The word “franchise” likely brings to mind big brands like McDonald’s, Dunkin’, 7-Eleven, or Taco Bell, among others. But forming a franchise relationship is much more common than most business owners realize, even when two parties may not intend to form such a relationship. Creating a franchise can have serious implications and requires business owners to navigate complex federal and state franchising laws, so it’s important to understand how the accidental franchise can be formed – and avoided.
When might a franchise be formed?
Generally, a business owner should be on the lookout for a potential franchise when they are granting certain business rights to someone else. For example, perhaps a restaurant owner wants to allow someone to open a new restaurant using their restaurant name. Generally, this can be accomplished through a license agreement or by creating a franchise.
What’s the difference?
A license agreement is between a trademark owner (a “licensor”) and someone who wants to use that trademark in connection with the sale of goods or services (a “licensee”). The trademark might be a business name, logo, or even the interior design and “ambience” of the business itself.
License agreements are fairly limited in scope because the licensor is only granting the licensee the right to use the trademark in their business. Thus, the licensor cannot exert control over other areas of the licensee’s business operations or advertising.
A franchise, on the other hand, exists where one party (a “franchisor”) sells the right to duplicate their business operations to another party (a “franchisee”). While the franchisee is granted the right to a trademark, the franchisor has the right to control aspects of the franchisee’s business.
Since every franchise contains a trademark license, business owners may think that they are only entering into a license agreement when making these types of deals. But depending on how the agreement is drafted, they may be inadvertently creating a franchise and opening the door to liability under various franchise laws.
Why does the franchise vs. license distinction matter?
Franchising is a highly regulated industry with a patchwork of federal and state franchise laws that business owners must comply with. In fact, California has some of the toughest franchise laws, which include registration requirements, advertising restrictions, and detailed disclosures before a franchisor can offer to sell a franchise.
Creating a franchise, even by accident, means that the parties must comply with these complex and burdensome laws. Failure to comply may subject business owners to severe consequences, including fines, civil and criminal sanctions, and other penalties.
How is a franchise created?
Generally, courts will find that a franchise relationship exists when three elements are met: (1) the license of a trademark; (2) control over business operations; and (3) the payment of a fee.
More specifically, California’s Franchise Investment Law (CFLI) defines a “franchise” as: a contract or agreement, either expressed or implied, whether oral or written, between two or more persons by which:
(1) A franchisee is granted the right to engage in the business of offering, selling or distributing goods or services under a marketing plan or system prescribed in substantial part by a franchisor; and
(2) The operation of the franchisee’s business pursuant to such plan or system is substantially associated with the franchisor’s trademark, service mark, trade name, logotype, advertising or other commercial symbol designating the franchisor or its affiliate; and
(3) The franchisee is required to pay, directly or indirectly, a franchise fee.
The phrase “marketing plan or system” is broader than one might think, as the California Commissioner of Corporations has explained that this element can be satisfied if the franchisor controls various aspects of the franchisee’s business, like employee uniforms, how customers pay, hours of operation, business decorations, prohibitions on competitor products, and, as the phrase suggests, advertising, sales pitches, and signage.
Like most states, California courts construe the definition of “franchise” expansively, meaning that a license or other agreement can be deemed a franchise even if the parties did not intend to form such a relationship. Instead, if there is a marketing plan, a trademark, and a fee, it will likely be deemed a franchise.
How can a franchise be avoided?
A party cannot avoid a franchise relationship simply by labeling the agreement something else. For example, in People v. Kline, two parties signed a written “partnership agreement” for several fast-food kiosks. 110 Cal.App.3d 587 (1980). Despite this “partnership agreement” terminology, the court easily found that all three elements of a franchise were met, explaining that the “whole aroma” of the transaction was clearly a franchise, despite the “partnership” label.
Similarly, in Kim v. Servosnax, Inc., the parties initially believed that they were entering into a “license agreement” for the operation of cafeterias. 10 Cal.App.4th 1346 (1992). However, a court later found that a franchise relationship actually existed. This meant that the franchisor was required to comply with various franchise regulations, which they had failed to do since they believed it was only a license, not a franchise.
While there are several exemptions for out-of-state franchises and experienced franchisees, among others, California law makes it difficult to avoid franchise law for these types of business transactions.
The following tips may help decrease the likelihood that a court will find a franchise:
• As a franchisor, avoid imposing duties or exerting control over the franchisee’s business. Instead, ensure that the franchisee is allowed to freely operate their business.
• Although not bulletproof, include a disclaimer in the agreement that outlines the parties’ intentions for the agreement and explains that the licensor does not have a right to control the licensee’s business operations.
• Even if there is no obligation for a franchisee to comply, a franchisor should not provide specific sales programs, advertising, demonstration kits, etc. to franchisees, even if these are merely suggested or recommended for the franchisee.
• When in doubt, comply with franchise laws. While compliance can be costly, there is a high potential for liability against franchise-related claims, especially in California. Thus, the legal expenses associated with compliance minimize the potential for future liability.
Ultimately, it’s always best to err on the side of caution and consult an attorney before entering into a license agreement. An attorney can help business owners navigate franchise laws and avoid falling into the “accidental franchise” trap. We are your Orange County trademark and business attorneys here to help.