New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

As franchise counsel I am a strong proponent of “disclosure” – the more of it, the better. Quality disclosures contained in your FDD serve a critical role in mitigating future litigation risk and expense. So, when it comes to FDD disclosure exemptions, we typically proceed with extreme caution. Nevertheless, in the appropriate circumstance, franchisors should consider or at least be aware of potential tools available to them when it comes to available exemptions to the disclosure mandates of the Federal Franchise Rule.

One "grouping" of potential FDD disclosure exemptions relate to transactions involving sophisticated investors, insiders and large franchise investments. These "potential" exemptions, should be evaluated and considered under the following circumstances:

• "Large Franchise Investment". The "Large Franchise Investment" exemption applies to franchise transactions involving a franchisee initial investment  of at least $1 million exclusive of unimproved land and franchisor (including affiliates) financing.  Application of this exemption is dependent upon an analysis of the transaction, satisfaction of the dollar volume criteria and the requirement that the franchisee sign a disclosure acknowledging that the franchise sale was exempt from the Franchise Rule.

• "Large Franchisee Entities". The "Large Franchisee Exemption" applies to franchise sales transactions involving prospective franchisees that are corporate entities, possess a minimum net worth of $5 million and possess no less that 5 years of prior business experience.  By combining both net worth and prior business experience requirements, this exemption is intentionally limited corporate franchisees that possess a predicate level of sophistication.

• "Insiders of the Franchisor". The "Insider Exemption" applies to franchise sales to the owners, directors, and managers of the predecessor entity of the franchisor.  That is, this exemption applies to the officers, owners and managers of a business before it became a franchisor.  These prospective franchisees must possess at least two years experience in the franchisors business and, at the time of becoming a franchisee, have maintained their insider status.These "sophisticated investor" exemptions are an important tool for franchisors to consider and beware of One such exemption relates to “Large Franchisees”.

The foregoing "sophisticated investor" exemptions constitute a critical tool for franchisors to be aware of when planning certain non-traditional franchise sales transactions and when evaluating potential litigation strategy.  Application of the foregoing exemptions requires a fact specific analysis of factors and legal criteria - including applicable rules and regulations associated with each exemption) .  The key, however, is to be aware of this potential "tool". 

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Trademarks comprise a fundamental component to all franchise systems.  So much so, that FDD "Item 13" is exclusively devoted to disclosures respecting the existence, registration, maintenance and defense of a franchisor's trademarks.  Franchisors that are serious about their "systems" must also also be serious about the protection of their trademarks.  

So, what are some of the factors and steps that serious franchisors (both start-up and established) understand about their trademarks?  Here are a few:

• Trademark Registration is Critical.  This point relates to start-up franchisors and comes down to a basic point: "don't sell a franchise until you register your primary trademarks with the United States Patent and Trademark Office ("USPTO")". Selling your first franchise without first securing USPTO registration will invite unnecessary "litigation risk" should your registration application be rejected or your mark challenged.

• USPTO Registration does Not Insure a Strong Trademark. The "legal value", strength and enforceability of your trademark will be influenced by a number of factors irrespective of your registration status.  Although USPTO registration is an important factor, by itself, it may not be enough.  Additional factors that you must consider and evaluate relate to the "legitimate" use of similar marks by third parties and whether or not your mark is comprised of "descriptive" terms.  Generally, registered trademarks that are comprised of descriptive terms  (i.e., such as "bakery", "store", "spa",   "rapid", and other terms that "describe" your goods or services)  will be afforded less protection than trademarks that are comprised of terms that are "arbitrary" (i.e., words that have no relation to the goods or services of your business).

• Periodic Evaluate your Marks and Registrations.  As systems and business develops, typically, so do trademarks. Over time, franchisors modify existing marks, develop new marks, expand usage of a particular mark (i.e. to a new business category) and, in certain instances, discontinue the use of a mark.   It is critical to insure that your trademark registrations remain current and reflect your "current" usage of your marks.  This "evaluation process" need not be complex nor expensive an open line of communication between management and franchise counsel.  

As your franchise develops and expands the value of your system, brand and owner equity will become more and more dependent on the strength and enforceability of your intellectual property assets.  Trademarks are a big part of your "IP" asset structure and they require serious attention. Strong trademarks are a big part of strong franchise systems.

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Franchise systems have various life cycles and require time to mature and develop the necessary systems and infrastructure to expand. For franchisors, many times, the biggest strain on their franchise system relates to and is traced back to an overambitious rate of expansion. While there are many considerations, motivations and good reasons why your should be aggressive about unit growth, you must nevertheless proceed with extreme caution and evaluate whether or not your systems are capable of supporting your planned levels of expansion. Some factors to consider, include:

• The current location of your franchisees and whether or not expansion should be reserved and limited to designated geographic locations;

• The capacity and capability of your supply chain and whether or not you have lined up the necessary vendors to supply your franchisees and maintain the necessary levels of quality control;

• The capacity of your management and marketing team and your ability to maintain consistent levels of quality control, franchisee development and overall system development;

• Whether or not your internal in-house legal counsel or outside franchise attorneys have implemented clear quality control measures respecting the delivery of your FDD, the management of your franchise agreements and the constant assessment and protection of your trademarks and intellectual property.

Great franchise systems do not need to be large – they just need a coherent plan and sustainable plan for system growth and a management team committed to quality over quantity.

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Inherent to every franchise system is the license of intellectual property rights that, for good reason, has been (and should remain) focused on the trademarks and trade dress associated with the franchise system. While trademarks, logos, and trade dress are critically important intellectual property ("IP") assets, an additional (and possibly overlooked) IP asset may exist in the form of "design patents" issued by the United States Patent and Trademark Office. Design patents relate to the "novelty" and "ornamental appearance" of a product and may add a supplemental layer of IP protection for franchisors. When evaluating your IP portfolio and whether or not you are maximizing the legal protection of your IP assets, consider the following:

• Design patents relate to the protection of the "ornamental design" of a product and may include the "surface" design and appearance of products and equipment.

• "Utility patents" protects the way a product is used and works, while "design patents" protects the way a product looks;

• The elements of a "design patent" must be limited to the "ornamental appearance" of a product (i.e., how the product looks) and not thef unctional aspects of the product (i.e., how the product works); and

• Examples of design patents include, the layout of buttons on the "Google" search page, the original Coca-Cola bottle, the exterior surface design of custard vending machines and the ornamental appearance of numerous other products and equipment - many of which may appear quite ordinary.

When managing the legal protections to be afforded to your intellectual property, it is critical to recognize that design patents could very well play an important role in your IP strategy. By branding and acquiring design patents in the ornamental designs associated with the equipment, displays and products offered by your franchise system, you will be adding a valuable layer of IP protection. One valuable strategy to consider is to evaluate the overall trade dress associated with your franchise system and determine whether or not design patents maybe applied to certain products, equipment and designs associated with your system. Dont overlook this IP asset.

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Many times, "start-up" franchisors (and, too often, some established franchisors) overlook the necessity of maintaining a thorough operations manual that is both "current and relevant" to the particular franchise system. That is, many times operations manuals are viewed as an "afterthought" or a"generic" obligation to be sourced out to third party vendors.

Much more than a "generic resource", your operations manual must be drafted, updated and maintained as an integrated extension of your franchise agreement and FDD disclosures. Recognizing the critical importance of a properly prepared and integrated operations manual, startup and established franchisors should consider the following:

• Franchise agreements are typically drafted and structured to integrate and obligate franchisees to abide by both current "and future" operational requirements set forth in the operations manual. If the franchise agreement is drafted properly, the operations manual should create "contractual flexability", allowing the franchisor to modify elements of the franchise system through amendments and supplements to the operations manual.

• Your operations manual must serve as a thorough blueprint to provide franchisees with detailed "how to" information respecting each and every administrative and operational element of the franchise system.  

Examples of "administrative obligations" include (a) the franchisees royalty and financial reporting obligations, (b) franchisees financial record retention obligations, and (c) system requirements for point of sale systems. 

Examples of "operational obligations" include (a) franchisees obligations respecting the management of the franchise business, (b) requirements for management and control of inventory and supplies, (c) building and construction plans and specifications, (d) training programs and obligations, and (e) operational elements respecting the day-today management and operation of the franchised business.

• The preparation of your operations manual cannot be a task that you simply "outsource". While it is prudent to obtain the advice and input of a qualified consultant (including your franchise attorney), the operations manual must directly reflect and embody "your" direct understanding and knowledge about the franchised business. "You" must be the primary contributor and driving force behind the preparation and development of your operations manual.

• Your operations manual must be consistent with your franchise agreement and FDD. Review with your franchise lawyer the content of your operations manual to ensure that there is consistency with your franchise agreement. Ensure that your training programs are extensively identified in the operations manual and properly disclosed.

• Your operations manual should be constantly updated, refined and clarified to reflect the constant and continuous evolution and growth of your franchise system. 

Your operations manual is critically important to the long-term success of your franchise - treat it as such.
 

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For the start-up and established franchisor alike, as your franchise system evolves continuous consideration must be given to your franchise agreement and "the legal rights that you reserve for your franchise system".  That is, basic to every franchise agreement are the "reservation clauses" identifying and  establishing alternative channels of distribution and legal rights  that are not granted, conveyed or licensed to your franchisees.  These reserved rights typically address alternative channels of  distribution and markets that are expressly reserved to the  franchisor.  Examples include internet sales, mail order sales, captive market accounts and licensed products sold through alternative sales channels.

Chances are that your "existing franchise agreement" contains reservation clauses.  However, have you recently reviewed these legal provisions?  Are the reservation clauses contained in your franchise agreement generic, or do they account for your future plans for expansion? When evaluating your franchise agreements and future plans for expansion, discuss with your franchise attorney and staff:

• Potential distribution and sale of private label products;
• Potential expansion and development of alternative franchise systems;
• Licensed distribution and sale of signature products and services through non-franchised outlets; and
• Your current and future plans for internet and/or mail order based sales.

There are other points but they are all based on the fundamental fact that you must be constantly evaluating your franchise agreement to ensure that it matches where your franchise is today and where it may be ten years from now.  Avoid the generic.

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At the New York Franchise Law blog we have been fortunate to receive insightful and instructive comments from our readers.  Many of our readers are franchisors, franchisees and some extremely experienced franchise consultants and professionals.  Basically, our readers have a lot of good information to share.  So, recently my staff had the opportunity to interview and speak with Bob Harper, an existing franchisor.  Mr. Harper, has posted some informative comments on our site and has shared his experiences as a "start-up" franchisor.   Mr. Harper's franchise provides bookkeeping services in the United Kingdom under the "Crunchers" trade name.  In his interview Mr. Harper shares some insights and experiences that prospective franchisors should consider before making the leap from "business owner" to "franchisor".  A portion of Mr. Harper's interview and some of my comments follows: 

Q: What is the Crunchers business all about?

A: Crunchers is a bookkeeping solution provider – we give clients the choice of doing their own books using our software as part of a managed service (where we become the bookkeeping manager) or we do the books for them.  

Q: How did you Get involved in the bookkeeping business? 

A:  My background is a tax accountant, having trained with Price Waterhouse in Windsor UK. After leaving in 1991, I set-up and ran my own accountancy business and from this had the idea to develop my own bookkeeping software because my micro and small clients struggled with the off the shelf [bookkeeping] packages. 

Comment: One interesting point that Mr. Harper brought up in his interview is that his franchise involves the license of certain book keeping software.  Mr. Harper considered expanding his business through a "license structure" only but ultimately decided to proceed with the establishment of a franchise system.  When evaluating a licensing structure as an alternative to franchising there are a number of factors that should be considered, including the fees that will be charged and the degree of control that will be exercised over the franchisees / licensees.

Q: Are your franchisees required to have Prior Experience with Accounting or Bookkeeping?

A: We decided to franchise about two years ago offering 350 territories in the UK. The first franchisees are accountants who have launched Crunchers on the side of their accountancy practice. We also have a few bookkeepers and are now offering the franchise to [individuals without an accounting background].

Comment: This is a critical issue for the start-up franchisor and established franchise systems - that is, what is your criteria and requirements for selecting a qualified franchisee.  Be selective, set clear guidelines as to the types of franchisees that you will approve and reject those that do not meet your select criteria.  Selecting / approving an unqualified franchisee is  costly mistake that creates a number of legal and business issues that will drain the resources of your franchise system.  

Q: What advice would you give to successful business owner about starting a franchise?

A. Running a franchise business is a separate and probably a completely different business to the business they are thinking of franchising. So, treat it as such and make sure you have the right funding, skill set team, systems and resources.

• Look at all other options of expanding so you can justify franchising as the best option because it is not easy.

Comment:  As to this point the advice of  Mr. Harper is extremely instructive for those looking to start a franchise.  Prospective franchisors must recognize that once you "start a franchise" your primary obligation becomes that of a "franchisor" and you are no longer the operator of a business.  Keep in mind that the "franchise business" is very different that the underlying business that you are franchising.  In Mr. Harper's case once he established a franchise system he stopped operating a "bookkeeping business" and became the operator of a franchise system.  Another major point that Mr. Harper mentions is "funding"  when establishing a franchise system, simply preparing and registering your "legal documents" is not enough.  You must possess the necessary capital and resources to establish the systems, products and procedures necessary to support your franchisees and to manage the development and growth of your franchise system. Franchise consultant Joel Libava offers some great pointers and information about this issue (what it takes to establish a franchise) in his article "Do you Really Want to Franchise your Business".

 Thanks to Bob Harper for sharing his experiences with us and, as always, I look forward to hearing from Bob in the future.  If you are a start-up franchisor it would be great to hear about your experiences on these topics.

Disclaimer:  Please note that our reference to a particular franchise should not be viewed as an endorsement of a franchise or a franchise opportunity.  At the New York Franchise Law Blog we do not recommend or solicit the sale of franchise opportunities.

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Short Answer:  Avoid lawsuits.  That is, work on and establish with your legal counsel "legal systems and procedures" that is designed to avoid unnecessary litigation. (Slightly longer answer follows)

While the advice that I am offering here may sound obvious and, possibly, even a little self-serving, it is nevertheless an honest and critical point that far too many franchisors and business owners overlook.  That is, in most (but not all) litigation once your are involved (either as a plaintiff or defendant) the advantages and benefits that may or may not stem from the outcome of the litigation will, many times, be outweighed by:

(a) the legal fees that you will incur,

(b) lost productivity associated with your focus on the lawsuit (as opposed to building your franchise systems), and

(c) the uncertainty that is inherent in all litigation - no matter how strong your case is.  

Faced with the inherent costs in all litigation, the best course of action for both start-up and established franchisors is to establish with your legal counsel open channels of communication focused on cutting-down and mitigating your "litigation exposure".  That is, in addition to the critically important task of managing your regulatory requirements and disclosures as a franchisor, you must discuss and establish with your legal counsel a fair and flexible relationship and system focused on the management and monitoring of your day-to-day legal activities. Some of these activities should include:

(a) The review of vendor agreements,

(b) The establishment of standardized franchisee communications and compliance notices;

(c) The quarterly evaluation and review of your trademarks and the filing of supplemental trademark applications and affidavits;

(d) The establishment and maintenance of a specified and well documented "encroachment policy" respecting the grant of additional franchises;

(e) The establishment of a clear and concise policy respecting the negotiated modification of your franchise agreements;

(f) The maintenance of strategic employment agreements with your key employees that are focused on the implementation "enforceable" restrictive covenants;

While establishing an on-going day-to-day working relationship with your legal counsel may be more expensive than "doing nothing", the value of this planning process will far outweigh the cost associated with unnecessary and avoidable litigation. Once tasks become standardized and well establish, my experience has been than many activities may be incorporated into the tasks of your "in-house" staff and, over time, serve to reduce your long-term legal fees.

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This afternoon in consulting with a client who had recently signed a franchise agreement involving a substantial commitment of capital, I was reminded about the importance of maintaining "realistic" expectations when buying a franchise. When discussing his expectations about his franchise purchase and the business that he will be developing, he was extremely "realistic" as to his expectations and the work ahead of him.  That is: 

(a) He diligently evaluated the "franchise opportunity" that he was investing in and thoroughly understood that, as with many businesses, it would be a number of months and possibly years (hopefully not) before he achieved a level of profitability and acceptable return on his franchise investment; and

(b) He understood that the success of his franchise rested on the hard work, marketing and business development that he (and his family) would bring to this new business. Significantly, his approach is not one of "lets wait and see" what business comes through the door.

The most important lesson that I was reminded of by my client - a lesson that future franchisees and franchisors may also put to use - is that getting your expectations "right" is critical.  When considering a business opportunity and setting your "expectations", franchisors and franchisees should consider:

• Profitability will Take Some Time -   Profitability is not guaranteed and, depending on your particular franchise opportunity, may take 8 days (unlikely), 8 months or 8 years (hopefully not).  That is, you must plan ahead and account for the extremely realistic fact that you in selling a franchise or purchasing a franchise you must properly communicate and/or understand that reserve capital will be critical.  Evaluate the opportunity thoroughly and ensure that you have developed the correct expectation about the future profitability of your business.

• Franchisors Can't (and Shouldn't) do Everything - Buying a franchise does not mean you just pay money and then sit back and wait for business to "walk through the doors".  You must be actively engaged in the marketing and "development" of your business.  Look to your franchisor as your "partner" and not your "caretaker".  Franchisors, be selective about the franchisees that you approve - look for franchisees that will contribute to the development of your franchise system. 

Get your expectations right.

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Part of the “Franchisor Basics” Series

Under the Federal Franchise Rule franchisors are required to disclose their “Financial Statements” in Item 21 of the Franchise Disclosure Document. All financial statements must be prepared in accordance with Generally Accepted Accounting Principals ("GAAP") and in all but an extremely limited number of situations involving a start-up franchisor, a franchisor’s financial statements must be “audited”.   In the franchise regulations (16 CFR Parts 436 and 437) FTC provides detailed information respecting a franchisor's "Item 21" disclosure requirements, including:

•  Financial statements must be audited by an independent certified public accountant and prepared in accordance with GAAP;

• Financial statements must be prepared in a "tabular" format providing for a comparison between current and prior fiscal years; and 

• Financial statements must include (a) Balance Sheet for the prior two (2) fiscal years and (b) Statement of Operations, Stockholders Equity and Cash Flows for each of the franchisor's prior three (3) fiscal years. 

Other provisions apply for "start-up" franchisors (a topic that will be discussed in future posts) and the disclosure of the financial statements of a franchisor's "affiliates". 

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In an effort to expand the information provided at the New York Franchise Law Blog and, hopefully, the timeliness and value of this information for our readers and subscribers, we will now be featuring a continuing series of succinct fact based articles (in addition to our commentary and reports) focused on the "basics of franchising", comprised of "Franchisor Basics" and "Franchisee Basics".

These articles will serve as a valuable reference tool to our readers and, as always,  it is important that you discuss the specifics of your franchise system, disclosure obligations and franchise decisions with your franchise attorney.

As always, we appreciate and welcome the comments and suggestions that we have been fortunate to receive from our readers. Please let us know if there are any specific franchise topics that you like us to address.  Thanks.

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For the "start-up franchisor" (and even established franchisors) determining the appropriate franchise fee and royalty structure for your franchise system is a critical task that will have long standing implications.  The fee structure that you establish will serve as the primary source of revenue for your franchise system and will represent one of the most significant "expenses and obligations" on the part of your franchisees.  Set the fees to high and you risk franchisee and, ultimately, franchise system failure.  Set the fees too low and you risk "franchise system" failure resulting from your inability (as the franchisor) to properly support, develop and expand your system. 

The process of establishing your franchise fee and royalty structure should not be based on a rigid formula or a formula that simply duplicates the fees charged by your "perceived" competitors. Rather, your franchise fee and royalty structure should reflect the unique characteristics of your business, the sophistication of your existing business systems, the strength of your trademarks and your future obligations to maintain, develop and refine your franchise system and the rights of your franchisees.

When establishing these fees, some of the critical factors/principals that you should be considering, include: 

• The Initial Franchise Fee Should Reflect the Value of Your Existing System(s). In many respects the initial upfront franchise fee that you will charge to your franchisees should reflect the value of the existing "system(s)" that you have already established.  Higher franchise fees are usually predicated on valuable, well established and tested "systems" and intellectual property assets.  In making this assessment, consider:

(a)  The legal strength of your trademarks and their USPTO registration status;

(b)  The strength and recognition of your trademarks and trade dress by consumers in the marketplace;

(c)  The competitive advantage(s) that will be afforded to your franchisees by your "established" business systems, products and services, including unique products and sources of supply.

•  The Initial Franchise Fee Should Reflect Your Initial Training Obligations. The initial training of your franchisees will play a significant factor in the development of your franchise system and the success of your franchisees.   Your initial franchise fee should reflect and give consideration to the initial training obligations that you will be undertaking as you add each franchisee.  Your franchise fee must be sufficient to ensure that you possess the necessary financial resources and systems to properly train your franchisees.

• Your Royalty Structure Should Reflect Your Business and be Geared toward Franchisee Success. The relationship between franchisor and franchisee is one of interdependence.  That is, to be a truly successful franchisor, you need successful franchisees.  When structuring the ongoing royalty obligations of your franchisees, consider:

(a)  Successful franchise systems require successful franchisees, so ensure that the ongoing royalty rate reflects the economics of your individual franchise units and does not inhibit franchisee "profitability";

(b)  Royalties must be sufficient to support and pay the expenses associated with your current and ongoing efforts and obligations to continuously refine, develop, recreate and protect the core components of your franchise system.  As a franchisor you will possess some serious and necessary obligations respecting the continued development and refinement of your franchise system.  this is a serious obligation and your royalty structure must be sufficient to properly fund these activities;

(c) Your royalty structure should reflect your business.  Although the typical or predominant royalty structure is based on a fixed percentage of gross sales, start-up (and even current) franchisors should consider possible alternatives that may  better reflect the "unit economics" of their franchisees.

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For the successful business owner considering the franchised expansion of his or her business one critical question that must be answered is "how do you approach the preparation and development of your franchise agreement."  That is, do you "approach" the preparation and development of your franchise agreement (and franchise disclosure documents) as:

(a) A "legal obstacle" that requires the preparation of "generic" agreements and disclosure documents;

OR

(b) A collaborative process focused on the development of a critical "asset" that uniquely reflects, identifies and protects the components of your business (that is what has made your business successful),  franchise, and  franchise system.  

Why do I ask?  Because your approach will determine the ultimate outcome of this important process.  

Approach "(a)" - the "legal obstacle approach" will typically lead to generic  agreements and disclosure documents that, by all accounts, result in little (if any) value to a developing franchise system.  While this approach may satisfy (or appear to satisfy) your regulatory disclosure requirements they do nothing to advance the development of your "franchise system".  That is, approach "(a)" typically leads to "form over substance" and not much else.  When speaking with start-up franchisors that have followed this approach - an approach that they followed with the best of intentions but based on what may be poor advice - I am typically advised that their franchise agreements simply do not work for their business and franchise system.   

For the start-up franchisor, approach "(b)" is the only true option.  By following this approach your franchise agreement and disclosure documents will serve as core business "assets: that will reflect and protect  the unique and critical components of your business and your newly established franchise system.  

When starting a franchise keep in mind that all agreements are not the same and and that your input will be critical to insuring that your agreements and disclosure documensts reflect the unique nature of your business.  This is no easy task and is not one that is not simply delegated - an indepth working relationship with your franchise lawyer is required.

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Can you expand your business in the State of New Jersey through a "license agreement" without triggering New Jersey's franchise relationship laws?  (This is not a simple question and, unfortunately, the answer involves an evaluation of both "objective" and "subjective" factors.)

Short Answer:  

Yes, however you must discuss and evaluate the substance of  your license agreement, including your degree of control over your "licensees" operations and your economic influence over your "licensees" business.  

Long Answer :

The New Jersey Franchise Practices Act contains extensive prohibitions and restrictions governing (and in many cases modifying) the contractual relationship between franchisors and franchisees within the state.  Under New Jersey law the following criteria give rise to a franchise relationship and the potential imposition of franchise regulation:

1. The existence of a written agreement for a definite or indefinite period;
2. Providing for a license to use a trade name, trademark, service mark or related characteristic is granted; and
3. The existence of a community of interest in the marketing of goods or services at wholesale, retail, by lease, agreement, or otherwise.

With New Jersey's definition of a "franchise" heavily dependent on the existence of a "trademark license", your contemplated "license agreement" may have the unintended consequence of creating a regulated "franchise relationship".  To determine if your (1) written (2) trademark license agreement "crosses the line into franchise territory" you must evaluate the (3) community of interest criteria and determine whether or not your written license agreement "creates a community of interest [between you and your licensee] in the marketing of goods or services..."

This "community of interest" criteria is not defined by the New Jersey statute, involves a subjective determination and has been expansively evaluated by New Jersey courts in favor of finding a franchise relationship. To make this determination the courts look to the relationship between the parties and, among other things, the extent to which the licensee (franchisee) is economically dependent on the licensor (franchisor).  That is, where a licensee invests in a business that is largely dependent on a licensor's trademarks, products and/or services and where the licensor possesses significant influence over the licensees business, a "community of interest" (and thereby a franchise relationship) may exist.  Some of the factors that the courts have found to be relevant, include:

• The extent and nature of the licensees /franchisees business investment;
• The bargaining power between the parties;
• The licensees/franchisees economic dependence on the licensor's/franchisor's goods or services;
• The licensor's/franchisor's control over the goods and services offered by the licensee/franchisee; and 
• The licensees/franchisees ability to procure and/or offer goods supplied by a third-party.

Ultimately, any determination as to whether or not your New Jersey license agreement "crosses the line" into franchise territory will require a detailed evaluation of your written agreement and the economic relationship and legal rights that you create.  If your "license agreement" gives rise to a "franchise relationship", your licensee (and now franchisee) will be granted substantial protections and rights granted by the New Jersey Franchise Practices Act.    The key is to be aware of this "unintended consequence" when structuring and planning your "license" agreements and business relationships

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Driving into the office this morning I listened to a radio commercial that I found to be repulsive . The commercial was not political, did not contain any profane language and, quite possibly, did not contain any false statements.  Nevertheless, the information conveyed in this commercial (really just a bunch of self-serving platitudes) could do harm to the unprepared.  

So what was this commercial about?  The sale of franchises for a national mall based / strip-center consumer video game franchise.  You see, the commercial was not promoting the operations of their retail stores or franchisee operations but rather the sale of "franchise opportunities".  Since I don't have the actual text of the commercial (I am basing this post on my memory of 5 minutes ago) I will not disclose the name of the franchise.

What Do I think is So Wrong about this Commercial? the fact that rather than promoting existing franchisee sales and informing consumers about the advantages of their stores (compared to competitors) they offered a generic pitch about buying their franchise.  Their "franchise sales" pitch followed the following formula:

• Make a generic statement about "becomming your own boss";
• Offer generic information about  "industry growth trends"; and
• Imply, with even more generic information, that you - as a franchisee - can benefit from this opportunity by utilizing their "proven and powerful" systems.

Basically, alot of hype and platitudes - many words but little, if any, information.  

Points for Prospective Franchisees: (1) Just buying a franchise does not make you your own boss; (2) Just because an overall "industry" is growing and profitable does not mean that as a "retail franchisee" your business will also be profitable; (3) Before buying a franchise give serious thought about what makes them "unique" and the "added value" that they bring to the table.  Most importantly, when you hear a franchisor brag about "proven and powerful systems" ask specific questions about those "systems" and what makes them "proven" and "powerful".  Don't wait until after you pay a franchise fee and invest in build-out.

Some of the many internet resources to consider include: The Franchise King, Franchise Essentials, Blue MauMau, Franchise Pick, WSJ Small Business. 

Points for Franchisors:  Advertising franchise sales is no a bad thing and, in fact, may be a key component to overall system development and growth. However, the ads should be based on the unique and fundamental characteristics of your particular system and the advantages that you offer.  If these "unique characteristics" are not readily identifiable then you are doing something wrong and you should be focusing on true "system development" and not unit sales.  Significantly, the witnessed success of existing franchisees is the best source of growth for a franchise system.

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The definition of a franchise and the factors utilized to evaluate the existence of a franchise have important implications.  That is, does the business arrangement providing for the multi-unit expansion of your business qualify as a franchise and thereby subject you to franchise regulations and disclosure requirements?  The answer to this question depends on the "substance" of the business relationship and an evaluation of both federal and state law.  

For the "New York franchisor" (comprised of any business - based in any state - seeking to offer or sell a franchise in the State of New York) the definition of what constitutes a "franchise" is more expansive that the federal definition.  Under the Federal Franchise Rule "trademarks" and "trademark licenses" are primary and critical components of a franchise system. Without the license of a trademark, under federal law, a "franchise" does not exist.  Under New York law however, the existence of a franchise is not dependent upon the existence of a trademark license.  That is, although your "business arrangement" does not involve a trademark license and therefore does not qualify as a "franchise" under federal law, you may nevertheless be subject to New York's franchise regulations and disclosure requirements if your "business arrangement" is based on a written or oral agreement providing for:

• (i) A Proscribed Marketing Plan or System: The offer, sale or distribution of goods or services under a proscribed marketing plan or system; and 

• (ii) Payment of a Franchise Fee: The direct or indirect payment of a "franchise fee". What qualifies as a "franchise fee" is also expansively defined and may include license fees and other charges associated with the business transaction.

Additionally, New York offers an alternative definition of a franchise replacing the "proscribed marketing plan" requirement (point (i) , above) with a "trademark license".  

So, under New York law, unlike federal law, although the existence of a  "trademark license" may give rise to a "franchise relationship" it is not mandatory.  In the State of New York franchises and franchise relationships are not dependent upon the existence of  trademarks and trademark licenses.  

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The typical franchise agreement is representative of the disproportionate bargaining power between the franchisor and franchisee.  That is, franchise agreements favor franchisors.  One such favorable clause contained in franchise and license agreements relates to "liquidated damages".

The typical franchise agreement will contain a "liquidated damages" provision whereby the franchisee agrees to pay, as damages, a fixed sum or a sum based on a fixed formula in the event of a court's finding of a breach of the franchise agreement.  If the franchisor is successful in a lawsuit against a franchisee, the liquidated damages provision may clear a path for a Court (without any further detailed inquiry) to award substantial monetary damages.  Similarly, when dealing with trademark license agreements, licensees may be subject to severe damages based on the liquidated damages clause contained in the license agreement.

Although presumptively valid in most jurisdictions, the enforcement of liquidated damage clauses is not universal and courts in states such as New York and New Jersey will make an inquiry as to the "reasonableness" of the liquidated damages and the "bargaining power" between the parties at the time of contracting. 

So what do franchisors, franchisees and licensees need to know:

• Franchisors:  For franchisors, liquidated damage provisions are critical components to your franchise agreement and serve as a significant tool when faced with franchisee litigation. When drafting liquidated damages into your franchise agreement insure that the method of calculating damages is not arbitrary, based on tangible factors and is not inconsistent with your royalty structure.  

• Franchisees: recognize that a possible "liquidated damage" clause in your franchise agreement may expose you to substantial liability should the franchisor prevail.  When negotiating your franchise agreement discuss the liquidated damage clauses with your franchise lawyer and try to cap your financial obligations and the accrual of royalties and other fees after any alleged event of default and the termination of the franchise agreement.

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If you are researching the benefits of franchising, buying a franchise or starting a franchise, chances are that you have come across articles and promotional materials discussing the benefits of a "proven franchise system".  That is, prospective franchisees are advised that if they become a franchisee of  a particular franchise they will benefit from a "proven system".  While this vague term is used often and claimed by almost all franchisors, not every franchisor possesses legitimate systems and not every franchise system is "proven".

So, what is a "proven franchise system"?  While this question is subject to a broad range of interpretation, the following is some fundamental information about "systems" and "franchise systems" that must be considered by prospective franchisees and franchisors:

• "Systems" - are simply the procedures and tasks undertaken by business owners and managers in connection with the day-to-day operations of a business.  Every aspect of a business including, advertising, financial controls, production of goods, employee management and customer service can all be boiled down to a set of procedures and "systems".  Not every business is successful and not every "system" is effective or beneficial.

• Franchise Systems - are the procedures and tasks itemized and detailed by a franchisor (typically disclosed and detailed in the franchisor's operations manual) in connection with the operation of a franchised business.  A franchisors business systems typically include tasks and procedures focused on (a) Marketing, (b) Customer Service, (c) Employee Training, (d) Production of products and (e) Methods for delivering services.

• Proven Franchise Systems - Are the "franchise systems" that have been "previously" implemented (presumably by the franchisor and other franchisees) and have been demonstrated to result in successful and profitable operations of the franchised business.

Considerations for Prospective Franchisees:  

Effective and legitimate "systems" are critical for the successful operation of a franchised business. Don't just assume that a franchisor's "systems" are "proven" or "effective".  Ask the franchisor's representatives detailed questions about what makes their "systems" unique, effective and profitable and recognize that the "proven" nature of a start-up franchisor's "systems, in most cases, may be extremely limited.

Considerations for Prospective Franchisors:

Successful franchise systems depend on successful franchisees.  The mere act of preparing franchise disclosure documents and registering disclosure documents does not create a franchise. Strong franchises require thought out and tested business "systems" and procedures that have been tested and proven successful.  During the start-up franchising stage controlled growth (with limited franchise sales) may be necessary to will permit the necessary monitoring and refinement of your business systems. 

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Although the State of New Jersey is not a Franchise Registration State, over the years, the New Jersey State legislature has implemented laws pertaining to and affecting the legal rights between franchisors and franchisees.  The New Jersey Franchise Practices Act (NJSA 56:10-1)("NJFPA") adopts an extremely "paternalistic" approach to the franchisee / franchisor relationship and implements a number of legislated rights designed to benefit franchisees.

Both franchisors and franchisees with operations in the state of New Jersey should be aware of the NJFPA and its legislated rights, including NJFPA's  extremely vague "prohibition" against "unreasonable standards of performance".

Franchisor Standards of Performance must be "Reasonable".  Under the NJFPA franchisors are prohibited from imposing "unreasonable standards of performance on franchisees". This extremely vague "prohibition" is open to a broad range of interpretation and is designed, among other things, to prevent the termination of franchisee rights under the pre-text of "non-compliance".  

Relevance to Franchisees: This provision of the NJFPA, essentially, imposes a "reasonableness" standard when evaluating a franchisors attempted termination of a franchise relationship.  Under the NJFPA lawyers for the "terminated franchisee" are afforded the legal right to challenge, question and have the court evaluate the "reasonableness" of the franchisor's standards.

Relevance to Franchisors: Even if your system standards are well thought out, balanced and fair (as is typically the case with "successful" franchisors) when dealing with New Jersey franchisees, franchisors and their legal counsel must recognize that your system standards may be subject to interpretation and evaluation in a judicial proceeding.  To avoid unnecessary litigation costs and expenses, before terminating a franchise relationship take extra caution to document and communicate your performance standards and issues of non-compliance. 

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The licensing of Intellectual property serves as one of the most fundamental rights granted in the franchisor / franchisee relationship.  Successful franchises and franchisors require strong trademarks (and sometimes, patents) that are both recognized by consumers in the marketplace and capable of protection under federal and state law.  When a franchise is granted, the franchisor undertakes a serious responsibility and obligation to defend and preserve the marks that it is licensing.  

When a franchisors trademark is challenged by a competitor or third party, the franchisor must vigorously defend its interests, and indirectly, the interests of its franchisees.  When counseling and advising clients as to intellectual property planning and litigation strategy, the potential purchase of "Intellectual Property Infringement Defense Insurance ("IPIDI") is sometimes raised as a means of defraying what may be substantial legal fees typically incurred in IP litigation.

What is IPIDI - basically it is an insurance policy that covers your legal fees in the event that you are sued for infringing on the trademarks or patents of a third party.  The exact nature of this insurance varies between insurance companies and will be defined by the express terms of the proposed insurance agreement.  So when considering this insurance and comparing premiums, it is critical to have your lawyer evaluate the express terms of the proposed policy.

Should IPIDI be Considered by Franchisors - Yes, but it is critical to recognize that this insurance is typically limited to only those instances where you are sued and not where you are suing a competitor for infringing on your trademarks or patents.  Also, remember that this policy only covers "legal fees" and if you lose the lawsuit (i.e., found to have infringed a competitors IP, insurance will not cover monetary awards or judgments issued against you.

Some of the Important Factors to Consider - When considering this form of insurance, you should discuss with your franchise or business lawyer some of the following issues:

• Does the policy exclude declaratory judgment lawsuits;
• If the policy excludes "intentional acts of infringement" from coverage, how does the policy define "intent;
• Does the policy require frequent opinion letters from legal counsel as to the subject trademarks and patents;
• How does the premium compare to historical and possible future IP "defense" legal fees. 

Like any insurance, Intellectual Property Infringement Defense Insurance does not offer a complete solution, but, depending on the terms of the policy and the cost of the premium, should be considered as a supplement to your intellectual property strategy and planning.

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If you are a successful business owner and entrepreneur, chances are that you have considered or, at least, thought about expanding your business through the establishment of a franchise system. That is, taking the trademark(s), services and business systems that you have created and licensing them to third parties (franchisees) who will then devote their own time and capital to expanding your business concept and, hopefully, benefit from the experience and success that you have achieved to date.  No doubt, franchising is a popular and extraordinary vehicle (when done correctly) to achieve the multi-unit expansion of a business.  However, the franchising is not right for every business or entrepreneur.  Before "starting a franchise", consider the following 4 questions to evaluate if franchising is right for your business:

• Franchise Question No. 1 - "Do you have Business Systems?"  

Franchising is all about duplication, consistency and uniformity.  That is, recreating, in each store / each franchisee's business, the unique qualities and customer experience that has made your business a success.  To recreate this success and franchise your business you cannot leave anything to chance and you must be able to identify, articulate, teach and recreate the "business systems" that "you" use to successfully operate your business. For example, the "business systems" that I am referring to will include your methods and procedures for (a) operating the business, (b) addressing and responding to customers/clients, (c) advertising, (d) preparing products or delivering services, (e) managing staff and (f) administration.  There are more and these "systems" will vary from business to business.  The good thing is that, as a successful business owner, deep down if you take an objective look at the things you do every day in operating your business, identifying your "systems" should be a straight forward task. But keep in mind that you must be able to quantify these systems (i.e., write them down), simplify them and teach them to your future franchisees.

• Franchise Question No. 2 - "Can your Systems be Taught to Franchisees?"

Once you have identified your "systems" (See, Franchise Question No. 1) the next question is whether or not your "systems" may be taught to franchisees and carried out by them consistently on a day-to-day basis.  Consistency is key and to establish a successful franchise your "systems" must be capable of duplication by your franchisees - to do this, your systems cannot be complex and must be "boiled down" to a set formula.  If your business "systems" are extremely complex (a) your business may not be an appropriate model for franchising or (b) your franchise may require extremely experienced franchisees with industry experience similar to yours. 

• Franchise Question No. 3 - "Do you Have a Strong and Protectable Trademark?"

One of the primary and core elements of a franchise and franchise system is its trademark(s). As a "franchisor" one of the primary assets that you will be licensing to your "franchisee(s)" is the right to use your Trademark(s).  So you need to make sure that your trademarks are unique to your business and be capable of obtaining legal protection - that is your trademark cannot be a generic term, cannot be a name that is currently used by others and must be capable of registration with the United States Patent and Trademark Office. For a more detailed discussion of the importance of trademarks to a franchise, check out "Trademarks Matter: Evaluate your Trademarks Often and Early Before Starting a Franchise."

• Franchise Question No. 4 - "Will your Business be Profitable for Franchisees?"

Right now I am certain that you can pinpoint the profits of "your business" on a monthly, if not weekly or daily basis.  To franchise your business you must first ensure that (a) your own business possesses a consistent track record of profitability and growth and (b) that your franchisees (if they follow your "systems") will possess the opportunity for profitable growth. When making this "profitability analysis", unlike your own business, you must take into account (i) the royalties that the franchisee will be paying to you on a weekly or monthly basis, (ii) the fact that the franchisee may have higher operating costs than your established business, and (iii) the franchisee may be servicing debt obligations used to establish its business.

For additional and insightful information on this topic check out Demir Barlas' article "How to Franchise Your Small Business" and Joel Libava's article "Does it Shout "Franchise Me!"?".  For a franchisees perspective as to what makes a good franchise system Sean Kelly's article "10 Criteria for Assessing a Franchise" provides some excellent insight.

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If you are a successful business owner and thinking about franchising your business, it is critical to recognize that with the benefits of franchised expansion come both federal and state regulation - regulation that is manageable and, actually, helpful if approached correctly.  While Federal Law provides an overriding framework regulating the offer and sale of franchises throughout the entire country, fifteen states have enacted their own franchise laws that, supplement and add additional regulations to be followed by franchisors. In Twelve of the states, registration of the franchisors Franchise Disclosure Document (FDD) is required. 

States that have Enacted Supplemental Franchise Laws and Require Registration of a Franchise Disclosure Document:

• California
• Hawaii
• Illinois
• Indiana
• Maryland
• Minnesota
• New York
• North Dakota
• Oregon
• Rhode Island
• South Dakota
• Virginia
• Washington
• Wisconsin

In these states, in addition to complying with the Federal Franchise Rule, franchisors must file and register their franchise disclosure document (FDD) prior to offering or selling a franchise.  Like a stock or security that must be registered with the Securities and Exchange Commission before offering or selling a franchise in these "registration states" your FDD must first be registered with the appointed state regulator.  For example in New York, FDD's must be registered with the New York Attorney General.  In California FDD's must be registered with the California Department of Corporations.  Since New Jersey is not  registration state, although FDD's are still required and must be disclosed, they are not registered with a state entity.

States that have Enacted Supplemental Franchise Laws but do not Require Registration of a Franchise Disclosure Document:

• Michigan (only notice)
• Oregon (no filing)

In these states there are supplemental regulations (in addition to the federal regulations that apply throughout the entire United States) that must be followed. Although Michigan and Oregon do not require "registration" of a franchisor's FDD, these state require the filing of a notice with each respective state advising of your proposed offer and sale of franchise.

Always remember that the "state" regulations are a supplement to the Federal Rule and that, at all times prior to offering and selling a franchise you must have a prepared and updated FDD. Your FDD must be disclosed and delivered to your prospective franchisee at least 14 calendar-days before the prospective franchisee (i) signs a binding agreement with you, or (ii) makes any payment to you or any affiliated entity or person.  If you are considering a "licensing system" as opposed to a "franchise system", check out "The Unintentional Franchisor: How a License Agreement may Subject you to Franchise regulation". For important information and insight into the new Franchise Rule and the FDD disclosure requirements definitely read attorney Rush Nigut's post on the New Franchise Disclosure Document. 

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In a recent decision of the United States Court of Appeals for the Second Circuit, In re American Express Merchants' Litig, 2009 WL 214525, *2, *5-*6 (2nd Cir. January 30, 2009), the Second Circuit rejected the enforcement of a "class-action waiver" clause contained in American Express's standard merchant agreement (the agreement between American Express and the restaurants and vendors that accept the American Express card).  Although the Court did not impose a per se prohibition, it held that "class action waiver clauses", may be invalidated where their implementation (i.e., prohibiting the plaintiff from joining together with others in a class action - and forcing the plaintiff to fight American Express on its own) would be to strip a plaintiff of its substantive statutory rights.  In the American Express decision, the plaintiff/vendor was one of many vendors claiming damages based upon American Express's alleged violation of federal law. The problem for this plaintiff was that, if forced to fight American Express alone (whether in court or an arbitration proceeding), it did not possess the resources to litigate against a corporate giant.

What does this mean for franchisees?  Right now, maybe not much.  But, down the line it could serve as a basis for expanding franchisee rights and possibly addressing onerous clauses in franchise agreements that undermine a franchisees "substantive rights".  For the time being, franchisees / individuals considering the purchase of a franchise, must recognize that as a small business owner and franchisee, the contractual rights and obligations specified in your franchise agreement will constitute one of your most important "business assets".  So, before buying a franchise, do your homework, read your franchise agreement, review the franchisor's disclosure document (FDD) and seek out the advice of an experienced accountant and attorney. Also, as discussed in a prior post, speak to existing franchisees. Definitely, ask questions.

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This weekend, driving back to New York from an an exceptional legal  conference in Virginia my partners and I came across one of my  childhood heroes (maybe not really a hero but a pretty cool guy):  "Bob's Big Boy". Meeting up with "Big Boy" reminded me, once again,  of the critical importance of trademarks and trade  dress to a franchise  system.  By the way "Bob's Big Boy" is a registered trademark of Big Boy Restaurants International, LLC.

For the prospective franchisor who would like to start a franchise or believes that franchised expansion may be in the future of his or her business, it is critical that you evaluate and protect your trademarks now.  Why is this so important?  Because trademarks and trade dress  are one of the most fundamental and critical assets of a franchise  system.  So, well before you start a franchise (where you will be  licensing your trademarks to franchisees) make sure that you consult    with a franchise lawyer or trademark lawyer (even if you are years  away from starting a franchise) and evaluate the following factors:

• Are your trademarks legally protectable?  Among many other factors,  your trademarks must go beyond "descriptive" terms and involve unique terms that have become associated with your business.

• Does your Trademark Actually Infringe on the Mark of a Third Party? It is quite possible that the mark you are using may actually infringe on the trademarks and intellectual property of a competitor.  Even if you never heard of the third-party competitor, depending on issues involving State and Federal trademark registration, your use of a trademark in one state, i.e., New Jersey, may actually infringe on the registered marks of an unknown competitor in California.

These points apply for any successful business - even if you never intend to start a franchise.The process for evaluating and registering your trademarks is not a complex process and may be accomplished cost effectively by a business and franchise lawyer.  Before you even contact a lawyer, you can conduct a basic and preliminary trademark search on your own by visiting the website of the United States Patent and Trademark Office (Click on the "Trademarks" Tab and then "3. Search TM Database").

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“Franchising” has been and remains one of the most successful vehicles for the multi-unit expansion of a business. However, for many entrepreneurs looking to expand their business and brand,“franchising” is too often disregarded as a viable business model. For these entrepreneurs, the establishment of a franchise system (unnecessarily) appears to be a daunting task and is disregarded in favor of “licensing”. That is, in an “attempted” effort to avoid franchise regulation, but nevertheless achieve brand growth, the entrepreneur (as a “licensor”) licenses his or her trade name and trademarks to third parties (known as “licensees”) who conduct their own business utilizing the licensed marks.

While “licensing” relationships, without question, possess a legitimate purpose, they are extremely limited and cannot serve as an “end-run” around franchise regulation. That is, license agreements cannot be used to create “franchise-type relationships” without the franchise regulation. The reason for this is simple: in the world of franchise regulation, “substance” matters more than “form”, labels do not matter and just because you call something a “license” does not mean that it is not a “franchise”. In short, your license agreement (no matter what you call it) may in fact be a franchise.

So, how do you determine if your license agreement “crosses the line”? You ignore titles such as “licensor”, “licensee”, “license fee” and “license agreement” and evaluate the “substance” of your business relationship. Under the federal Franchise Rule, the defining characteristics of a franchise include:

(1) Continuing Commercial Relationship.  a “continuing commercial relationship”;

(2) Agreement. a written or oral “agreement”;

(3) License. the “license” of a trademark;

(4) Control / Obligation to Support. “significant control” over your “licensees/franchisees” methods of operation, or, an obligation to “support” those operations, and

(5) Fee. the payment of a “fee”.

Since, factors (1), (2) and (3) are, by necessity, inherent to both franchise and license agreements, the determination as to whether or not your license agreement “crosses the line” into franchise territory, boils down to an evaluation of “control” and “fees”. That is:

• Will you possess significant control over your “licensee’s” methods of operation, or, in the alternative, are you obligated to provide significant support to your “licensee’s” operations? and

• Will you receive or be owed a fee as a condition for your “licensee” to commence its operations?

If the answer to both of these questions is “yes” or “possibly yes”, your “licensee” may actually be a “franchisee” and you may be subject to franchise regulation. When making this evaluation, you must go beyond labels and consider both the substance of the relationship that your are creating and the long-term goals that you are attempting to achieve.

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