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Franchising: Ins and Outs
Excerpted from How to Buy a Franchise by James A. Meaney © 2004
As obvious as this may seem, it is important to clearly understand what a franchise is if you are thinking of buying one. Unfortunately, the term franchise does not lend itself to an easy or precise definition. Simply put, it is a method of distributing goods or services—a unique selling concept that fits hand-in-glove with our highly mobile, service-intensive society. The franchise system benefits both individual franchisees and the franchise as a whole. These benefits usually include:
• proven business format;
• standardized method of operation;
• national advertising;
• franchise name recognition;
• franchisee training;
• franchisee network;
• standardized fixtures and equipment;
• professional site location assistance;
• centralized buying power; and,
• rules and quality control standards.
Franchisors create this system to expand their business without investing more capital or adding personnel and increasing their payroll. In fact, franchisors raise capital by charging franchise fees to their franchisees. In other words, by franchising their products and/or services, franchisors can build both their profits and their business, without spending significant amounts of money. Understanding the development of franchises can also help define a franchise.
A Brief History
The booming post-war economy of the 1950’s propelled franchising into the modern economic era. The newly-formed interstate highway system provided the infrastructure for new restaurants, hotels, and service stations, all designed to meet the changing, growing needs of a new breed of mobile and adventurous Americans. Added to the mix was the power of television that provided the first truly national advertising medium. These dynamic forces, combined with newfound wealth, fueled the franchise fire.
Yet franchising can trace its roots back over one-hundred years, from when Isaac Singer first utilized the concept. He reportedly accepted a royalty or license fee from independent salesmen for territorial rights to sell his sewing machine. Then, the invention of the automobile thrust franchising into a higher gear, as it did with many other aspects of American life in the early 1900’s. General Motors established dealerships to meet the rising demand for automobiles and oil companies offered service station franchises to the mechanics of the day to create an automobile service industry that thrives to this day.
The names Howard Johnson’s and Kentucky Fried Chicken could not have been etched into our collective memories without the upsurge of the franchising method of doing business. McDonald’s would not have taken on the proportions of an American icon. Much is owed to the early franchise pioneers who provided a novel business methodology that allowed rapid expansion, the pooling of capital, and a harnessing of the American entrepreneurial spirit.
As franchising evolved in the early 1960’s, the need for a precise definition increased. However, it was not until 1971 that California adopted the first law regulating the sale of a franchise. It was not until the end of that decade that the Federal Trade Commission (FTC) adopted a regulation on the federal level under the Federal Trade Commission Act. Unfortunately, the definitions adopted by the FTC and California were not identical and the enforcement structures were very different. These twin starts established a regulatory morass that continues today.
There are now three basic approaches used to define a franchise: the California model, the FTC approach, and the Minnesota model (or community of interest approach). Each requires that the purchaser pay a fee and that the buyer receive, in some way, the right to use a trademark, service mark, or trade name of the franchisor. From there, the three approaches diverge.
Defining a Franchise
The three main approaches give the average franchise purchaser a good overview of what are generally considered the essential elements of a franchise. Those elements include:
• payment of an initial franchise fee;
• the right to use a trademark, service mark, or trade name; and,
• an additional ingredient connecting franchisor and franchisee, called either a marketing plan, significant assistance, or community of interest. (Years of legal interpretation, case law, and advisory opinions further define the meaning of many of the esoteric terms and phrases used to define a franchise.)
From these three approaches a general definition can be formed:
Franchising is a legal business arrangement, governed and created by a contract, under which the franchisor (owner/supplier) sells to a franchisee (retailer/buyer) the right to sell certain goods and/or services of the supplier under specific, agreed-upon conditions.
California Model
The California model focuses on the franchisor’s requirement that a franchisee follow a prescribed marketing plan. This approach is generally followed by Illinois, Indiana, Maryland, Michigan, North Dakota, Rhode Island, Wisconsin and, with some variances, New York and Virginia. Under the state laws adopting the California model, the term prescribed marketing plan is not specifically defined, but rather left for the courts to interpret and define. The various interpretations assigned by courts are well beyond the scope of this book, but suffice it to say that courts tend to “know it when they see it.” In other words, any advertising or marketing plan or system outlined by a franchisor will do.
FTC Approach
The FTC approach requires a franchisee to meet the quality standards of the franchisor. In addition, a franchisor must exert, or have the authority to exert, a significant degree of control over the franchisee’s business operation. Finally, the franchisor is required to give significant assistance to the franchisee before the relationship is considered a franchise.
While significant assistance is not defined directly in the FTC Rule, the Rule does inform us of the subjects it relates to:
the franchisor gives significant assistance to the franchisee in the latter’s method of operation, including, but not limited to, the franchisee’s business organization, management, marketing plan, promotional activities, or business affairs; provided, however, that assistance in the franchisee’s promotional activities shall not, in the absence of assistance in other areas of the franchisee’s method of operation, constitute significant assistance.
So, unlike the California model—and it is difficult to distinguish between the terms “marketing plan” and “promotional activities”—assistance with “promotional activities” alone is not enough—more is required in one or more of the other areas (business organization, management, marketing plan, or business affairs).
Minnesota Model (Community of Interest Approach)
Minnesota, Hawaii, South Dakota, and Washington follow the community of interest approach. Central to it is the requirement that a community of interest exist between the franchisor and franchisee. Similar to the California model, the state laws following the Minnesota model do not define the phrase community of interest. The language simply provides:
…the franchisor and franchisee have a community of interest in the marketing of goods or services at wholesale, retail, by lease, agreement, or otherwise.
Once again, the Minnesota model leaves it for the courts to decide. Quite simply,
