Once you have decided to franchise your business, there are many key components to consider and build out. Because of the strict regulatory environment of the franchise space — both at the federal level and as part of a complex patchwork of various state laws — it is crucial to have a solid legal foundation on which to build your franchise system. As a quick primer on some legal aspects of franchising, here are some of the more common questions we get:
What is an FDD?
Before you may offer a franchise to any potential buyer, you must give them a Franchise Disclosure Document, or FDD. The purpose of this legal requirement is to protect potential purchasers of franchises by giving them a standardized document that provides them with key information about the franchise opportunity.
The United States has a complex patchwork of state and federal franchise laws, as well as business opportunity laws that can also come into play. For each potential buyer of your franchise, you need to ensure you are meeting federal law as well as any applicable state laws, which usually depend on where the buyer resides and plans to operate the franchise.
Every FDD contains 23 “Items” as well as certain prescribed exhibits. These “Items” cover topics that regulators have determined are most relevant to prospective buyers of franchises. They include information about the franchisor, its leaders, its history, costs and information about business operations. When all is said and done, the FDD with all its exhibits typically runs 200 to 300 pages or more.
The Franchise Agreement
While they often get lumped together, the FDD and Franchise Agreement serve separate purposes. The FDD is designed to inform potential buyers, through a series of required disclosures, key information about the franchise. The Franchise Agreement, which is an exhibit to the FDD, is the legal document that the parties will sign that will govern their relationship during the term of the franchise. The Franchise Agreement sets out the specific legal obligations that each party has.
Complying with State Franchise Laws
At the state level there are various franchise registration, filing, disclosure, and relationship laws that franchisors must follow. As noted above, the United States has a complicated patchwork of franchise and business opportunity laws. States that require FDD registration are known as the franchise registration states. These states typically have the most strict franchise laws and most rigorous registration process that requires an annual renewal after the initial registration. Another group of states are known as franchise filing states that typically have a less stringent process and require either one-time or annual state franchise filings. The third group of states are non-registration states that do not require any state specific FDD registrations or filings.
Financial Statements
One of the required exhibits to the FDD is a set of financial statements. The general rule is that the franchisor entity must include its last three years of audited financial statements. Because new franchisors usually form a new corporate entity to sell franchises, new franchisors often will not have three years of statements and will include only those statements since the formation of the entity. Additionally, under the federal and most state franchise laws, there is an exemption from the requirement that statements be audited during the first full or partial fiscal year of franchising. A handful of states, however, have heightened requirements for the first year, such as an audited opening balance sheet. So whether you will need audited financial statements will depend on which states you wish to be registered in to sell franchises.
Can I Avoid the Franchise Laws by Just Licensing My Business?
We are often asked if it is possible to avoid the need for a franchise system – and thereby avoid the need to create and FDD and comply with all the federal and state franchise laws – by simply “licensing” a business idea rather than franchising it. The short answer is that it is very difficult – and in many scenarios nearly impossible – to structure a legal licensing relationship that allows a third party to operate a business under your name and systems that does not fall under the franchise laws and regulations. If this were a more viable option, most businesses would opt to license their business to avoid the more onerous franchise regulations; for that very reason, however, the legal regulations capture almost all such relationships other than true product licenses. A limited number of exemptions from the franchise disclosure and registration requirements are available, and we can help you explore those if they make sense for your situation.
