The FTC Franchise Rule is the federal regulation designed to ensure that prospective purchasers of franchises have the material information they need in order to weigh the risks and benefits of such an investment. The Rule requires franchisors to provide potential franchisees with an FDD containing 23 specific items of information, including information about the franchisor, the franchisor’s directors and officers, the franchise opportunity offered, investment costs, fees, and other franchisees. In addition to the required items of the FDD, the FTC Franchise Rule outlines the proper sales process for selling a franchise and provides exclusions and exemptions in certain circumstances.

Your FDD is not approved by any federal government agency, although it is regulated by the Federal Trade Commission. Most people think the FDD is protection for franchisees, which is why it exists; however, in reality, the FDD protects the franchisor. If you want your contract to be enforced, the first level of inquiry will be: did you give your franchisee the information you were required by law to provide to them before they even signed? If that answer is no, your contract may be unenforceable.

It is important that you follow the law and develop a compliant FDD and sales process to prevent a franchisee from later alleging that they were defrauded. At some point, someone’s going to check, either when you go sell your entire system for millions of dollars or when someone knocks on your door with a subpoena.

Everyone wants to be able to defend themselves against a lawsuit, but a second significant reason why you should be 100% compliant with franchise disclosure and sales laws is in preparation of a private equity firm showing interest in purchasing your franchise system. Private equity will look at 100% of your agreements, 100% of your FDD files, and 100% of your state registration files. If you want to maximize your exit, you need to be in compliance.

ABC Holdings LLC

• This is the main company that will file a tax return
• If there are multiple owners (such as outside investors or multiple founders/partners) it will require a more complex operating agreement documenting capital contributions, governance and distributions
• ABC Holdings will be the sole owner of the two subsidiary entities below

ABC IP LLC

• This is the intellectual property (IP) company that owns all trademarks and IP and licenses them to ABC Franchise LLC
• We will draft a simple 2 to 3 page standard licensing agreement to document the structure between the entities
• The operating agreement will be a simple single member operating agreement reflecting ABC Holdings as the sole owner
• This is a disregarded entity for tax purposes

ABC Franchise LLC

• This is the franchise company and the name on the FDD
• Will require audited financial statements
• Will be the entity that signs the Franchise Agreement with each franchisee
• The operating agreement will be a simple single member operating agreement reflecting ABC Holdings as the sole owner
• This is a disregarded entity for tax purposes

How to form the entities

The best practice is to form these entities in the home state of the new Franchisor. The above is a guideline however, not a rule, as unique situations will require unique solutions. You should discuss your ownership situation with us, your corporate attorney and your accountant so as a team we can decide what makes the most sense.

You should always use a professional to form your entities, but if you don’t be sure to remember that each entity will require the owner’s legal name, one person’s social security number for the IRS to issue a Tax ID number and a non-PO Box street address.

It is recommended to speak with a certified CPA to review your goals and financial obligations before deciding on what type of business entity a franchisor and/or franchisee should establish. Each will have their own pros and cons as it pertains to taxes and liabilities. When it comes to the entity being for the use of anything franchise related, it is best to have the entity only connected to the franchise and no other types of businesses or responsibilities, keeping the entity cleaner, more organized and more protected.

Sole Proprietorship

This is a business run by one individual for his or her own benefit. It is the simplest form of business organization. Proprietorships have no existence apart from the owners. The liabilities associated with the business are the personal liabilities of the owner, and the business terminates upon the proprietor’s death. The proprietor undertakes the risks of the business to the extent of his/her assets, whether used in the business or personally owned.

Single proprietors include professional people, service providers, and retailers who are “in business for themselves.” Although a sole proprietorship is not a separate legal entity from its owner, it is a separate entity for accounting purposes. Financial activities of the business (e.g., receipt of fees) are maintained separately from the person’s personal financial activities (e.g., house payment).

Partnerships – General and Limited

A general partnership is an agreement, expressed or implied, between two or more persons who join together to carry on a business venture for profit. Each partner contributes money, property, labor, or skill; each share in the profits and losses of the business; and each has unlimited personal liability for the debts of the business.

Limited partnerships limit the personal liability of individual partners for the debts of the business according to the amount they have invested. Partners must file a certificate of limited partnership with state authorities.

Limited Liability Company (LLC)

An LLC is a hybrid between a partnership and a corporation. Members of an LLC have operational flexibility and income benefits similar to a partnership but also have limited liability exposure. While this seems very similar to a limited partnership, there are significant legal and statutory differences. Consultation with an attorney to determine the best entity is recommended.

Corporation

A corporation is a legal entity, operating under state law, whose scope of activity and name are restricted by its charter. Articles of incorporation must be filed with the state to establish a corporation. Stockholders are protected from liability and those stockholders who are also employees may be able to take advantage of some tax-free benefits, such as health insurance. There is double taxation with a C corporation, first through taxes on profits and second on taxes on stockholder dividends (as capital gains).

Small Business Corporation (S-Corporation)

Subchapter S-corporations are special closed corporations (limits exist on the number of members) created to provide small corporations with a tax advantage, if IRS Code requirements are met. Corporate taxes are waived and reported by the owners on their individual federal income tax returns, avoiding the “double taxation” of regular corporations.

Sole Proprietorship

• Simplicity of organization – this is the most common form of business organization in the United States because it is the easiest and least expensive to establish.
• Minimum legal restriction – fewer reports have to be filed with government agencies. There are no charter restrictions on operations.
• Ease of discontinuance – the business can be terminated at the will of the owner. The owner is truly the boss, making all decisions, keeping all profits, and assuming responsibility for all losses and debts.
• Difficulty in raising capital – this can be a problem since an individual’s resources are typically less than the pooled resources of partners.
• Limited life of the business – untimely, unanticipated, or unplanned removal of the proprietor from the operation of the business may have ramifications for creditors.
• Unlimited liability – this is by far the greatest disadvantage to the proprietorship. Even though proprietors may invest only part of their capital in the business, they remain personally liable to the full extent of their assets for the liabilities of the business.

Partnerships – General and Limited

• Greater possible capital availability
• Greater resources for decision making, support, creative activity
• Unlimited liability in general partnerships
• Divided authority – having to divide the authority for making decisions among the partners can delay the decision-making process and occasionally lead to disagreement.

Limited Liability Company (LLC)

• Allow greatest flexibility for customizing the structure of the business Limits member liability
• In many states, an LLC may have only one member (have the benefits of a sole proprietorship but limits liability).
• Requires comprehensive operating agreement because of the high degree of variability/flexibility.

Corporation/S-Corporation

• Limited liability to stockholders – liability is limited up to the amount invested personally in the business. In addition, personal assets may not be seized by creditors to satisfy debts (although now creditors often request personal guarantees on business loans).
• Perpetual life – the business continues as a legal entity. Shares in the corporation can be passed on to heirs.
• Ease of transferring ownership – stockholders can sell their shares when they desire, if there is a market.
• Ease of expansion of the company – greater capacity to raise capital by legal sale of stock.
• Government regulation – a corporate charter must be obtained from the state, and the corporation is subject to all state and record keeping regulations that pertain to corporations.
• Costs to organize a corporation are higher.
• Unless permission is obtained from other states, the corporate charter restricts operation to the state where it was issued.
• Double taxation feature unless S-Corporation election is made.

If you are new to franchising, you may only be familiar with the unit franchise offering, which is the basic license to allow another person to operate his or her own business using your brand and systems. Different types of franchise ownership include:

Single Unit Ownership: One franchise location, operated by the owner

Multi-Unit Development: Multiple franchise locations under one owner

Area Representative Ownership: Recruits franchisees and provides regional support

Master Franchise Ownership: Assumes role as franchisor in a large territory (Most often Internationally)

Fractional Franchise: Franchise within an existing business

The simplest and most common type of franchise is a single unit franchisee. Many franchises and franchisees start this way, in order to build their futures one brick at a time. A single unit franchise is an agreement in which the franchisor grants the franchisee the rights to open and operate one franchise unit. One unit to one franchisee commonly represents owner-operated models. However, many times after the franchisee opened their single-unit and is prospering, it may become negotiated with the Franchisor for them to have the possibility of opening other units over time.

Instead of growing only one location at a time, many franchisors decide to offer the option of a multi-unit development agreement to prospects in addition to a single unit offering. A multi-unit development agreement (referred to as a MUDA) is where a franchisor grants a franchisee the rights and obligation to open and operate a specific number of locations during a defined period of time, usually within a designated and assigned territory. To avoid the risks of losing a desirable territory/location or possible price increases are some of the main reasons why prospective franchisees consider this type of franchise ownership over a single unit agreement.

A Multi-Unit Agreement will have precise dates that the franchisee is required to meet – purchased, open and operated dates. There can be legal repercussions if these location dates are not met. A multi-unit agreement, or relationship, can have significant advantages for both the franchisor and the multi-unit franchisee; but it cannot be overlooked by the franchisor to be sure that the franchisee is properly capitalized for any chosen venture, but especially those with more than one location commitments.

Area Representative Agreements relate to the designation of an “area developer” for a proscribed territory. Area Representatives do not typically establish or operate their own individual Franchise units outside of perhaps one unit that may double as a training facility but, rather, sell individual unit franchises to prospective franchisees within the Area Representatives proscribed territory. It is very common that an Area Representative will train franchisees within the proscribed territory and monitor franchisee compliance on behalf of the franchisor. Simply put, the Area Representative is a commissioned sales and field support person for the franchisor who shares in a portion of the royalties collected from the franchisees in the Area Representative’s territory.

The Master Franchise or Sub-Franchisor Ownership is the most complex of ownership options. This type of ownership is less common in the United States and is more often seen internationally. Within a Master Franchise Agreement, the “Master Franchisee” is granted the legal right to both sell Franchises and to approve and sign franchise agreements with sub-franchisees. Essentially, the Master Franchisee “steps into the shoes” as the Franchisor and maintains a direct relationship with Franchisees.

The key differentiating factor between an Area Representative and a Master Franchisee is that the Master Franchise Agreement grants the Master Franchisee to basically become the franchisor in an area that they are authorized to offer sub-franchises. The Master Franchisee will have their own Franchise Disclosure Documents and agreements, containing information about themselves and their offered services, and the Master Franchisees documents will be prepared by the Master Franchisor.

Fractional franchise – The franchise is housed in a clearly demarcated area of an established business, usually one that is active in a related sector. Fractional franchise means any relationship in which the person described therein as a franchisee, or any of the current directors or executive officers thereof, has been in the type of business represented by the franchise relationship for more than 2 years and the parties anticipated, or should have anticipated, at the time the agreement establishing the franchise relationship was reached, that the sales arising from the relationship would represent no more than 20% of the sales in dollar volume of the franchisee for a period of at least one year after the franchisee begins selling the goods or services involved in the franchise.

Fractional franchisee’s total sales could be calculated in one of four ways. Specifically, the increase in product sales attributed to the fractional franchise relationship could be measured against: (1) the fractional franchisee’s total sales for that type of product; (2) the fractional franchisee’s total sales at the store where the new product is sold; (3) the fractional franchisee’s total sales at all franchised units; or (4) the fractional franchisee’s total sales from all businesses (franchise and non-franchised), regardless of the source.

With regard to location licensing, you have to be careful about when a license agreement is appropriate. Just because an outlet is proposed at a non-traditional and/or captured market venue, it does not mean that the arrangement is outside franchise laws and regulations. The venue does not dictate whether a relationship is a franchise or a license.

A “franchise” exists under federal law if (a) the franchisor licenses the use of its trademark, (b) the franchisor exerts significant control over, or provides significant assistance to, the operator’s method of operation, and (c) the operator will make payment(s) to the franchisor. Be aware, certain states have lower requirements.

Many arrangements will meet this definition. Notwithstanding, the federal regulation provides certain exemptions, and if one or more of these exemptions are applicable, the franchisor will not need to provide the FDD or use the standard-form Franchise Agreement. Many non-traditional venue operators will either meet the net-worth exemption (a business operating for at least 5 years and has a net worth of at least $6.165M) or fractional franchise exemption (operator has been in the same type of business for at least 2 years and sales from the franchise are not expected to exceed 20% of the operator’s total sales).

However, the laws in registration states can get tricky, and the federal exemptions may not work in registration states or may require exemption filings prior to having any discussions with the proposed operator.