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

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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If you are a successful franchisor or entrepreneur (of a non-franchised business), chances are that you place great priority on the development of your "intellectual property" such as your trademarks, trade designs and innovations that may be the subject of a patent. While successful business owners and entrepreneurs are great at innovating and creating "intellectual property", sometimes, mistakes are unnecessarily made respecting the protection of your "intellectual property.

When evaluating the development and protection of your intellectual property, the following are some factors that you should be aware of and considering as you manage your critical intellectual property assets:

Intellectual property is a "Two-Sided Coin" and is not limited to just "One Thing".  That is, your view toward your intellectual property assets should be expansive and involve the recognition that you are not just limited to "trademarks" or "patents".  Many of the key intellectual property assets that comprise your business may be afforded an array of protections involving trademarks, patents and a  broad array of "common law" protections associated with "trade secrets", "customer lists", "production sources" and other confidential components that drive your business.  The key is to properly structure your legal approach to these assets and afford them the maximum protection possible.  For example:

- Have your key employees with access to confidential information about customers and production sources signed limited but enforceable confidentiality agreements;

- Do you review with your corporate counsel the current usage of your trademarks to ensure that your trademark registrations are current and that supplemental applications are not warranted;

- Have your production sources signed off on confidentiality agreements respecting key components or processes involved in the production of your proprietary products and supplies; 

-Have you evaluated key product designs to determine whether or not your product may benefit from a "design patent.

As you are certainly aware there are many more issues and considerations concerning the protection of your intellectual property assets.  However, the basic and extremely limited point I wish to convey that the creativity that you put into developing the unique intangible assets that drive your business should also be applied toward the active management and protection of these assets.  Set a plan and actively discuss the protection of these critical assets with your corporate counsel. 

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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 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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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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