A Guide to Franchise Compliance

Franchising is regulated by the Federal Trade Commission (FTC) and a variety of individual states. If you are interested in expanding your franchise nationwide, it is imperative that you have registered your franchise properly in the states that require it.

The registration process for franchisors can be an arduous and intimidating one for a franchisor regardless of how many years they have been in existence. Many states have a regulatory oversight agency that reviews every franchise disclosure document (FDD) for any business trying to offer a franchise for sale within its state. Several of these registration states have different requirements to register the franchise properly with a variety of state specific required disclosures. Moreover, many of these states require an annual registration to ensure the franchise is still in compliance with their requirements year after year.

The state agencies carefully review the FDD to make sure it is amenable with state law and regulations.  It is typical for the agency to comment on an FDD and require a franchisor to clarify or even change certain provisions in their FDD. Furthermore, the franchisor is then asked to resubmit the FDD with their comments integrated. Even FDDs that have been previously approved, or clauses that have been approved in other franchise offerings can be questioned and rejected.  The entire process can be a grueling one and in some cases in certain states it can take months to gain approval.

Many states will grant approval with a requirement for the franchisor to make a “financial assurance” which is a type of financial guarantee that the franchisor will perform their obligations to the franchisee. This burden usually falls on startup franchisors and franchisors with weak financial statements.

The Federal government says that if you’re going to offer a license of your intellectual property in exchange for payment, you have to disclose certain information to interested parties prior to taking their money. That information is provided so that buyers can compare “apples to apples”. The primary purpose and philosophy behind this disclosure is to level the information playing field. It is assumed, rightfully so, that you, as the brand owner, have much more information about the brand, the history of the business, the cost, etc. This information is formally presented in a Franchise Disclosure Document or FDD, which you are required to prepare and update on a regular basis.

If a state does not have a specific disclosure or filing requirements for your FDD, it is considered a “federal state” meaning that no registration of the FDD is required in order to sell franchises.

However, even in federal states, there could be state specific franchise laws known as franchise relationship laws or business opportunity laws that govern the relationship between you and your future franchisees.

Don’t assume just because a state is a federal state that the franchise agreement between you and your franchisee is the last word governing the relationship. In the event of a dispute, issue or question please call us first so we can give you the latest updates on where the relevant state law stands.

Learn more about federal requirements.

Under the FTC Franchise Rule, not every franchise offering requires disclosure of an FDD, though the majority do require disclosure. State laws often layer additional requirements to the below exemptions if the state allows for such exemptions. The following franchise transactions are exempt from disclosure under federal law:

  • Fractional Franchise Exemption
    • Where a franchisee prospect will be adding your product or service to an existing business, all of the following must be met:
      • Experience – prospect must possess at least two years of experience in the industry of the franchised business
      • You and the prospect must have a reasonable basis to believe that sales resulting from the franchised business will not exceed 20% of total annuals sales by franchisee in the first year of operation
    • Large Franchise Investment Exemption
      • Where a franchisee prospect’s initial investment is $1 million dollars or greater.
        • “Initial Investment” includes the start-up costs and expenses typically disclosed in FDD Item 7 and expenses paid by the prospect franchisee through the opening of the franchised outlet and through the three-month period thereafter minus costs associated with unimproved land and any funds obtained through franchisor financing or an affiliate.
      • Basis for this exemption presumes that a prospect making a large franchise investment will be more sophisticated and is less likely to require the protections afforded by FDD disclosure.
      • You must obtain a signed acknowledgement from the prospect franchisee that contains the following:

The franchise sale is for more than $1 million – excluding the cost of unimproved land and any financing received from the franchisor or an affiliate – and thus is exempt from the Federal Trade Commission’s Franchise Rule Disclosure requirements, pursuant to 16 C.F.R. Section 436.8(a)(5)(i).

  • Large Franchisee Exemption
    • Two criteria must be met:
      1. The prospect franchisee must possess a net worth of at least $5 million. Net worth is determined by the prospect’s balance sheet.
      2. The prospect franchisee must also have been in business for at least 5 years. The prospect’s prior business experience does not need to be related to the franchised business.
    • You may consider prior experience and net worth of the prospect franchisee’s parent and affiliates.
  • Leased Department Business Exemption
    • Most often this exemption is used in retail settings where an independent retailer conducts its business from a premises leased from a larger retailer and in the larger retailer’s location, provided that the independent retailer is not required to purchase goods or services from the larger retailer or from suppliers designated by the larger retailer.
    • This exemption is very atypical of franchise offerings and in general, will not apply to you if you are an active franchisor with an FDD.
  • General Partnership Exemption
    • Partnerships are excluded from the FTC Franchise Rule. Note that a partnership requires a proportionate allocation of liability exposure and risk.
  • Insider Transaction Exemption
    • Applies to a franchise sale to a prospect franchisee employed (as officer, director, managing agent, general partner, owner) by you within prior 60 days and for at least 24 months
    • The Insider must want to purchase at least a 50% ownership interest in the franchise being offered.
  • Minimum Payment Exemption
    • Where the total of the required payments, or commitments to make a required payment, to you or an affiliate that are made at any time before to within 6 months after the prospect franchisee’s business has commenced operations is less than $500.
    • Commencement of franchisee operations is determined by the date the franchisee first makes goods or services available to the public.
    • This exemption is very atypical of franchise offerings and in general, will not apply to you if you are an active franchisor with an FDD.
  • Oral Franchise Agreement Exemption
    • Applies to franchise agreements that are oral only and where there is no written documentation of the material terms of the franchise relationship.
    • This exemption is very atypical of franchise offerings and in general, will not apply to you if you are an active franchisor with an FDD.
  • Petroleum Marketing Practices Act Exemption
    • Applies to gasoline stations and other businesses that are governed by the Petroleum Marketing Practices Act.
    • This exemption is very atypical of franchise offerings and in general, will not apply to you if you are an active franchisor with an FDD.
  • Single Trademark License Exemption
    • Applies where an individual licensee is granted the right to use your trademark so long as the typical indicia of a franchise system are absent.

Remember, if you think there is a federal exemption that may be applicable in a given situation, it is still imperative to reach out to your Spadea Lignana team for an evaluation of state-specific franchise laws as certain states, particularly states that require registration, do not recognize many of the federal exemptions or have additional requirements to meet the state definition of a given exemption.

In order to legally sell franchises, in addition to the federal FTC Franchise Rule, you must comply with state law.  Certain states, in addition to registration and filing requirements, have state specific exemptions to disclosures under certain circumstances. The state rules can be complex and at times cumbersome, so be sure you are compliant before you disclose a candidate or offer a franchise to a prospect. Click on each state to learn more about the state specific requirements.

AK

ME

VT

NH

WA

ID

MT

ND

MN

IL

WI

MI

NY

MA

RI

OR

NV

WY

SD

IA

IN

OH

PA

NJ

CT

CA

UT

CO

NE

MO

KY

WV

VA

MD

DE

AZ

NM

KS

AR

TN

NC

SC

DC

OK

LA

MS

AL

GA

HI

TX

FL

PR

Federal FDD only*
One Time Registration*
Annual Registration and Approval Required*

*the above legend only applies to franchisors that have a valid federally registered trademark. Franchisors without a trademark are subject to additional requirements in certain states.

Some states will look at a new franchisor, or in their perception an undercapitalized franchisor, and require what the industry calls “financial assurance.” A financial assurance provides “assurance” to the state regulators that you, as the franchisor, will have an incentive to perform your obligations and won’t go broke before the franchisee opens, or if you do go broke before the franchisee opens, the franchisee will not lose their franchise fee. Typically, although this is more of a guideline and not a rule, the states like to see at least $100,000 in non-borrowed cash on your balance sheet if you are a new franchisor or at least $100,000 net worth if you have been franchising for at least a year.

It is worth noting that not only do the state regulators look at your balance sheet, but your prospects do as well. So, a new franchisor with $5,000 in the bank who is looking to charge franchisees a $30,000 franchise fee will not appear as strong as a well-capitalized startup franchisor.

If you have a financial assurance requirement in place in a state, you will see an orange outline around the state. This should serve to remind you that you won’t be able to collect the initial franchise fees for any franchisee with whom you sign a deal who is a resident of that state.

The types of Financial Assurance you may provide are:

  • Deferral of all initial fees owed to you until you’ve performed all of your pre-opening obligations (our recommendation)
  • Posting of a surety bond
  • Placement of the initial fees in escrow
  • A guarantee of performance by your affiliate or parent company

The types of Financial Assurance available to you varies from state to state and may vary within a state depending on the state examiner assigned to your filing.

We recommend this option as it’s the simplest and least expensive way to handle the financial assurance requirement. You simply do not collect any initial fees owed to you until you’ve performed all your pre-opening obligations and the franchisee’s business is open and operating. The fee deferral option doesn’t require involvement from any outside institutions like the state or a bank. While some states may require a written agreement to govern the fee deferral, such agreement would only be between you and your franchisee. While there is some risk that the franchisee may walk away prior to opening, as long as they’re spending money on things like an attorney, incorporation or formation of an entity, and a real estate search, they’re less likely to quit.

The definition of “open for business” is something with which you want to be careful. For a brick-and-mortar business, it’s easy – when they open their doors to the public! For service businesses, a franchisee may be open for business but may not have a client yet. You will want to discuss the definition of “open for business” with us so we so we can spell it out in your franchise agreement very clearly.

This method requires you to post a surety bond usually calculated according to the number of franchises you intend to sell in a state multiplied by the total of all initial fees listed in Item 5 of your FDD. Bonds are expensive, and while some clients have had success, finding an insurance company with which to work at an affordable price can be a challenge – the list is always changing and the fees vary widely. If you are interested in this form of financial assurance, reach out to your Spadea Lignana legal team so we can talk it through and connect you with a few companies that may handle the transaction.

Escrow requires you to place the initial fees in an account at a state bank that agrees to act as your escrow agent. Some state banks will require you to have a bank account (savings, checking, etc.) with them before they will agree to act as your escrow agent. The process is often cumbersome and expensive.

The biggest challenge is having the funds released from escrow. The bank would need to go through the state to begin the release process, at which time you will have to prove to the state examiner that you have performed all of your obligations to the franchisee. The examiner will then correspond with the franchisee to let them know there has been a request to release the funds. The franchisee would need to state whether or not you’ve fulfilled your obligations to them, and then based on the franchisee’s statement, the state would go back to the bank to advise on release. Each of these communications is afforded its own time period for response (30 days, 15 days, etc.). In our opinion, this puts too much control in the franchisee’s hands, and it doesn’t set the right tone in terms of leadership and who is in charge of the relationship.

This method may be used if you have an affiliated company that has adequately strong financials and can act as a guarantor for you. In this scenario, it is the guarantor’s audited financials that are used in Item 21 of the FDD, along with a Guarantee of Performance form signed by an officer of the guarantor. In effect, this method removes the financial assurance, because the guarantor is guaranteeing your obligations. If the guarantor does not want their financials in the FDD or does not want their financials audited (which can be very expensive), this method may not be employed.

A Certificate of Deposit is another type of financial assurance with the caveat that it is not available in all states that may require some form of financial assurance.

As an example, within Illinois: Posting a Certificate of Deposit for each franchise intended to be sold in Illinois (Section 200.506 of the Rules); each CD posted must be in the amount of the initial franchise fee. The CD requirement must be disclosed in Item 5, or on each Illinois addendum, and in the appropriate section of the Agreement. Item 5 or each Illinois addendum must also disclose that the Illinois Attorney General’s Office imposed the financial assurance requirement due to Franchisor’s financial condition. If a Development Agreement is being offered, the CD must include the development fee, which cannot be released until the first franchise opens.

Depending on the state, and if Posting a Certificate of Deposit is an option, each state’s details and requirements should be read carefully and followed specifically. Each state might have slightly different details to comply to.

You must update your FDD with the prior year’s data within 120 days of the end of your fiscal year. This means if your fiscal year end is December 31, you must update your FDD by April 30. If you do not complete the updates by this 120-day deadline, then you will be forced to “go dark” because as of May 1, your FDD is considered stale and cannot be used for disclosures.

If you are planning on having a national franchise offering and will therefore be registering in most or all of the registration states, we recommend you change your fiscal year end to something other than December 31. This is because the vast majority of franchisors have a December 31 fiscal year end, and as a result, the registration states receive a huge influx of renewal filings from March to April (and often into May and June) which causes extreme delays and backlogs in providing approvals for these renewal filings. By choosing a fiscal year end from June 30 through October 31 instead, you will be updating your document in the “off-season” and can sidestep those delays in approvals at the states.

Perhaps the most important recommendation we have for you regarding annual FDD updates is START EARLY!  The reality is, you are in a race against every other franchisor to update your FDD and file your renewals with the states. We encourage you to start gathering information and thinking about the updates and changes you wish to make to your FDD in the month prior to your fiscal year end. We also recommend appointing one person to lead your effort internally, someone we like to call the “FDD Hero”. Get that person in touch with us and have them take charge of the process as early as possible. This will put you in position to win the renewal season race!

Once your new FDD is issued, you should use only the new document from that point forward. You can no longer use the old FDD, even if it has a live registration in a certain state, as material changes have been incorporated into your new document, and these render your old document dead.

Every year when the new FDD is finalized and completed, we issue it with a new issuance date. It is at this point when all the registration states need to be renewed. While this can be a quick process in some states, it is very often a months-long process in other states. You will notice some states on your Map are now red, indicating you can’t make disclosures in those states and therefore no new deals can be closed. You have effectively “gone dark” in those states until we get your new FDD approved and the registration renewed. You should be cognizant of the sales you have in the pipeline, because if you have a deal that is very near to closing, you may want to delay the issuance of your new FDD by a few days or a week so you can close that sale first. This is because once we issue the new FDD, any prospects with whom you have not closed a deal must be redisclosed with the new FDD. This is true for prospects in all states – non-filing/non-registration states, also!  Once your new FDD is issued, you must redisclose everyone in your pipeline and wait the requisite 14-day period before you can sign an agreement. (Remember, your old FDD is dead upon the issuance of your new FDD!)  You should communicate with us regarding any deals in your pipeline as we approach the final punch list items on your FDD updates. Together we can come up with a game plan that makes sense for you.

On the other hand, when thinking about renewing in the registration states, remember this is typically a first-come, first-serve situation. You don’t want to cost yourself weeks, or even months in delays in some states, waiting for approvals because you delayed issuing your new FDD to save one sale. Remember, you are in a race against every other franchisor to file your renewals in the registration states!

In certain situations, and in certain states, you may be able to use the old FDD for informational purposes with a prospect – provided you still have a live registration in that state. For example, let’s say you have a registration in Virginia with an effective date of July 1, but you updated and issued your new FDD before April 30. The old FDD is still under live registration in Virginia, but you can’t close a deal using it because you have a newly issued FDD, and that old FDD was considered expired federally on April 30. While you may be able to share the old FDD with a Virginia prospect before your new FDD is approved and the registration is renewed, you will still be required to redisclose that prospect with the new FDD once it is approved.

Think of it in terms of a soft-shell crab – there is always a small period of time when you’ve lost your hard shell and you’re vulnerable…walking around, just waiting for your new hard shell to form. With your FDD, there will be a period of time when you will be dark for a number of days or weeks in some registration states – where you cannot close a deal and sign a franchise agreement. Like a soft-shell crab, this in-between period is when you are the most vulnerable, and it is the time when you are most likely to make a mistake by closing a deal with a stale FDD. Pay attention to your Map, and let it guide you where you can and cannot disclose and close sales. We will always have the most current information available to you on your Map, but of course, if there is any doubt, be sure to reach out to your Spadea legal team!

When we issue your new FDD, make it part of your process to redisclose each prospect in your pipeline by sending a new email with your map link to each of them. This is the best way to ensure the clock has been restarted and when you and they are ready to sign an agreement, there will be no delay due to a stale disclosure.

During the year, if you need to make a “material change” to your FDD, we must then amend the document and issue an amended FDD. Some examples of a material change, as used in section 683.9 of the General Business Law, includes but is not limited to: 

  • A change in the franchise fees charged by the franchisor 
  • Increased royalties 
  • Litigation or serious threats of litigation 
  • Change in your management team 
  • Sale of your system 
  • Changes in the business model or cost structure for your franchisees 
  • A purchase by the franchisor in excess of five percent of its existing franchises during six consecutive months 
  • Any significant adverse change in the business condition of the franchisor or in any of the following: 
    • The obligations of the franchisee to purchase items from the franchisor or its designated sources 
    • Limitations or restrictions on the goods or services which the franchisee may offer to its customers 
    • The obligations to be performed by the franchisor 
    • The franchise contract or agreements, including amendments thereto 
    • The franchisor’s accounting system resulting in a five percent or greater change in its net profit or loss in any six-month period 
    • The service, product or model line. 
  • Audited financial statements of the preceding fiscal year 
  • The termination, closing, or failure to renew, during a three-month period, of the lesser of 10, or 10 percent, of the franchises of a franchisor, regardless of location 

If you suspect there may be a material change to your system, let us know. We will help you decide whether your FDD needs amending. Unfortunately, there is no hard and fast rule, but only general guidelines and industry standards to help us determine whether or not a change would be deemed material. A useful way to look at it is to think of it from the perspective of the franchisee…is this change something you would want to know if you were investing in a franchise?  Is it something that would be relevant to your go- or no-go decision?  If so, then it is likely a material change.

In addition to amending your FDD for use in all the non-filing/non-registration states, you will have to amend the registrations and file amendments in many of the registration states. This is an important part of the process because, technically speaking, once you have made a material change and amended your FDD, your prior FDD is stale in the same way it would be stale if you didn’t renew on time and it then expired!  You again must redisclose all the prospects in your pipeline with the amended FDD, and effectively restart the 14-day clock on their deals. Although it seems like a pain, it would be a lot worse if you didn’t disclose the material change and amend your FDD – because if you later have a deal that goes south, you are putting yourself at risk of being accused of failing to disclose a material change and then doing an invalid deal with a franchisee who ended up failing. Like a lot of things in franchise law and compliance, it’s all about an ounce of prevention to avoid future issues and pain!

These pages are for informational purposes only and do not establish an attorney-client relationship between the author and the reader. Additionally, we make no representations or warranty to any of the information as legal information is subject to change over time. Before taking action on any of the information presented, you must discuss this with your attorney to ensure it is relevant and applicable to your current situation.