Starting a business as part of a franchise is a complicated process with its own set of legal considerations. These include understanding both the potential benefits, and -- more importantly -- the likely costs of a franchise relationship.
What Is a Franchise?
According to the Federal Trade Commission (FTC), which has the authority to regulate franchises, there are two types of business arrangements that may constitute a franchise:
- A franchisor licenses you, the franchisee, to operate your business under a format it has established; familiar examples include fast food restaurants, coffee shops, motel chains, auto repair shops, and copy shops. This arrangement is sometimes known as a “package franchise” or “business format franchising.”
- You, as franchisee, sell products made or controlled by the franchisor and which carry the franchisor’s trademark, trade name, or similar proprietary symbol; familiar examples are gas stations and car dealerships. This arrangement is often called a “product franchise.”
Under the FTC’s definition, generally a franchise exists if:
- you have the right to distribute products bearing the franchisor’s trademark, trade name, logo, or similar proprietary symbol
- the franchisor provides you with significant assistance in operating your business, and
- you pay a minimum fee of $500 to the franchisor during the first six months you’re in business.
In practice, the last of these conditions, the $500 minimum fee, is a non-issue, as it usually costs far more money to buy into a franchise.
As franchisors will often be quick to tell you, operating a business as a franchisee does provide certain potential benefits. These include being given a preexisting business plan, getting certain help as needed when running your business, and benefiting from group marketing.
In exchange for the benefits of being part of a franchise, there are significant costs. Generally speaking, you will have to operate under far more restrictions than if you opened your own independent business. More specifically, you will be subject to a franchise contract which will favor the franchisor, and which likely will give the franchisor rights to:
- decide where other competing franchisees will be located
- block sale of your franchise to a particular prospective buyer
- choose the geographic location where any disputes will be resolved, and
- require you to buy all of your goods and services from the franchisor.
Along with the restrictions contained in the franchise contract, you should keep in mind the financial costs of a franchise. Apart from a large initial franchise fee, expect to be required to pay the franchisor:
- a percentage of your profits—often a substantial percentage—as a royalty
- an above-market cost for equipment, goods, and supplies purchased from the franchisor
- finance charges on those same purchases
- training fees for you and your employees, and
- contributions to a fund for group advertising.
Elsewhere on this website you can find a detailed list of reasons why the costs of buying a franchise, both financial and legal, may well outweigh the possible benefits; see Nolo's article, Want to Buy a Franchise? Ten Reasons Not to Do It.
The Franchise Disclosure Document
The FTC requires franchise sellers to make a Franchise Disclosure Document available to prospective franchisees. By law, this document should have sections covering roughly two dozen critical issues, such as:
- how long the franchisor has been in business
- likely competition
- any special laws that pertain to the business, such as license or permit requirements
- the identities of the executives of the franchise system and their experience
- litigation history
- initial and ongoing costs
- restrictions on the franchisee
The franchisor is required to make the Franchise Disclosure Document available to you at least 14 days before you sign any franchise contract, or at your first face-to-face meeting with the franchisor.
You should read through the entire document and be aggressive about asking questions. Keep in mind that if something in the document appears too good to be true, it probably is.
The Franchise Agreement
If you decide to buy a franchise, you will need to sign off on a lengthy franchise agreement. You should carefully read the entire agreement. Among key areas of potential concern are:
- the fees for the initial buy-in, for advertising, and to be paid as royalties
- any required sales quotas
- the term of the agreement (how many years does the agreement cover)
- rules for assigning the business to someone else
- rules for terminating the agreement
- how competition with other franchisees is handled
In light of the risks and costs involved, you should seriously consider having a lawyer assist you in this reviewing this contract.
A detailed overview of franchises is contained in Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo). There is also excellent, detailed information on franchising on various webpages within the FTC website.