Franchise

A franchise is a continuing commercial relationship in which one business, the franchisor, licenses its brand and method to another, the franchisee, in exchange for payment. The Federal Trade Commission's Franchise Rule defines a franchise as an arrangement, "whatever it may be called", in which the franchisee obtains the right to operate a business identified or associated with the franchisor's trademark, the franchisor exerts or has authority to exert "a significant degree of control" over the franchisee's method of operation or provides significant assistance with it, and the franchisee makes or commits to make "a required payment" to the franchisor or an affiliate as a condition of starting.

The definition is functional rather than a matter of labels. An arrangement called a "license" or a "dealership" that meets all three elements is a franchise for the rule's purposes, and one called a franchise that lacks an element may not be. In everyday speech "franchise" also means a sports team or a film series, and in older legal usage a privilege granted by the government; the state tax called a franchise tax comes from that last sense and is a different subject.

The disclosure document. The Franchise Rule makes it an unfair or deceptive practice for a franchisor to fail to furnish its current disclosure document "at least 14 calendar-days before the prospective franchisee signs a binding agreement with, or makes any payment to, the franchisor or an affiliate." If the franchisor changes the agreement's terms unilaterally and materially, the buyer must get the revised agreement at least seven calendar days before signing it; changes that come out of negotiations the buyer started do not trigger that period. The document is known as the Franchise Disclosure Document, or FDD, and the FTC's buyer's guide tells readers to "read each of the 23 numbered 'Items'".

The Items that carry the most information. Item 3 discloses litigation against the franchisor and its executives. Items 5 through 7 cover the initial fee and whether it is refundable, the other fees in a required table, and the estimated initial investment. Item 17 covers renewal, termination, transfer and dispute resolution. Item 19 holds any financial performance representations, and the FTC guide is explicit that the rule "doesn't require a franchisor to provide sales or earnings information", but that any claim about sales, income or profits must appear there. Item 20 shows outlets opened, closed and transferred, and lists current franchisees and those who left in the last fiscal year, which the FTC suggests may be "the most reliable way to verify the franchisor's claims." Item 21 contains the franchisor's audited financial statements.

What the buyer pays. The FTC guide lists an initial franchise fee that may be non-refundable; royalties figured as a percentage of the outlet's weekly or monthly revenue, which the guide says a franchisee must typically pay "even if you are losing money"; contributions to advertising funds; and required purchases from the franchisor or approved suppliers. Because royalties are a share of sales rather than of profit, they come off the top.

What the rule does not cover. Section 436.8 exempts certain arrangements, among them very small required payments, a large initial investment where the buyer signs an acknowledgment, sales to buyers with substantial net worth and experience, fractional franchises and leased departments; its dollar thresholds are adjusted every fourth year for inflation. Several states also have franchise registration or disclosure laws of their own, and the FTC guide points buyers to their state attorney general or securities regulator for them.

1. The buyer receives the FDD, by hand, email, an online link, or mail sent at least three days before the deadline, at least 14 days before signing or paying anything.
2. The buyer reviews it, with an accountant's help as the FTC suggests, and talks to current and former franchisees.
3. The parties sign the franchise agreement, and the franchisee pays the initial fee and builds out the outlet to the franchisor's standards.
4. The franchisee operates under the brand and system, paying royalties and advertising contributions on gross sales and buying required supplies.
5. The agreement ends at the end of its term, at renewal on the terms then offered, at a transfer the franchisor approves, or on termination.

Take an example of how royalties behave. A franchise agreement charges a 6 percent royalty and a 2 percent advertising contribution on gross sales. In a good year the outlet sells $900,000 and earns $110,000 before those fees. The fees are 8% × $900,000 = $72,000, leaving $110,000 − $72,000 = $38,000 for the owner. In a bad year sales fall to $700,000 and profit before the fees falls to $30,000. The fees are still 8% × $700,000 = $56,000, so the owner ends the year $30,000 − $56,000 = −$26,000, a loss, while the franchisor's revenue from the outlet fell by only about a fifth. That asymmetry is what the FTC means when it warns that royalties are due even when the franchisee is losing money.

Pros

• A tested operating system, training and a recognized brand can shorten the time it takes a new owner to reach steady sales.
• The FDD is a mandatory federal disclosure, so the buyer sees the franchisor's litigation history, every fee and franchisee turnover before signing.
• National advertising, site selection help and ongoing support are part of the package, where an independent owner would have to build or buy them.

Cons

• Royalties and advertising contributions are a percentage of sales, owed in losing years as well as profitable ones.
• The franchisor's controls over suppliers, pricing, hours, design and territory limit the owner's own business judgment.
• Renewal is not automatic, and terms on renewal can be worse; an owner may have to sell or close at the end of the term.
• The initial fee may be non-refundable, and a termination can mean losing most of the investment.