Should the Fractional Franchise Exemption be Viewed as a Pathway to Starting a Traditional Franchise?
It is certainly common for business owners who are considering expansion and the establishment of a franchise system to consider and evaluate a less "regulated" pathway toward franchise development. One option that many consider (an option that I strongly advise against and one that 99% of the time is not the right course of action) is licensing. Another option or "path" that many consider – a path down the franchising road – is one relying on the "fractional franchise exemption". As will be discussed below, the fractional franchise exemption is a limited exemption that is not designed for start-up franchisors and, as such, not something that I would recommend.
So, lets discuss some basics about the fractional franchise exemption:
- A LIMITED EXEMPTION – The fractional franchise exemption, under Federal Law is a limited exemption to the FDD disclosure mandates. That is, if the fractional franchise exemption applies, the franchisor is not required to prepare, disclosure or register its FDD. The fractional franchise exemption is designed to reduce disclosure obligations and burdens when dealing with sophisticated franchisees with industry experience and an existing business within the same industry as the franchise offering.
- REQUIREMENTS FOR A FRACTIONAL FRANCHISE – To qualify under the federal fractional franchise exemption: (a) The prospective franchisee must have more than two (2) years experience in the same type of business as the franchised business; and (b) the franchisor and franchisee must have a reasonable basis to anticipate that the franchisees sales (from the activity of the franchised business0 will not exceed twenty (20%) percent of the franchisees total dollar volume in sales for the first year.
- CAUTION: STATE RISK – Caution must be applied when evaluating the fractional franchise exemption because – separate and apart from the federal law – certain states, including Hawaii and Washington do not recognize the fractional franchise exemption. Also, certain states, including New York and California, define fractional franchises differently. Also, fractional franchisors are nevertheless also required to file annual registration exemption filings.
- CAUTION: DUE DILIGENCE REQUIRED – Prior to proceeding with a fractional franchise exemption, due diligence is required. Evaluation of the prospective franchisees current business and sales will be required. Also, you must evaluate and discuss with your franchise lawyer the impact of state specific franchise laws applicate to the franchisor's place of business, the franchisor's state of incorporation, the state wherein franchise negotiations occurred, the state where the franchisee resides and the state where the franchised business will be located.
Fractional franchising is designed to assist a sophisticated franchisor and franchisee with the role out of supplemental services or products. It is not a viable pathway to establishing a traditional franchise.