"Hola, amigos. I know it's been a long time since I rapped at ya," but my brother's recent posts about franchises prompted me to get back into the Doughnut blog headspace. If that opening quote sounds familiar, you were likely a regular reader of the Onion print edition in the 90's and the musings of journalist Jim Anchower. Both Jim and Jean Teasdale have influenced my writing, and life more generally, in ways that cannot be adequately described. In any event, I am back on Doughnuts to discuss franchises from a legal perspective.
Trust me, and not just because I'm photo-shopped into a law library.
Franchise Law
In addition to my own experience working in a Subway franchise, which you may know from reading my brother's last post, I practiced franchise law for about 5 years at my prior firm. While most of my experience was representing motor vehicle and other heavy equipment franchisors, my work in that area touched on many areas of the complex legal system dealing with the relationship between franchisors and franchisees (or distributors and dealers, as they are commonly referred to in the vehicle/equipment space).
As my brother alluded to in his last two posts, the franchisor-franchisee relationship is essentially symbiotic but often adversarial. That is to say, in an ideal situation, a franchisor provides the franchisee an opportunity to start a business or represent a brand without investing too much of its own capital, while generating revenue from the individual franchises as they operate. On the other hand, the franchisee enjoys the benefits of national or international brand recognition and business model without the burden of establishing and growing its own brand. However, this relationship is not perfectly symbiotic. The franchisor wants to control its own brand and maximize profits from its franchises, while the franchisee wants to maximize its own return and avoid or circumvent regulation by the franchisor in the daily operation of the business.
In light of this sometimes contentious relationship, federal and state governments began regulating the franchise business model as it became more prevalent in the mid-1900s. Generally speaking, these regulations were and are aimed at protecting the franchisee, who typically has less money and power than the franchisor. It would be impossible to summarize franchise law in a short blog post, but very briefly: the Federal Trade Commission (FTC) regulates many types of franchises via the FTC Franchise Rule, which touches on subjects such as initial investment requirements, ongoing royalties, and how disputes will be decided. Additionally, many states have their own franchise laws that are either generally applicable or specific to certain industries (e.g., motor vehicles, farm/industrial equipment, gas stations, liquor/beer/wine, etc.). These laws regulate many common issues that arise in the relationship, including formation, ongoing operations, and termination. Additionally, franchisors may impose requirements on their franchisees via the franchise agreement that restrict the actions of franchisees, which agreements are in turn subject to the broader franchise laws.
Starting A Franchise
Rather than expounding on the details of the laws, and without disclosing any attorney-client privileged information, I thought I would share a few examples of situations that can arise in the franchisor/franchisee relationship. Most of the storied franchises in history start with a successful individual business, which then successfully expands to other locations before beginning to franchise to third parties. McDonald's is a great example, and if you're curious, you should watch the very interesting movie "The Founder." One word of caution, come for the story, not the script/acting (e.g., the 1:30 mark of this video).
However, I have encountered people with big dreams of franchising their business before even developing the concept and proving it through a few profitable locations, thereby demonstrating the ability to replicate the business on a wider scale. McDonald's and Jiffy Lube are successful because people love fast food and need oil changes, and both started with a few successful locations. In contrast, just because you enjoy your local pinball bar/cafe doesn't mean that such a concept will work on a national scale with hundreds or thousands of locations, or that others haven't attempted such a concept and encountered failure. Whether you have a McDonald's/Jiffy Lube or pinball bar/cafe sort of idea, you need to learn the market and consult a lawyer before beginning the long and complicated journey of starting a franchise. And, of course, if you want to buy into such a model as a franchisee, you will need legal counsel to understand the investment/return expectations as well as restrictions on operating the business.
Operating As A Franchisee
If you are operating as a successful franchisee and looking to expand to multiple locations, you may be subject to geographic and other restrictions imposed by the law and/or your franchisor. For example, let's say that you are a franchisee operating two successful California locations in Los Angeles and San Diego, and both you and the franchisor would love for you to replicate your success in other parts of the state. You found an ideal spot in Santa Barbara for your third location, but there is an existing (but under-performing) franchisee in nearby Goleta. Both you and the franchisor may be limited by state franchise laws to open that location in Santa Barbara, based on the expectation that your establishment of that location may siphon business from the Goleta location.
Terminating a Franchise The most stringent laws surrounding the franchise model tend to deal with termination, which makes sense given the financial consequences of termination. Depending on the industry and jurisdiction, these rules may involve notice/cure requirements, equipment buy-back provisions, and whether good cause is required for termination, among many other topics. There are many reasons a franchisor may want to terminate a franchisee, but typically it boils down to the franchisee not adequately representing the brand, following franchise rules, and/or maximizing returns in the eyes of the franchisor. And if you're a franchisee, you have to be aware that your business may be terminated by the franchisor even if you are comfortable with your profits, which is a challenge that a non-franchisee business owner doesn't have to consider. While these laws are important for the protection of both the franchisor and franchisee, either party may find itself with the short end of the stick depending on what the law will permit and need to understand the legal implications of their desired outcome.
Conclusion
In a perfect world, a franchise business model benefits both the franchisor and franchisee, with both parties enjoying their respective roles in the business relationship. But when conflicts arise, both parties are subject to state/federal laws, as well as the terms of their own franchise operating agreement. At the start of the relationship, and if conflicts arise, both parties would be wise to seek legal representation familiar with the applicable laws in order to protect their own interests.
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