FUNDAMENTALS OF

FRANCHISING YOUR BUSINESS

Eric C. Perkins, Esq.
Justin M. Laughter, Esq.

OUTLINE OF TOPICS
I. What is a Franchise?.......................................................................................................... 2

II. Why Franchise?.................................................................................................................. 4

III. Is Franchising Right for Your Business?......................................................................... 5

IV. Common Elements of a Successful Franchise System.................................................... 7

V. Different Franchise Structures....................................................................................... 7

VI. Regulation of Franchising................................................................................................. 8

VII. The FDD . .............................................................................................................................10

VIII. The Franchise Agreement................................................................................................ 14

IX. The Operations Manual.................................................................................................... 14

X. Getting Help...................................................................................................................... 14

XI. Fun Facts About Franchising............................................................................................16

XII. Glossary of Franchising Terms.......................................................................................16

©2008 by Hirschler Fleischer, A Professional Corporation. All rights reserved.


I. What is a Franchise? B. Legal Definitions

A. Common Sense Definitions 1. Federal Law: The FTC Rule

1. Definition by Example The federal franchise regulation is for-

mally titled “Disclosure Requirements
McDonald’s, Wendy’s, Dairy Queen, and Prohibitions Concerning Franchis-
Holiday Inn, Molly Maids, Midas Muf- ing and Business Opportunity Ventures”
flers, and the other 6,000+ franchise and can be found at 16 Code of Federal
systems operating in the United States. Regulations Part 436 (the “FTC Rule”).
The FTC Rule defines a “franchise” as
2. Practical Definition follows:

Franchising is a method of distributing any continuing commercial rela-

goods or services. A franchise is a type tionship or arrangement, whatever
of business in which someone (the fran- it may be called, in which the terms
chisee) agrees to pay certain fees and of the offer or contract specify, or the
obey certain rules for the right to sell franchise seller promises or repre-
the goods or services of an established sents, orally or in writing, that:
company (the franchisor) and benefit
from its business methods, trade secrets, (1) the franchisee will obtain the
goodwill, professional training, and op- right to operate a business iden-
erating assistance. tified or associated with the
franchisor’s trademark, or to offer,
3. Elements of a Franchise sell, or distribute goods, services,
or commodities identified or as-
Under federal law and most state fran- sociated with the franchisor’s
chise statutes, a franchise consists of the trademark;
following three elements:
(2) the franchisor will exert or has
(i) Trademark Element. The franchi- authority to exert a significant
see operates his business under the degree of control over the fran-
franchisor’s trademark or service chisee’s method of operation, or
mark or distributes goods or servic- provide significant assistance in
es associated with the franchisor’s the franchisee’s method of opera-
marks. tion; and

(ii) Fee Element. The franchisee is re- (3) as a condition of obtaining or

quired to make a payment to the commencing operation of the
franchisor (or an affiliate of the fran- franchise, the franchisee makes a
chisor) as a condition of obtaining or required payment or commits to
beginning the franchise operation. make a required payment to the
franchisor or its affiliate.
(iii) Control/Assistance Element. The
franchisee is subject to various
requirements imposed by the fran-
chisor, including requirements 2. State Law: The Virginia Retail
regarding the location of the fran- Franchising Act
chised business, site design or
appearance, hours of operation, The Virginia Retail Franchising Act is
sales methods, management sys- codified at Sections 13.1-557 through
tems, marketing, etc. 574 of the Code of Virginia of 1950, as

 amended (the “Virginia Franchise Stat- is commonly defined as the sale of prod-
ute”). The Virginia Franchise Statute ucts, equipment, supplies, or services to
defines a “franchise” as follows: a purchaser upon payment of an initial
fee for the purpose of enabling such
a written agreement under which purchaser to start conducting business,
(i) a franchisee is granted the right and in which the seller represents that
to sell goods or services at retail he will provide a sales program that will
(not wholesale) under a marketing enable the purchaser to derive income
plan or system prescribed in sub- from the program exceeding the price
stantial part by the franchisor; (ii) paid to the seller. Common examples
franchisee’s business is operated include vending machine routes, en-
under franchisor’s trademark, trade velope-stuffing programs, automobile
name, or other commercial symbol cleaning systems, and coin-operated
designating the franchisor or one of telephones, among others.
its affiliates; and (iii) the franchisee
is required to pay, directly or in- The FTC Rule regulates franchises and
directly, a franchise fee of $500 or business opportunities, but most states
more. govern franchises and business oppor-
tunities under separate statutes.
C. Common Franchise Types
Business opportunity statutes typically
1. Business Format Franchise require pertinent information to be dis-
closed at designated times prior to the
A business format franchise involves a sale of a business opportunity. Some
franchisor offering a franchisee the right business opportunity laws require a
to use its business methods and systems seller to obtain a surety bond or estab-
in addition to selling the franchisor’s lish a trust account prior to making
signature goods and services. The busi- sales. Other statutes also impose regis-
ness format franchisees use the same tration requirements.
procedures, recipes, and practices of the
franchisor. Examples include typical 2. Distributorships
restaurant franchises, home cleaning
service franchises, and auto repair fran- A distributorship is a contractual re-
chises. lationship in which a manufacturer
or supplier authorizes a distributor to
2. Product Franchise distribute or sell supplies or products to
others. The distributor buys the products
A product franchise is a type of franchise from the manufacturer or an authorized
in which a manufacturer of a product supplier and often is entitled to identify
contracts with a select number of retailers its business by the supplier’s trademark.
or wholesalers to distribute its products. Distributorships typically will not be
The retailer or wholesaler typically gets classified as franchises under federal
the right to identify itself as an “autho- or state law unless the manufacturer or
rized dealer” of the franchisor. supplier provides significant operating
assistance or imposes significant con-
D. Similar Types of Business Relationships trol over the distributor in exchange for
payment of a fee. Unfortunately, it is all
1. Business Opportunities too common for parties to inadvertently
structure a distributorship arrangement
Although precise definitions vary from in such a manner that it constitutes a
state to state, a “business opportunity” franchise under applicable law.


3. Licensing Relationships ginia may not be a franchise under
Georgia law. A business opportunity
Owners of trademarks or other intel- under Florida law could be a franchise
lectual property that have developed a under North Carolina law and neither
level of public recognition and secondary a franchise, nor a business opportunity
meaning will often find it advantageous under Mississippi law.
to license such intellectual property
to someone else in connection with
another line of business. For example, II. Why Franchise?
professional sports leagues regularly li-
cense the use of team logos on all types A. A Brief History of Franchising
of merchandise.
The word “franchise” comes from a medieval
Structured properly, a single-mark French term “francis” which meant to grant
licensing arrangement is a valid alterna- rights or privileges to peasants. In the Middle
tive to franchising and offers the owner Ages, a local lord would give others the right
an excellent opportunity to maximize to hunt, hold markets and fairs, or engage in
the value of its intellectual property by other activities on his land. These were the
increasing brand recognition through earliest franchise relationships and gradually
identification with new products and evolved through the Common Law.
services at a lower cost to the owner.
Modern franchising as we know it today was
A primary risk under a typical licensing developed by German beer brewmeisters
arrangement is that the licensor exercises and the Singer Sewing Machine Company
little or no control over the licensee be- in the mid-1800s. Isaac Singer negotiated
yond periodic oversight to monitor quality licensing fees from independent salesmen for
control over the licensee’s use of the intel- the right to sell Singer Sewing Machines in a
lectual property. In other words, a licensor defined territory. By the Great Depression,
will have significantly less control in a franchising was gaining momentum with
licensing relationship than it would as a the beginnings of the A & W Root Beer and
franchisor in a franchise relationship. Dairy Queen franchise systems.

4. Inadvertent Franchises and the The golden age of franchising really started
Confusing Interplay of Federal and State to take off in the years following World War
Law II and has continued through today. There
are several socioeconomic factors that help
When structuring a licensing relation- explain this growth, but that is beyond the
ship, distributorship, or similar type of scope of this outline. Society’s increased
arrangement, the parties must carefully mobility and desire for predictability and
examine the substance of the underly- uniformity have fueled the explosive growth
ing relationship to avoid inadvertently of franchising in this country.
creating a franchise relationship. It is
also possible for a certain business re- B. Benefits of Franchising
lationship to be defined as a franchise
under the FTC Rule, but not fall within Franchising has become increasingly popular
a particular state’s definition of a fran- over the past 30 years. According to the
chise (and vice versa). When a company International Franchise Association (“IFA”),
desires to do business in several states, franchising’s annual retail sales exceed $1
each state’s franchise and business op- trillion. Not only are established franchises
portunity laws must be examined. expanding, but new industries are starting to
What is considered a franchise in Vir- franchise. With the evolution of co-branding,


 franchised businesses are reaching new introduced for the first time included a
markets and utilizing new distribution “children stay free” feature, swimming
channels (e.g., convenience stores, sports pool, air conditioning, telephones, free
arenas, college campuses, shopping malls, parking, and a restaurant. Wilson soon
office buildings, amusement parks, etc.). started selling franchises at a time which
coincided with the massive expansion
Business owners realize that franchising can of the U.S. interstate highway system.
offer the following fundamental benefits: By 1968, there were over 1,000 Holiday
Inns across the United States.
1. rapid market expansion at reduced
costs; 4. Midas Mufflers. Nate Sherman opened
the first store in Macon, Georgia in
2. increased revenues from franchise fees 1956, introducing the lifetime muffler
and royalties; and warranty. Within a year, there were 100
locations. The first international location
3. bulk discounts from suppliers and opened in Canada in 1961. The franchise
advertisers. steadily grew and by the 1980s, there
were over 2,000 Midas Muffler locations.
C. Humble Beginnings of Some Successful
Franchises 5. Subway. Frank DeLuca was 17 years
old when a family friend, Dr. Peter Buck,
1. Baskin-Robbins. Irv Robbins opened convinced him to open a submarine
his first ice cream store in Glendale, sandwich shop. They joined forces to
California. He named his store open “Peter’s Super Submarines” in
“Snowbird” and proudly featured 1965 in Bridgeport, Connecticut. They
21 flavors of ice cream. In 1946, he quickly opened several other locations
teamed up with his brother-in-law and as they plotted an aggressive growth
competitor, Burt Baskin, to form Baskin- strategy. They changed the name to
Robbins. After opening six successful “Subway” and began selling franchises
locations, the two businessmen began in 1974. By 1999, there were over 14,000
licensing their business format to others, Subway locations.
thus giving birth to the world’s first ice
cream franchise.
III. Is Franchising Right for
2. Pizza Hut. While Frank and Don Carney Your Business?
were in college, a friend convinced them
in 1958 to open a pizza parlor in Wichita, A. Key Indicators of a Successful Franchise
Kansas. They borrowed $600 from their System
mother to buy some used equipment,
rented a small building, and opened As you contemplate franchising your
the first Pizza Hut. The first franchised business, you should first consider the
Pizza Hut opened the following year. following common indicators of a successful
By 1968, there were over 300 Pizza franchise system:
Hut locations serving over 1 million
customers each week. The growth and 1. one or more successful, company-owned
popularity of the franchise continued stores;
throughout the rest of the century.
2. a business plan or set of procedures,
3. Holiday Inn. Kemmons Wilson opened processes, or recipes that can be easily
the first Holiday Inn in Memphis, learned and replicated from location to
Tennessee in 1952. Special features location;


 3. an effective training and assistance 1. personal fitness;
program;
2. real estate brokers/services;
4. marketable goods and services that have
wide appeal; 3. coffee and tea;

5. a reasonable growth plan; 4. sub sandwich shops; and

6. well-protected intellectual property 5. specialty/gourmet retail foods.

(trademarks, logos, copyrights, trade
secrets, etc.); C. Misconceptions About Franchising

7. a management team with franchising Common misconceptions about franchising

experience; include:

8. an effective franchise marketing and MYTH:  ith a successful, marketable

W
sales program; concept or product, financial
success is guaranteed.
9. a strong understanding and appreciation
of the franchisee perspective; and REALITY: Franchising is, in many respects,
a separate business requiring
10. sufficient financial strength to fulfill a significant investment of
obligations to franchisees. resources, commitment,
and patience to succeed in
B. What Kinds of Businesses are Franchisable? an increasingly competitive
market.
While virtually any business in any industry
can be franchised, some industries are more MYTH:  ranchise
F locations can
susceptible to successful franchising than operate independently without
others, including the following: supervision from the franchisor
once they survive the start-up
1. restaurant/food service concepts are period.
relatively easy to franchise, provided the
recipes and menus are easy to replicate; REALITY: The franchisor must actively
supervise, monitor, and assist
2. businesses that manufacture or supply its franchisees to promote the
goods and services with widespread growth and success of the
consumer appeal; franchise system over the long
term.
3. businesses that currently operate in
fragmented industries not already MYTH: A franchisor is free to open
saturated with franchised brands; and company-owned stores wherever
it wants.
4. businesses with procedures and
systems that are easily learned and REALITY: This depends on the specific
implemented. wording of the relevant
franchise agreement. There
According to data published by the IFA, may be potential liability
emerging franchise systems rapid growth for encroachment or unfair
over the past year include the following competition with nearby
categories: franchisees.


IV. Common Elements of a should determine which markets are: (a) not
Successful Franchise System saturated by competition, (b) located where
the franchisor can effectively monitor and
A. Replicable Products or Services service its franchisees, (c) located where
the franchise’s trademark is recognized
Franchising is not appropriate for every and respected, and (d) located where
business. Prior to franchising, a business the franchisor can economically deliver
owner should examine its products and products and materials to its franchisees.
services to determine if franchising is a
viable growth and distribution strategy. E. Franchisee Support – Operating and
Successful franchise systems utilize a plan Management Services
or set of procedures that are easily learned,
copied, and maintained from one location A successful franchisor creates and maintains
to another. Consistency is an essential uniform operating and management systems
ingredient of a franchise system. for use by its franchisees. Uniformity ensures
a consistent level of product and service
B. Protectable Trademark and Other quality throughout a franchise system. A
Intellectual Property successful franchisor also provides valuable
services to its franchisees, including, but not
A significant portion of the value a limited to: (a) advertisement and marketing
franchisor has to offer its franchisees is the programs, (b) research and development
goodwill associated with its brand. Prior of new products and services, and (c)
to franchising, a business owner should procurement of materials, equipment, and
protect its trademarks and other intellectual goods for operation of the franchise location.
property through federal registration. After
registration, the franchisor should take the
proper steps to maintain its trademarks and V. Different Franchise Structures
intellectual property and protect against
brand deterioration. A. Single-Unit Franchises

C. Effective Franchise Structure A single-unit franchise agreement grants a

franchisee the right to construct and operate
There are several different types of a single franchised business in a specific
franchising structures. A business owner location. Under such an agreement, a
should examine its line of business and franchisor may grant a franchisee territorial
financial situation to determine which protection, or reserve the right to franchise
franchise structure best fits its model. A brief other units or open company-owned units.
explanation of various options is provided Although this structure slows market
in the “Different Franchise Structures” penetration, it allows for calculated growth
section below. and remains the most common franchise
structure in the United States
D. Recruiting Franchisees at a Manageable
Rate in Identified Markets B. Area Development Programs

A successful franchisor understands the An area development agreement grants

limitations on its ability to effectively a franchisee the right to open and operate
expand its franchise network. Prior to an agreed-upon number of franchise
expanding, a franchisor should examine locations within a defined territory. Area
its infrastructure to determine if it will development agreements generally require
support additional franchisees. Prior to a franchisee to commence operating the
entering into a new market, a franchisor franchised businesses within a specified


 timeframe and to execute a separate exposes the franchisor to potential vicarious
franchise agreement for each location. Area liability for an area representative’s failure
development agreements allow franchisors to comply with disclosure obligations or
to attract more sophisticated, wealthier misrepresentations.
franchisees wishing to open a cluster of
franchises, increasing franchisor’s income E. Conversion Franchise
stream through more rapid development.
Under a conversion franchise arrangement,
C. Master Franchise (or Subfranchise) a franchisee converts its preexisting
Programs business into a franchise by replacing its
current mark and system with those of the
Under a master franchise (or subfranchise) franchisor. This is a common approach of
agreement, a franchisor divides its market franchisors in the real estate brokerage and
into large territories and allocates the hospitality industries.
territories to various master franchisees.
Each master franchisee is then empowered
to recruit and sell unit subfranchisees to VI. Regulation of Franchising
individual operators who will operate
the subfranchised units. The franchisor There are both federal and state laws that
generally retains national rights such as regulate the sale of franchises. These laws first
advertising and product development, appeared in the 1970s after widespread reports
while delegating local and regional rights to of fraudulent start-your-own-business oppor-
the master franchisees. Other than granting tunities throughout the United States began
subfranchises, the master franchisees getting publicized. Authorities discovered that
generally collect fees and provide certain most victims were first-time investors who had
consulting, promotional, and training minimal business knowledge or experience.
services to unit subfranchisees. They often
also own and operate one or more franchised After receiving hundreds of complaints, the FTC
units. Although under a master franchise took a close look at this growing trend of unfair
agreement, the franchisor must relinquish and deceptive business practices and concluded
some control and part of its revenue to its that a primary source of these problems was
master franchisees, such agreements allow the informational imbalance between franchi-
for rapid growth and decrease franchisor’s sors and prospective franchisees. As a result,
costs to solicit and service franchisees. the FTC concluded that prospective franchisees
should be provided more complete information
D. Area Representative Programs about franchise opportunities. These findings
and conclusions gave rise to the franchise dis-
Under an area representative agreement, an closure laws in effect today.
area representative acts as an agent of the
franchisor to market and solicit prospective A. Federal Law: The FTC Rule
unit franchisees within a defined territory.
Once potential unit franchisees have The FTC Rule was promulgated in 1979
been identified, the franchisor enters into after years of investigations and hearings
franchise agreements directly with the concerning the widespread deception and
identified franchisees. The franchisor unfair trade practices of unscrupulous
is typically responsible for providing franchisors. Today, every franchise offered
services and collecting fees (some portion for sale in the United States is subject to
of which will often be shared with the area the FTC Rule, which was most recently
representative). This arrangement allows amended in 2007.
the franchisor to retain greater control over
franchisee selection and operations, but The FTC Rule requires franchisors to provide


 a minimum level of pre-sale disclosure to FTC Rule. An aggrieved franchisee may
prospective franchisees. benefit as a result of FTC enforcement
action (as referenced in (c) above) or
a. Information Requirements. The he may have available causes of action
FTC Rule requires franchisors to and remedies under state law, but it is
provide prospective franchisees with important for franchisees to understand
information about the franchisor and that they have no private rights to
the franchised business being offered enforce the FTC Rule.
for sale. Each category of the required
disclosure document is described later. B. State Regulation

b. Delivery Deadline. An FDD must be The FTC Rule does not require franchisors
given to a prospective franchisee at to file or register with any federal or state
the earlier of: (i) at least fourteen (14) government agency. Some states, including
calendar days before the execution of Virginia, have franchise statutes that impose
any agreement, or (ii) at least fourteen numerous restrictions, requirements, and
(14) calendar days before money other controls on the offer and sale of
changes hands. Second, if a franchisor franchises. Some state franchise laws also
makes any unilateral changes to the control certain aspects of the franchise
form of franchise agreement (or other relationship, including termination and
agreement between the parties) initially renewal rights.
provided to the prospective franchisee,
it must deliver the revised versions to 1. State Registration Laws
the prospective franchisee at least seven
(7) calendar days before execution. There currently are 14 states (includ-
ing Virginia) with statutes specifically
c. Penalties. The FTC has the power to requiring registration of an FDD and
impose the following penalties for other materials prior to an offer or sale
violations of the FTC Rule: of a franchise in that particular state.
Other states impose less onerous notice
i. civil penalties of up to $10,000 per filing requirements.
day for each violation of the FTC
Rule or an FTC cease and desist or- 2. State Business Opportunity Laws
der;
In many states without franchise statutes,
ii. FTC may compel rescission or refor- and in some states that do have franchise
mation of contracts, refunds, return statutes, there are business opportunity
of property, payment of damages, statutes. These laws generally concern
and public notification of violations; the typical self-employment, “get rich
quick” schemes like vending machine
iii. FTC may issue cease and desist routes where the seller promises that a
orders requiring a party to refrain certain level of profit will be made or
engaging in any unfair method that all purchases are fully refundable.
of competition or deceptive act or
practice in or affecting commerce. 3. State Franchise Relationship Laws

d. No Private Right of Action. Private Some state franchise laws impose

citizens cannot sue franchisors for certain substantive requirements on
violations of the FTC Rule. Only the the contractual relationship between
FTC can take any action to enforce the franchisors and franchisees. Examples
of such provisions under the Virginia
 16 C.F.R. §436.1; 15 U.S.C. §45.


 Franchise Statute include: franchisee an opportunity to thoroughly
review the documents with legal counsel
a. Section 13.1-564. This provision and to understand all of his rights
prohibits the cancellation or termi- and obligations under the franchise
nation of a franchise agreement by agreement and related agreements.
a franchisor without “reasonable
cause.” This provision also prohib- 2. The waiting period provides the
its franchisors from exerting undue franchisee a limited mechanism to
influence to encourage franchisees get out of a franchise agreement if
to surrender their rights under the the disclosure documents were not
Virginia Franchise Statute. delivered in a timely fashion under the
FTC Rule and applicable state law.
b. Section 13.1-565(b). This provision
requires that all provisions of a fran- Most franchisors will send potential
chise agreement must be negotiable franchisees disclosure documents upon
to the extent that such negotiations request, although many implement a
will not hurt the uniform image or pre-screening process so that only seri-
quality standards of the franchise. ous candidates get access to disclosure
documents.

VII. The FDD B. Breakdown of an FDD

A. What is an FDD? The FDD format consists of 23 categories of

information about the franchisor and the
The FDD is the disclosure document franchise opportunity being offered for sale.
required by federal and state franchise laws These categories are summarized below in
to be given to prospective franchisees. This the order in which they appear in the FDD.
document describes the franchise being
offered for sale in a standardized, plain 1. The Franchisor and any Parents,
English format. The standard format of Predecessors, and Affiliates
the FDD enables individuals to efficiently
compare one franchise with another. This section of the FDD summarizes
the history of the franchisor and the
A franchisor’s FDD is not subject to franchise system being offered for sale.
prior review or approval by the federal It will also describe the organizational
government. A number of states have structure of the franchisor, including
registration requirements which provide affiliated entities (some of which might
for prior state approval of a franchisor’s offer other franchises for sale).
FDD before franchise sales can take place,
but such approval does not mean the state This section also will include a descrip-
endorses or recommends a particular tion of the market for the franchisor’s
franchise opportunity. products and services and a general
discussion about the franchisor’s com-
As stated above, the FTC Rule requires petitors.
franchisors to provide prospective
franchisees with copies of the FDD at least 2. Business Experience
14 calendar days prior to any contracts
being signed. This “waiting period” feature This section will generally describe the
protects franchisees in two ways: employment histories of the franchisor’s
officers, directors, and other key execu-
1. The waiting period provides the tives with management responsibility

10
 related to the sale and operation of fran- franchisees’ experiences in recent years.
chises. This is valuable information for prospec-
tive franchisees who need to carefully
3. Litigation plan budgets and business plans, obtain
financing, etc.
This section will summarize important
litigation involving the franchisor, in- 8. Restrictions on Sources of Products and
cluding franchisor-initiated litigation Services
against its franchisees. This might
include disputes with franchisees, This section summarizes the methods
customers, suppliers, or competing by which the franchisor attempts to
franchisors. preserve uniformity from franchisee
to franchisee across the United States.
4. Bankruptcy Consistency of products and services
is the essence of a successful franchise
This section of the FDD describes any program. Therefore, a franchisor will
bankruptcy of the franchisor, its affili- typically have very specific require-
ates, officers, or directors during the last ments concerning what a franchisee
ten years. can sell and where a franchisee can
buy its supplies and inventory. Some
5. Initial Fees franchisors require franchisees to buy
certain supplies and inventory from the
This section describes the initial fran- franchisor or affiliates of the franchisor.
chise fee or fees payable to the franchisor These sorts of relationships must be dis-
or its affiliates related to the purchase closed in the FDD, including the income
of a franchise. The initial franchise fee derived by the franchisor or its affiliates
will vary greatly, depending upon a from these types of requirements.
number of factors, including the term of
the franchise, the services offered by the 9. Franchisee’s Obligations
franchisor, and the protected territory,
if any, of the franchise granted to the This important section of the FDD lists
franchisee. the duties and obligations of the fran-
chisee under the franchise agreement.
6. Other Fees
10. Financing
Section 6 of the FDD will describe all
fees the franchisor will collect from If the franchisor offers financing programs
the franchisee for itself or third parties to assist its franchisees, this section
on an ongoing basis. These fees might of the FDD will describe the terms of
include operating royalties, advertising such financing. If the franchisor leases
fund royalties, lease negotiation fees, equipment to franchisees, the terms of
site selection fees, permitting fees, train- such programs will be described in this
ing fees, audit fees, transfer fees, and section.
renewal fees.
11. Franchisor’s Assistance, Advertising,
7. Estimated Initial Investment Computer Systems, and Training

This section describes the costs a new This section summarizes what services
franchisee will likely incur to start the franchisor will provide the fran-
its business. This information gener- chisee during the term of the franchise
ally comes from data gathered by other agreement. For a prospective franchisee,

11
 this section is very important and should sors own patents that are material to the
be studied carefully and compared franchise system. For those franchisors
with the FDDs of different franchisors. who have developed patented processes
Details of the franchisor’s initial train- or inventions, these patents will be de-
ing and ongoing assistance programs scribed in this section of the FDD.
will appear in this section. Franchisors
must offer prospective franchisees a Most franchisors claim copyright pro-
reasonable opportunity to review any tection for their operations manuals and
applicable operations manual or include computer software used in the operation
the table of contents in the FDD. of the franchised business. Franchisors
will also strive to protect other trade
12. Territory secrets and proprietary information.
Franchisees will be prohibited from
This section defines the type of territo- disclosing or using such information for
rial protection (if any) the franchisor any purpose other than operation of the
offers its franchisees. In other words, franchise system.
a franchisor must describe any and all
limitations on its right to directly or 15. Obligation to Participate in the Actual
indirectly compete with franchisees in Operation of the Franchised Business
any way. For example, many franchi-
sors reserve the right to sell franchised As a general rule, franchisors believe
goods and services through alternative that franchised units will be more suc-
channels of distribution such as conve- cessful if the owner of the franchise
nience stores or grocery stores. Many unit is directly involved in the busi-
franchisors also reserve the right to ness. Thus, many franchisors require
open competing locations very close to an owner of the franchised unit to be
another franchisee’s location. A specific involved in the day-to-day operation of
disclaimer must be included if no exclu- the business (i.e., passive investors will
sive territory is offered. be rejected as candidates for franchised
units).
13. Trademarks
16. Restrictions on What the Franchisee
This section discloses the franchisor’s May Sell
ownership interest in the primary trade-
marks, service marks, and trade names This section describes what are usually
under which the franchisor operates. very specific restrictions on what prod-
These are the marks that a franchisee ucts and services franchisees can sell.
will be allowed to use in operating its These restrictions are necessary to pre-
franchised business. The franchisor’s serve the uniformity, consistency, and
trademarks embody the franchise integrity of the franchise system. While
system’s goodwill, recognizability, and these restrictions may seem strict to an
uniformity. If a primary trademark is individual franchisor, the fact that all
not federally registered, the FDD must franchisees in a given franchise system
include a specific disclaimer to that ef- must comply with the same restrictions
fect. benefits each and every franchisee.

14. Patents, Copyrights, and Proprietary 17. Renewal, Termination, Transfer, and
Information Dispute Resolution

This section is relatively unimportant in This section describes important pro-

many cases because not many franchi- visions of the franchise agreement

12
 concerning if and how the franchise Note, however, that cost and expense in-
agreement can be renewed, terminated, formation is not considered a financial
or transferred. A franchisee does not ac- performance representation under the
tually “buy” a franchise but, instead, is FTC Rule; therefore, franchisors may
awarded a temporary right or license to provide that type of information to pro-
use a franchisor’s business systems, prod- spective franchisees.
ucts, and services for a specific period of
time. These rights are not perpetual. In 20. Outlets and Franchisee Information
fact, some franchisees do not fully com-
prehend this concept and are surprised This section contains a series of statistical
to learn that they have breached the charts listing the number of franchised
agreement and their franchise is on the units opened, closed, transferred, ter-
verge of being terminated. minated, non-renewed, reacquired, and
projected to be opened (not including
While most franchise agreements give foreign units). Disclosure requirements
the franchisor the right to terminate the also include providing a five-year own-
franchise agreement in several situa- ership history for previously owned
tions, franchisees typically have very franchise units now under franchisor
limited, if any, rights to terminate the control. Confidentiality agreements
franchise agreement before its stated with current or former franchisees must
expiration date. also be disclosed.

This section also describes the meth- 21. Financial Statements

ods and procedures by which disputes
between the franchisor and franchisee Franchisors are required to disclose
will be resolved. In many cases, all their audited financial statements for the
disputes must first be submitted for me- prior two years. Under the FTC Rule, a
diation or arbitration in the franchisor’s start-up franchise system may phase in
home state. This requirement can be the use of audited financial statements,
very burdensome to franchisees and, but some registration states may none-
in effect, deter the franchisee from ever theless require audited financials.
attempting to enforce its rights under a
franchise agreement. 22. Contracts

18. Public Figures This section of the FDD identifies all

standard contracts the franchisor typi-
If a well-known personality (actor, pro cally requires its franchisees to sign.
athlete, musician, etc.) is involved with Leases, guarantees, and promissory
the franchise or endorses the franchise, notes are common examples.
such relationships must be described in
the FDD. 23. Receipts

19. Financial Performance Representations The final page of the FDD is a receipt
which is signed by the prospective
This optional section of the FDD dis- franchisee to document that he received
closes historical information about the the FDD on a particular date. The fran-
income and earnings of franchise units chisor will retain this receipt as proof
and company-owned units. This section that it complied with the disclosure
also includes forecasts of future earn- requirements under the FTC Rule and
ings. Due to the risk of liability, most applicable state law. The receipt must
franchisors do not make earnings claims. also be signed by any “franchise seller,”

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 a term defined as any “person that offers this flexibility can be burdensome to franchi-
for sale, sells, or arranges for the sale of sees and the source of many surprises and
a franchise.” unexpected changes in the franchise system.

For example, it will often become necessary for
VIII. The Franchise Agreement a franchisor to compel its franchisees to make
additional capital expenditures (e.g., new signs,
The franchise agreement is the actual contract fixtures, or computer systems). This require-
between the franchisor and franchisee that ment generally will be disclosed in either the
governs their relationship. As referenced above, franchise agreement or the operations manual.
the key provisions of the typical franchise
agreement will be summarized in the FDD.
When drafting the documentation for your new X. Getting Help
franchise system, you should generally begin
with the franchise agreement because (i) it will Developing and implementing a franchise
be the most important document from a legal program will possibly be one of the most sig-
and business perspective, and (ii) much of the nificant and expensive decisions a business will
FDD will depend on what is provided in the make during its existence. Such a monumental
franchise agreement. decision should not be made on a whim based
a need for quick capital. Sound business judg-
ment, thorough research and analysis, and
IX. The Operations Manual common sense should be your guide in decid-
ing to develop a franchise program. Even with
The heart and soul of a franchise system is the careful research and preparation, professional
operations manual. Most franchisors supply assistance is advisable.
their franchisees with a detailed operations
manual that provides specific step-by-step A. Legal Assistance
guidance on the franchise system’s operating
procedures, methods, guidelines, and recipes. An experienced franchise law attorney:
A summary or table of contents should be
disclosed in the FDD but, for obvious reasons, • can provide valuable assistance with the
a franchisor should not divulge its business many legal and business issues involved
secrets in the FDD. These secrets, however, gen- with developing and implementing a
erally are found in the operations manual. franchise program;

Operations manuals are beneficial in many • can assist you in comparing various
ways. Besides being a key information resource franchise opportunities by reviewing
for franchisees, the operations manual is useful the FDDs of different franchise
in resolving disputes over operating procedures opportunities and comparing the
and standards. relative advantages and disadvantages
of each franchise;
An important point to remember about an op-
erations manual is that it usually is subject to • can assist you with the planning and
amendment at any time in the sole discretion of formation of a separate business entity
the franchisor. Major aspects of the franchise or entities through which you will
system can be changed by the franchisor and organize your franchise program.
the franchisees will be required to obey. From Using a corporation or limited liability
the franchisor’s perspective, this flexibility is company is almost essential to protect
necessary to allow the franchise system to grow your personal and corporate assets from
and change to meet ever-changing consumer debts and liabilities arising from the
demand. From the franchisee’s perspective, various aspects of your business; and

14
 • can also assist you with real estate 4. providing ongoing franchise consulting
acquisition or leasing issues. When and mentoring services.
starting a new business, there will be
a number of employment law, tax, and D. Useful Sources of Information About
estate planning needs. Franchising

B. Accounting Assistance 1. Internet

An accountant with experience working with i. Federal Trade Commission (www.

franchised businesses is equally important ftc.gov)
in developing a successful franchise system.
An experienced accountant can help ii. Small Business Administration
prepare budgets and pro forma financial (www.sba.gov)
statements, as well as the required financial
statements for the FDD. An accountant can iii. International Franchise Association
also provide useful advice about financing (www.franchise.org)
the costs of developing and implementing a
new franchise program and help prepare an iv. American Franchisee Association
effective business plan. (www.franchisee.org)

An accountant can also offer practical advice v. American Association of Franchi-

on what to expect financially as a franchisor, sees and Dealers (www.aafd.org)
including anticipated rates of return, whether
the proposed franchisee fee and related terms 2. Books
are reasonable, and other business issues.
An experienced accountant can assist with i. Sherman, Andrew J., Franchising
federal, state, and local tax issues. and Licensing: Two Powerful Ways
to Grow Your Business in any Econ-
C. Franchise Consultants omy, AMACOM (2003).

Over the past 20 years, a cottage industry of ii. Keup, Erwin J., The Franchise Bible,
franchise consulting firms has emerged to Oasis Press (1995).
serve the unmet needs of both prospective
franchisors and franchisees. For a company iii. Bradach, Jeffrey L., Franchise Orga-
contemplating franchising, an experienced nizations, Harvard Business School
franchise consultant can add significant Press (1998).
value by:
iv. Bond’s Franchise Guide, published
1. conducting a franchise feasibility annually by Source Book Publica-
analysis to assess potential costs and tions.
benefits of franchising for a particular
company; v. Meaney, James A., How to Buy a
Franchise, Pilot Books (1999).
2. developing a strategic plan for designing
and implementing a franchise program; 3. Periodicals

3. assisting with the development of i. Franchise Times (6 issues per year)

operations manuals and internal policies 2500 Cleveland Ave., N. Ste. D So.
and procedures for implementing a Roseville, MN 55113-2728
franchise program; and telephone: (651) 631-4995
Internet: www.franchisetimes.com

15
 ii. Entrepreneur Magazine XII. Glossary of Franchising Terms
(12 issues per year)
telephone: (800) 274-6229 Approved Supplier. A designated source from
Internet: www.entrepreneurmag.com which franchise owners may purchase supplies,
equipment, ingredients, inventory, and other
iii. Inc. Magazine (12 issues per year) materials for use in operating the franchise
P.O. Box 54129 business.
Boulder, CO 80322-4129
telephone: (800) 234-0999 Arbitration. A method of dispute resolution
commonly required in franchise agreements in
iv. Franchise Law Journal (4 issues per which disputes are resolved by an independent
year) person or persons. Arbitration is typically—but
ABA Forum on Franchising not always—faster and less expensive than
750 North Lake Shore Drive litigation. Arbitrators are often experts in fran-
Chicago, IL 60611 chise law or the particular industry in question.
telephone: (312) 988-6101 Depending upon the terms of the franchise
Internet: www.abanet.org agreement, the arbitrator’s decision may be final
and binding on the parties.
v. Leader’s Franchising Business &
Law Alert (12 issues per year) Area Representative. An employee or rep-
Leader Publications resentative of the franchisor whose job it is to
345 Park Avenue South supervise and assist franchisees in a particular
New York, NY 10010 geographic area. Area representatives may,
telephone: (800) 888-8300 (ext. 6170) among other things, inspect franchise locations
for quality and cleanliness, help franchisors
solve management and technical problems,
XI. Fun Facts About Franchising mediate disputes between the franchisor and
a franchisee, and coordinate regional and local
A. Did You Know? advertising and marketing efforts.

• Applebee’s was the first casual-dining Business Format Franchising. A type of fran-
chain to reach the 1,000 restaurant chise whereby a franchisor sells to a franchisee
milestone. a total blueprint for doing business, including,
without limitation, trademark and service mark
• Best Western International is the world’s licenses, operational guidelines, site selection
largest hotel brand, with over 4,200 assistance, assistance with permits and licenses,
hotels in 80 countries around the world. training, and ongoing supervision and assis-
tance. Common examples of business format
• The first fast-food hamburger chain franchises include fast-food restaurants, conve-
in the United States was White Castle, nience stores, motels, and car rental businesses.
which opened its first location in 1921.
Business Opportunity Laws. Business oppor-
• On average, a new McDonald’s tunity laws regulate the sale of non-franchised
restaurant opens every three hours. business opportunities, common examples of
which include vending machine routes, envelope
• McDonald’s founder, Ray Kroc, and Walt stuffing schemes, and worm farming businesses.
Disney served together as ambulance States that have such statutes typically exempt
drivers during World War I. Eighty franchise systems that have federally regis-
years later, in 1998, McDonald’s opened tered trademarks or service marks or franchise
the first fast-food restaurant at Walt systems that are already covered by franchise
Disney World. statutes and regulations of that state.

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Buy-Back Option. A common term in fran- marks and business methods. This fee generally
chise agreements whereby the franchisor has does not include inventory or equipment.
the right (not the obligation) to buy back all of
the franchisee’s equipment and inventory if the Good Cause or Reasonable Cause. A legal term
franchisee goes out of business or commits a that means having legally sufficient grounds
serious breach of the franchise agreement enti- to support the actions of a party to a franchise
tling the franchisor to terminate the agreement. agreement, typically in the case of a franchisor’s
decision to terminate or not renew a franchise
Company-Owned Outlet. A franchise loca- agreement.
tion owned by the franchisor. These locations
typically serve as models or examples for fran- Goodwill. The positive public reputation,
chisees to follow. They also serve as training trust, image, or loyalty which a franchisor has
facilities where new franchisees learn about the developed. A franchisor’s goodwill cannot be
franchisor’s operating methods and systems. accurately measured in monetary terms, but is
often a franchisor’s most valuable asset.
Default. A breach or violation of the franchise
agreement by one of the parties. Multi-Unit Franchising. A type of franchise
relationship where a single franchisee pur-
Development Agreement. An agreement chases two or more franchise locations from a
whereby a franchisor sells to a subfranchisor franchisor.
the exclusive right to establish, market, and/or
sell franchises in a specific geographic area for Operations Manual. The confidential docu-
a defined period of time, usually in accordance ment detailing the trade secrets and operating
with a development schedule. methods of a particular franchise, including
such topics as quality control requirements,
Encroachment. Action taken by a franchisor to required hours of operation, required operating
invade the exclusive territory of a franchisee by procedures, recipes, product or service speci-
selling products or services within the territory fications, required uses and restrictions on the
or opening franchisor-owned locations within franchisor’s trademarks and other intellectual
the territory. property, and other operational issues related to
the franchised business.
Federal Trade Commission (the “FTC”). An
independent agency of the federal government Subfranchising. A type of franchise relation-
consisting of five commissioners. The FTC ship where one party (the “subfranchisor”)
is responsible for investigating and bringing enters into a master franchise agreement with a
enforcement actions against illegal business franchisor which provides that the subfranchisor
practices in interstate commerce. is responsible for soliciting others (the “subfran-
chisees”) to open new franchise locations within
Franchise Disclosure Document (“FDD”). a specific geographic area. In some cases, the
The required disclosure document describing franchisor retains various rights and controls
important aspects and details of franchise op- over the subfranchisees, but in other cases, most
portunities that must be given to prospective rights and controls over subfranchisees rest with
franchisees at least 14 days prior to the execu- the subfranchisor. Either or both the franchisor
tion of any agreement or payment of money. and the subfranchisor provide ongoing supervi-
sion and assistance to the subfranchisees.
Franchise Fee. A sum of money paid by the fran-
chisee to the franchisor, usually at the time the Turn-Key Operation. A term used to describe
franchise agreement is signed. The initial franchise a franchise package offered by a franchisor that
fee may cover a variety of expenses and services comes fully equipped and all-inclusive so that a
including training costs and assorted start-up costs new franchisee practically needs only to “turn
as well as the right to use the franchisor’s trade- the key” to start a business.

17
Eric C. Perkins Justin M. Laughter

Eric C. Perkins is a member Justin M. Laughter is an as-

of the firm’s Business sociate in the firm’s business
Section and Real Estate section. His practice focuses
Securities Practice Group. on a broad range of general
His practice focuses on real business and corporate mat-
estate securities offerings, ters, including formation
franchising, and tax-exempt and maintenance of business
organizations. entities, franchising, and
preparation of trademark
Eric has assisted real estate and copyright filings. In addition to his general
sponsors raise over $800 business practice, Justin represents musicians
million in Regulation D private offerings, includ- in entertainment related matters and real estate
ing tenants-in-common, REITs, syndicated limited syndicators in Regulation D private offerings.
liability companies, real estate opportunity funds,
and promissory note offerings. In addition, he spe- Justin is a member of the firm’s Real Estate Securi-
cializes in advising entrepreneurs on franchising ties Practice Group and Franchise Group. He also is
matters and related business issues. Eric also works a member of the firm’s recruiting committee. Justin
regularly with tax-exempt organizations on a vari- maintains an active pro bono practice, including
ety of corporate, tax, and compliance issues. representation of immigrant juveniles in the United
States immigration process. In addition to other
Eric is an author and lecturer on a variety of secu- community activities, Justin is a member of the
rities and business law topics, including co-author YRichmond steering committee, where he serves as
of a Virginia CLE Handbook titled Contract Law in Co-Chair of the Service Committee, and a member
Virginia. of the Richmond Real Estate Coalition.

Eric received his Bachelor of Arts from the University Justin received his Bachelor of Arts degree with
of Virginia and his Juris Doctor from the University distinction in Government from the University of
of Virginia School of Law. Virginia in 2003, where he was inducted into Phi
Beta Kappa. Justin received his Juris Doctor from
Eric is admitted to practice in the Commonwealth of the College of William and Mary in 2006, where
Virginia and is a member of the Virginia State Bar he was inducted into the Order of the Coif. While
and the American Bar Association. attending law school, Justin was a member of The
William and Mary Journal of Women and the Law
To contact Eric: and an executive board member of the William and
Phone 804.771.9583 Mary Public Service Fund.
E-Mail eperkins@hf-law.com
To contact Justin:
Phone 804.771.9506
E-Mail jlaughter@hf-law.com

IMPORTANT NOTICE
THE INFORMATION CONTAINED IN THIS OUTLINE IS PRESENTED WITH THE UNDERSTANDING THAT
THE AUTHOR IS NOT RENDERING ANY LEGAL, ACCOUNTING, OR OTHER PROFESSIONAL SERVICE TO
THE RECIPIENTS OF THIS MATERIAL. THIS OUTLINE IS PROVIDED FOR INFORMATIONAL PURPOSES
ONLY. BECAUSE OF THE RAPIDLY CHANGING NATURE OF THE LAW, INFORMATION CONTAINED
HEREIN MAY BECOME OUTDATED; THEREFORE, ANYONE READING THIS OUTLINE MUST RESEARCH
ORIGINAL SOURCES OF AUTHORITY AND UPDATE INFORMATION TO ENSURE ACCURACY OR SEEK PRO-
FESSIONAL LEGAL ADVICE. IN NO EVENT WILL THE AUTHOR BE LIABLE FOR ANY DIRECT, INDIRECT,
OR CONSEQUENTIAL DAMAGES RESULTING FROM THE USE OF THIS MATERIAL FOR ANY PURPOSE.

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