The use of another s trademark in the operation of a business; Where the franchisor has substantial control over or provides significant assistance in the franchisee s methods of operation; and The franchisee makes a required payment to the franchisor. 16 CFR 436.1(h). Specifically exempted from the federal definition of a franchise is a business concept where the required payment from the start of the business relation going forward six months is less than $ CFR 436.8(a) Most State s law have a similar definition, but some are different. For example, New York's definition only requires element three, plus either element one or two from the above definition. History of Franchise Laws in the United States 1950 s and 1960 s- Growth and legal claims The 1950 s and 1960 s saw the advent and growth of the franchise business format in the United States. As the concept grew, so did claims of fraud and deception in the selling process and unfair treatment by franchisors against franchisees California In 1971, California passed the first franchise laws in the United States requiring franchisors to register their franchise systems with the State of California and provide a franchise disclosure document to prospective franchisees before a franchisee could purchase a franchise FTC Franchise Rule The FTC passed the FTC Franchise Rule requiring a Disclosure Document containing 23 items about the franchisor and a 10-business day holding period by a prospective franchisee before they could purchase a franchise FTC issues an updated Franchise Rule In 2007, the FTC issued an updated Franchise Rule which largely tracked the original Franchise Rule, but had certain updated requirements, again requiring the disclosure of 23 items in a Franchise Disclosure Document and this time carrying a 14-calendar day hold before a prospective franchisee can enter into a binding contract or make a payment to a franchisor. 16 CFR et seq. 3

4 The 23 Items Required in the Franchise Disclosure Document are: 1. The Franchisor and any Parents, Predecessors and Affiliates 2. Business Experience 3. Litigation 4. Bankruptcy 5. Initial Fees 6. Other Fees 7. Estimated Initial Investment 8. Restrictions on Sources of Products and Services 9. Franchisee s Obligations 10. Financing 11. Franchisor s Assistance, Advertising, Computer Systems and Training 12. Territory 13. Trademarks 14. Patents, Copyrights and Proprietary Information 15. Obligation to Participate in the Actual Operation of the Franchise Business 16. Restrictions on What the Franchisee May Sell 17. Renewal, Termination, Transfer and Dispute Resolution 18. Public Figures 19. Financial Performance Representations 20. Outlets and Franchisee Information 21. Financial Statements 22. Contracts 4

5 23. Receipt State Franchise Laws- Registration States- A franchisor must file the FDD with the state to be able to sell franchises in the state. Examiners review the FDD to varying levels and can issue comments to require changes. See Appendix A for the 27 non-registration states, the 13 states with franchise registration laws, the 6 states with abbreviated filing laws, and the 5 trademark states through which ownership and doing business under a federal trademark exempts a franchise from business opportunity laws. Relationship/Termination Laws 20 states also have laws that govern franchise registration/filing and relationship laws. Generally, relationship/termination laws require fair dealing with the franchisee and required good cause and a certain notice period (e.g., 30 or 60 days) be given before termination of a franchise. (Arkansas Code et seq., California Bus. & Prof. Code et seq., Connecticut Gen. Stat e et seq., Delaware Code tit et seq,, Hawaii Stat. 482E-1 et seq., 815 Illinois Stat. 705/18 et seq., Indiana Code et seq., Iowa Code 523H.1 et seq., Louisiana Stat. tit. 23, 921(E) and tit. 12, 1042, Michigan Laws et seq., Minnesota Stat. 80C.14 and , Mississippi Code et seq., Missouri Stat et seq., Nebraska Stat et seq., New Jersey Stat. 56:10-1 et seq., Rhode Island Gen. Laws et seq., Virginia Code , Washington Code et seq., Wisconsin Stat et seq.). 5

6 The Three Most Likely Client Scenarios I. SCENARIO ONE: A client wants to purchase a franchise- 1. There are, of course, basic business considerations: a. Does the client have knowledge about the industry from his or her own experiences? b. Sufficient Capital? 2. Franchise specific considerations: a. Did the franchisor comply with the law? i. Did the Franchisor provide a Franchise Disclosure Document? ii. Did the Franchisor register with the state? iii. Did the Franchisor give 14 Days to review the FDD before signing agreement or requiring payment? b. What are the Franchisee s risk factors in the Franchise Disclosure Document? i. Costs and fees [FDD Items 6 and 7- Appendix B] ii. Franchisee s Duties [Item 9] iii. Franchisor s Duties [Item 11 ] iv. Territory Protections [FDD Item 12] v. Renewal Rights [FDD Item 17] vi. Legal Waivers (Arbitration, Forum Selection, Jury Waiver) [FDD Item 17] vii. Non-compete [FDD Item 17] viii. Advertising fund [FDD Item 11] ix. Franchisee Organization [FDD Item 20] c. Due Diligence: i. Evaluate Financial Performance Representation [FDD Item 19. See Appendix C for sample negative Financial Performance Representation] ii. Analyze Franchisee Turn-Over [FDD Item 20- see Appendix D] iii. Contact Franchisees who have been terminated, cancelled, not renewed, or otherwise ceased to do business as a franchisee [FDD Item 20 Exhibit] iv. Contact current Franchisees [FDD Item 20 Exhibit] v. Evaluate the Franchisor s Financial Strength [FDD Item 21] 6

7 3. Single unit versus multi-unit ownership. a. Higher capital needs and risk in multi-unit ownership b. More of a managerial role over staff in a multi-unit format c. More diversity of risk with several outlets 4. Area Developer or Master Franchisee versus unit franchise owner. a. Amount of initial investment b. Would client rather sell and support unit owners or deliver the ultimate product or services of the franchisor? c. Ultimate goal- Area Developer often looks to develop seasoned unit business owners, resulting in a reduction of selling and support function and a long term income stream more akin to an annuity. d. The #1 consideration for an Area Developer is- will the franchises sell and be viable. e. The #2 consideration for an Area Developer is- what happens if the Area Developer does not meet Minimum Sales Requirements II. SCENARIO TWO- A Business Client Wants to Franchise their Business 1. Franchise Considerations a. Profitable b. Will it sell c. Credibility of the management team d. Support System e. Personnel- Operations, Marketing, Sales, Accounting and Legal i. Operations Manual (Item 11 of FDD) ii. Training Program (Item 11 of FDD) f. Sufficient Capital i. Financial Statements required for FDD ii. Regulators may require Addendum III. SCENARIO THREE- A Franchisor Wants to Start an Area Developer or Master Franchise Program 1. Unit franchise v. Area Developer a. Unit franchise refers to an individual operator b. Area Developer refers to someone who has a large territory of unit franchises and attempts to sell those territories and offer some support to the unit franchise owners c. See Appendix E for an article published in the IFA s July 2012 Franchising World magazine entitled, Benefits and Challenges of Implementing an Area Developer Program. 7

8 2. Investment Level v. Gain a. Area Developers have higher capital level, but also a higher potential return b. Area Developer are customarily paid a portion of the initial franchise fee and royalties paid by the unit franchise owner 8

9 Appendix A Non-Registration States Full Registration States One-time Filing Alabama California Kentucky Alaska Hawaii Nebraska Arizona Illinois Texas Colorado Indiana Delaware Maryland One-time w/federal Trademark District of Columbia Minnesota Connecticut Idaho North Dakota Iowa New York Annual Filing States Kansas Rhode Island Michigan Massachusetts South Dakota Utah Mississippi Virginia Missouri Washington Business Opportunity Exemptions Montana Wisconsin w/ Federal Trademark Nevada Florida New Hampshire Georgia New Jersey Maine New Mexico North Carolina Ohio South Carolina Oklahoma Oregon Pennsylvania Tennessee Vermont West Virginia 9

10 Appendix B ITEM 6 OTHER FEES* Fee Amount Due Date Remarks Royalties $4000/mo. 5 th day of each month as to royalties owed for prior month See Franchise Agreement Advertising fees $600/mo. 5 th day of each month as to advertising fees owed for prior month Renewal Fee $25,000 When you enter into a new franchise agreement upon the expiration of the term of your original franchise agreement Interest 6% or the maximum permitted by law Owed on past due amounts Transfer fee $5,000 At the time you transfer the franchise Sales or gross receipts tax If required by the state or locality in which your franchise is located, the initial franchise fee, royalties, and advertising fees will be subject to sales or gross receipts tax. See Franchise Agreement See Franchise Agreement See Franchise Agreement See Franchise Agreement 5 th day of the month as See Franchise Agreement to monies owed for the prior month *Except where otherwise specified, we impose all the fees in this table, you pay them to us, and we do not refund them. 10

11 ITEM 7 ESTIMATED INITIAL INVESTMENT* YOUR ESTIMATED INITIAL INVESTMENT Estimated Amount Method of Payment When Due Initial Franchise Fee $30,000 (Note 1) Check Upon entering into franchise agreement To Whom Payment is to be Made Opening Advertising $500-$9,000 Check/Charge As incurred Suppliers Initial Training Start-up Supplies/inventory $0-$5,000 (Note 2) $2,000-$3,000 (Note 3) Equipment and Furniture $1,000-$5,000 (Note 4) Rent $0-$5,000 (Note 5) Payroll $3,000-$6,000 (Note 6) Check/Charge As arranged Third-party vendors Us Credit card As incurred Suppliers Check/Charge Before opening Third-party vendors Check Monthly Landlord Check Bi-weekly Employees Insurance $500-$1,000 Check Bi-weekly Insurance agent Additional Funds-3 months $3,000-$15,000 (Note 7) TOTAL $40,000-$79,000 (Notes 8 and 9) Check or credit card As incurred Third party vendors *The initial franchise fee is refundable upon the conditions described in Item 5 above. Otherwise, none of the expenses described in this chart are refundable. Note 1: The initial franchise fee for a new franchise is $5,000. Please see Item 5 for a description of the separate pricing applied to existing franchises. Note 2: Normally, we will offer initial training via the internet and you will incur no expense to attend. However, we reserve the right to occasionally offer initial training live. If you attend in person, travel and living expenses will vary significantly depending upon whether you live in the local area or whether you must drive a distance, fly, rent a car, or incur lodging expenses. The cost of air travel varies considerably upon time of year, city of origination, how far in advance you purchase your ticket, and other factors. 11

12 Note 3: Your primary cost for start-up supplies and inventory will be to purchase office supplies. Note 4: Unless you have these items already, you will need a computer, a printer, internet service, fax service, a telephone, desk, chair, and file cabinet along with standard office supplies to operate the franchise. Further, you must maintain a dedicated telephone number for use as a franchisee. Note 5: We recommend that you operate your franchise from home and not incur any rent expense. However, if you lease an office and make improvements to the property, you will incur additional expense. Note 6: Wage rates vary by market areas. Note 7: Additional funds are to pay government fees, miscellaneous supplies, utility costs, internet access, professional expenses, and other items. Note 8: Does not include royalties or advertising fees that you also pay to us. See Item 6, above, for a description of these fees. Note 9: These figures are estimates of your initial expenses covering the first three months of your operation. We cannot guarantee that you will not have additional expenses starting the business. Do not construe the estimates as a break-even point. Your costs will depend on: how well you follow our methods and procedures; your management skills; experience and business acumen; local economic conditions; the local market for our services; the prevailing wage rate; competition; and the sales level reached during the initial period. You should review these figures carefully with a business advisor before making any decision to purchase the franchise. 12

13 Appendix C- Sample Item 19- Negative Financial Performance Representation ITEM 19 FINANCIAL PERFORMANCE REPRESENTATIONS The FTC s Franchise Rule permits a franchisor to provide information about the actual or potential financial performance of its franchised and/or franchisor-owned outlets, if there is a reasonable basis for the information, and if the information is included in the disclosure document. Financial performance information that differs from that included in Item 19 may be given only if: (1) a franchisor provides the actual records of an existing outlet you are considering buying; or (2) a franchisor supplements the information provided in this Item 19, for example, by providing information about possible performance at a particular location or under particular circumstances. We do not make any representation about a franchisee s future financial performance or the past financial performance of company-owned or franchised outlets. We also do not authorize our employees or representatives to make any such representations either orally or in writing. If you are purchasing an existing outlet, however, we may provide you with the actual records of that outlet. If you receive any other financial performance information or projections of your future income, you should report it to the franchisor s management by contacting [name of responsible person at franchisor, address, and phone number], the Federal Trade Commission, and the appropriate state regulatory agencies. 13

14 Appendix D- Sample Item 20 (taken from a start up franchisor) ITEM 20 OUTLETS AND FRANCHISEE INFORMATION Table No. 1 Column 1 Outlet Type Column 2 Year Column 3 Outlets at the Start of the Year Column 4 Outlets at the End of the Year Column 5 Net Change Franchised Company-Owned Total Outlets Systemwide Outlet Summary For Fiscal Years Ending December 31, 2009 to December 30, 2011 State Table No. 2 Transfers of Outlets From Franchisees to New Owners (Other than the Franchisor) For Years Ending December 31, 2009 to December 31, 2011 Column 1 Year Column 2 All States Total Column 3 Number of Transfers 14

15 Column 1 Table No. 3 Status of Franchised Outlets For Fiscal Years Ending December 31, 2009 to December 31, 2011* Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 Column 9 State Year Outlets at Start of Year Outlets Opened Terminations Non- Renewals Reacquired By Franchisor Ceased Operations-Other Reasons Franchised Stores Operating at Year End All States Total *If multiple events occurred affecting an outlet, this table shows the event that occurred last in time. Table No. 4 Column 1 Status of Company-Owned Outlets For Fiscal Years Ending December 31, 2009 to December 30, 2011 Column 2 Column 3 Column 4 Column 5 Column 6 Column 7 Column 8 State Year Outlets at Start of Year Outlets Opened Outlets Reacquired from Franchisees Outlets Closed Outlets Sold to Franchisees Outlets at End of the Year All States All States All States

16 State Table No. 5 Projected Openings as of June 30, 2012 Franchise Agreements Signed But Outlet Not Open Projected New Franchised Outlets in the Next Fiscal Year Alabama Alaska Arizona Arkansas California Colorado Connecticut Delaware D. of Columbia Florida Georgia Hawaii Idaho Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Projected New Company- Owned Outlets in the Current Fiscal Year 16

17 Maryland Massachusetts Michigan Minnesota Mississippi Missouri Montana Nebraska Nevada New Hampshire New Jersey New Mexico New York North Carolina North Dakota Ohio Oklahoma Oregon Pennsylvania Rhode Island South Carolina South Dakota Tennessee Texas Utah