Exploring Alternatives to the Franchise Model

To adequately advise Cupcakes, the following six commercial arrangements should be explored. The first three arrangements are not franchises; rather, they are franchise-avoidance techniques that omit at least one of the elements that create the franchise relationship by law. The last three, generally available in states that only require compliance with the FTC Rule (ie, non-registration states), are in fact franchises by definition, but qualify for one of the FTC Rule's exemptions from disclosure.

Three Non-Franchise Distribution Models

'Franchises' are creatures of statute, consisting of three elements: the trademark license, control of franchisees' operations and/or marketing plans, and the payment of a fee. Having explained to Cupcakes that the trademark element and operational assistance/marketing plan element cannot be avoided if expansion is to concurrently increase equity in the Cupcakes' brand name, your advice to Cupcakes is to: 1) operate the new units itself under a management agreement, thereby eliminating the need to license its trademark; or 2) eliminate the fee element, either under (a) a bona fide whole sale price agreement, or (b) a bona fide joint venture.

The largest expenses incurred by business enterprises that open new units occur during the construction and build-out phase of development. By using a management agreement structure, Cupcakes can avoid these expenses because investors would use their capital for construction of the new units. In exchange, Cupcakes would operate the new units, manage the day-to-day activities, and pay its investors profits from the units' revenue. Franchise laws have no affect on the management agreement because Cupcakes would not need to license its trademark.

Although this may be attractive, the management agreement approach does have its downfalls. For example, Cupcakes would remain exposed to liability for all occurrences taking place in or around its units, including tort and contract liability. Additionally, Cupcakes should be advised to consider the insurance costs, among other management-related costs, associated with daily operation of the new units. Another consideration is that Cupcakes would be required to hire, train, and manage all employees in each location pursuant to one or more management agreements. Because these expenses are not ordinarily present in the franchise environment, clients like Cupcakes that explore the management agreement approach must be advised to pay close attention to the economic and legal trade-offs the enterprise structure presents.

The next two models, a bona fide wholesale price distribution and a joint venture, could enable Cupcakes to eliminate the fee element from its relationships with investors.

Using a bona fide wholesale price distribution model, Cupcakes would provide its investors with a license to sell its trademarked Cupcakes brand under conditions prescribed by Cupcakes. In exchange for the license, the investors would agree to buy the product ingredients exclusively from Cupcakes at a bona fide wholesale price. The FTC Rule and every state franchise act exclude from the definition of 'franchise fee' amounts paid for reasonable quantities of goods or merchandise sold at 'bona fide' wholesale prices and for 'resale.' This can be broken down into two parts. First, 'reasonable quantities' are quantities not in excess of those which a reasonable businessperson normally would require to stock his or her inventory. Second, the inventory purchased by investors must be purchased with intent that it will be resold as opposed to being used as operating supplies.

The wholesale distribution model, however, only increases Cupcakes' brand recognition. What if Cupcakes wants its expansion to also create direct income from investors/operators? The answer may be a joint venture or one of several other enterprise models.

A joint venture is an association that conducts business for joint profit and shares joint losses. The essential elements of a joint venture include a sharing of the profits and losses generated by the business and a right to joint management and control of the business. In our hypothetical, Cupcakes would join forces with an investor, or investors, companies B and C, to form a venture to operate additional units. Each additional unit's business would be marketed according to Cupcake's marketing plan and in connection with its trademark, yet the economic success and/or losses would be shared proportionally according to Cupcakes', B's, and C's capital investment in the venture. Unlike a franchise, B and C would not pay Cupcakes any fee to operate the new units, and Cupcakes would have capital and intellectual property at-risk in the venture units. Notably, relationships that are designed in such a way to avoid the fee, or direct payment for a license to use another's trademark, may nevertheless be subject to franchise law regulation if the FTC or a state regulatory authority construes profits disproportionately shared by the trademark licensor as an indirect fee that satisfies the fee element of the franchise definition. (See FTC Informal Staff Advisory Opinion No. 98-5 (June 24, 1998), Bus. Fran. Guide (CCH) '6494, mark holder's receipt of stock and minority ownership in a joint venture may be the equivalent of a franchise fee.) It is therefore critical that Cupcakes' capital investment returns from the venture are relatively proportionate to its economic interest in the enterprise.

Exemptions from Disclosure Under FTC Rule

Alternatively, Cupcakes may want to avoid the attendant risk of franchise-avoidance techniques and instead structure expansion precisely as a franchisor would, yet remain exempt from FTC-mandated disclosure requirements. There are three options that should be explored.

1) Create a joint venture just as the one described above, but with receipt of any direct fee from franchisees that exceeds $500, or a disproportionate capital return from the venture that exceeds $500, suspended until after the new unit has been in operation for at least 6 months. The FTC Rule and the franchise laws of six states (California, Illinois, Maryland, Michigan, Minnesota, and Wisconsin ' note that the qualifying dollar amount may vary among these states) exempt from the fee definition payments which may otherwise be considered a fee, but amount to less than $500 during the initial 6-month period of new unit operations. This exemption is premised on the theory that if a franchisor does not perform, a franchisee will have defenses for nonpayment. There are numerous FTC advisory opinions that discuss this exemption, the most useful being the advisory opinion issued in Automobile Importers of America, Inc. (See Bus. Fran. Guide (CCH) '6382 (Aug. 9, 1979); FTC Advisory Opinion 96-5, Bus. Fran. Guide '6480 (1996). This particular opinion discusses the acceptable use of a promissory note between a franchisor and a franchisee, not payable until after the 6-month waiting period, and concludes that a safe-harbor does exist.

2) Utilize the nominal fee exemption described above within a traditional franchise relationship, absent the joint venture structure.

3) Use the fractional franchise exemption. The fractional franchise exemption is made express under the FTC Rule (See 16 C.F.R. '436.1-3). It is also made available under several state franchise laws, including California, Illinois, Indiana, Michigan, Minnesota, Virginia, and Wisconsin. Under the FTC Rule, Cupcakes may qualify for the fractional franchise exemption from disclosure by satisfying two elements. The first is that Cupcakes would only be allowed to enter into franchise or license agreements with franchisees that have a minimum of 2 years prior experience in a type of business related to the sale of cupcakes or other food products. Second, Cupcakes and its franchisees should anticipate, at the time the agreement creating the franchise relationship is established, that the sales arising from the relationship would represent no more than 20% of the sales in dollar volume of the franchisee. By way of illustration, Cupcakes could license the right to open and operate a Cupcakes facility to a hotel franchisee with the required experience in food operations. So long as the hotel franchisee has been in business for 2 previous years and can anticipate that sales from Cupcakes' products would not exceed 20% of the franchisee's sales volume, Cupcakes would be exempt from FTC disclosure obligations.

This distribution model may be attractive to businesses like Cupcakes that have a small product that can be integrated into the existing franchise or business operations of other business owners. However, this approach may not work in situations where the integration of the Cupcakes brand and business system does not make sense for the licensee from an operational perspective.

Option to Convert

An additional consideration worth exploring with Cupcakes is the inclusion of an 'option to convert' clause in its contracts with investors or franchisees. For example, suppose Cupcakes tells you that after a certain number of units have proven successful in non-metropolitan markets, the company wants to begin franchising. Can management do that? And if so, must existing joint venture partners convert to franchisees?

The answer is that the company needs to include in its agreements with unit owners an 'option to convert' clause. It is critical that this is deemed an option, and not a mandatory conversion clause. A 'mandatory' conversion may be interpreted as the current offer of a franchise to be opened at a later date. Accordingly, if the clause is mandatory, or exercisable at Cupcakes' discretion, there is risk that the FTC or one or more registration states will interpret the arrangement as a franchise from the outset of the relationship and thus impose sanctions for failing to register and disclose in accordance with the requirements of the FTC Rule and state registration and disclosure laws.

Conclusion

If a client presents you with a proposed deal structure that satisfies the statutory definition of a franchise, there are a limited number of ways to restructure the deal to avoid such a determination. The most direct path is to eliminate one of the three elements of the franchise definition. However, as discussed above, there are certain risks that follow from avoidance techniques, and may result in your client being deemed to be a franchise. The second path is to structure the relationship in such a way as to take advantage of one of the exemptions available under the FTC Rule. The nominal franchise fee exemption and the fractional franchise exemption are both bright-line rules that allow your clients to be structured as a franchise, but without the expense or resource necessities associated with disclosure law compliance. In the end, it is important to counsel your client that avoiding franchise laws may cost as much or more than complying with such laws.

Jeffrey Kolton is a principal with Franchise Market Ventures LLC in New York City. He can be reached at [email protected]. Matthew Gruenberg (partner) and Kevin Hein (associate) are attorneys with Snell & Wilmer L.L.P. in Denver. Gruenberg can be contacted by telephone at 303-634-2081, and by e-mail at [email protected]. Hein can be contacted by phone at 303-634-2015 and by e-mail at [email protected].

We have all run into a situation where an existing or potential client has outlined a deal management wants to do (or, in some cases, has already done), which meets the legal definition of a franchise, but the client is adamant about avoiding the real or perceived burdens of being deemed a franchisor. Establishing a franchise system may require, among other things, compliance with franchise sales laws, public disclosure of financial statements, observing contractual limitations imposed by franchise relationship laws, and enduring the public image of being a franchise. There are a variety of distribution models other than franchising available to clients for structuring envisioned expansion. However, if certain elements are involved in the proposed transaction, creation of a franchise system may become legally necessary. This article addresses the issues practitioners face in advising clients in these scenarios and explores some of the various alternatives to the franchise model and exemptions from franchise disclosure law that are available to your clients.

The 'Cupcakes' Hypothetical

For illustration, consider a hypothetical bakery concept, 'Cupcakes,' that has several very successful company-owned stores in a metropolitan area known as 'City.' Cupcakes wants to expand outside of City into surrounding suburban markets to further test the Cupcakes concept before it invests the money and resources necessary to create a franchise system. Cupcakes has several parties interested in the concept, but wants to avoid the franchise structure until profitable expansion into non-metropolitan markets has been proven. A significant obstacle Cupcakes faces, however, is that it does not want, or is not able, to front the necessary capital to expand into all of the markets it intends to test. Instead, Cupcakes wants to use other people's money to grow its operations.

To adequately advise Cupcakes, the following six commercial arrangements should be explored. The first three arrangements are not franchises; rather, they are franchise-avoidance techniques that omit at least one of the elements that create the franchise relationship by law. The last three, generally available in states that only require compliance with the FTC Rule (ie, non-registration states), are in fact franchises by definition, but qualify for one of the FTC Rule's exemptions from disclosure.

Three Non-Franchise Distribution Models

'Franchises' are creatures of statute, consisting of three elements: the trademark license, control of franchisees' operations and/or marketing plans, and the payment of a fee. Having explained to Cupcakes that the trademark element and operational assistance/marketing plan element cannot be avoided if expansion is to concurrently increase equity in the Cupcakes' brand name, your advice to Cupcakes is to: 1) operate the new units itself under a management agreement, thereby eliminating the need to license its trademark; or 2) eliminate the fee element, either under (a) a bona fide whole sale price agreement, or (b) a bona fide joint venture.

The largest expenses incurred by business enterprises that open new units occur during the construction and build-out phase of development. By using a management agreement structure, Cupcakes can avoid these expenses because investors would use their capital for construction of the new units. In exchange, Cupcakes would operate the new units, manage the day-to-day activities, and pay its investors profits from the units' revenue. Franchise laws have no affect on the management agreement because Cupcakes would not need to license its trademark.

Although this may be attractive, the management agreement approach does have its downfalls. For example, Cupcakes would remain exposed to liability for all occurrences taking place in or around its units, including tort and contract liability. Additionally, Cupcakes should be advised to consider the insurance costs, among other management-related costs, associated with daily operation of the new units. Another consideration is that Cupcakes would be required to hire, train, and manage all employees in each location pursuant to one or more management agreements. Because these expenses are not ordinarily present in the franchise environment, clients like Cupcakes that explore the management agreement approach must be advised to pay close attention to the economic and legal trade-offs the enterprise structure presents.

The next two models, a bona fide wholesale price distribution and a joint venture, could enable Cupcakes to eliminate the fee element from its relationships with investors.

Using a bona fide wholesale price distribution model, Cupcakes would provide its investors with a license to sell its trademarked Cupcakes brand under conditions prescribed by Cupcakes. In exchange for the license, the investors would agree to buy the product ingredients exclusively from Cupcakes at a bona fide wholesale price. The FTC Rule and every state franchise act exclude from the definition of 'franchise fee' amounts paid for reasonable quantities of goods or merchandise sold at 'bona fide' wholesale prices and for 'resale.' This can be broken down into two parts. First, 'reasonable quantities' are quantities not in excess of those which a reasonable businessperson normally would require to stock his or her inventory. Second, the inventory purchased by investors must be purchased with intent that it will be resold as opposed to being used as operating supplies.

The wholesale distribution model, however, only increases Cupcakes' brand recognition. What if Cupcakes wants its expansion to also create direct income from investors/operators? The answer may be a joint venture or one of several other enterprise models.

A joint venture is an association that conducts business for joint profit and shares joint losses. The essential elements of a joint venture include a sharing of the profits and losses generated by the business and a right to joint management and control of the business. In our hypothetical, Cupcakes would join forces with an investor, or investors, companies B and C, to form a venture to operate additional units. Each additional unit's business would be marketed according to Cupcake's marketing plan and in connection with its trademark, yet the economic success and/or losses would be shared proportionally according to Cupcakes', B's, and C's capital investment in the venture. Unlike a franchise, B and C would not pay Cupcakes any fee to operate the new units, and Cupcakes would have capital and intellectual property at-risk in the venture units. Notably, relationships that are designed in such a way to avoid the fee, or direct payment for a license to use another's trademark, may nevertheless be subject to franchise law regulation if the FTC or a state regulatory authority construes profits disproportionately shared by the trademark licensor as an indirect fee that satisfies the fee element of the franchise definition. (See FTC Informal Staff Advisory Opinion No. 98-5 (June 24, 1998), Bus. Fran. Guide (CCH) '6494, mark holder's receipt of stock and minority ownership in a joint venture may be the equivalent of a franchise fee.) It is therefore critical that Cupcakes' capital investment returns from the venture are relatively proportionate to its economic interest in the enterprise.

Exemptions from Disclosure Under FTC Rule

Alternatively, Cupcakes may want to avoid the attendant risk of franchise-avoidance techniques and instead structure expansion precisely as a franchisor would, yet remain exempt from FTC-mandated disclosure requirements. There are three options that should be explored.

1) Create a joint venture just as the one described above, but with receipt of any direct fee from franchisees that exceeds $500, or a disproportionate capital return from the venture that exceeds $500, suspended until after the new unit has been in operation for at least 6 months. The FTC Rule and the franchise laws of six states (California, Illinois, Maryland, Michigan, Minnesota, and Wisconsin ' note that the qualifying dollar amount may vary among these states) exempt from the fee definition payments which may otherwise be considered a fee, but amount to less than $500 during the initial 6-month period of new unit operations. This exemption is premised on the theory that if a franchisor does not perform, a franchisee will have defenses for nonpayment. There are numerous FTC advisory opinions that discuss this exemption, the most useful being the advisory opinion issued in Automobile Importers of America, Inc. (See Bus. Fran. Guide (CCH) '6382 (Aug. 9, 1979); FTC Advisory Opinion 96-5, Bus. Fran. Guide '6480 (1996). This particular opinion discusses the acceptable use of a promissory note between a franchisor and a franchisee, not payable until after the 6-month waiting period, and concludes that a safe-harbor does exist.

2) Utilize the nominal fee exemption described above within a traditional franchise relationship, absent the joint venture structure.

3) Use the fractional franchise exemption. The fractional franchise exemption is made express under the FTC Rule (See 16 C.F.R. '436.1-3). It is also made available under several state franchise laws, including California, Illinois, Indiana, Michigan, Minnesota, Virginia, and Wisconsin. Under the FTC Rule, Cupcakes may qualify for the fractional franchise exemption from disclosure by satisfying two elements. The first is that Cupcakes would only be allowed to enter into franchise or license agreements with franchisees that have a minimum of 2 years prior experience in a type of business related to the sale of cupcakes or other food products. Second, Cupcakes and its franchisees should anticipate, at the time the agreement creating the franchise relationship is established, that the sales arising from the relationship would represent no more than 20% of the sales in dollar volume of the franchisee. By way of illustration, Cupcakes could license the right to open and operate a Cupcakes facility to a hotel franchisee with the required experience in food operations. So long as the hotel franchisee has been in business for 2 previous years and can anticipate that sales from Cupcakes' products would not exceed 20% of the franchisee's sales volume, Cupcakes would be exempt from FTC disclosure obligations.

This distribution model may be attractive to businesses like Cupcakes that have a small product that can be integrated into the existing franchise or business operations of other business owners. However, this approach may not work in situations where the integration of the Cupcakes brand and business system does not make sense for the licensee from an operational perspective.

Option to Convert

An additional consideration worth exploring with Cupcakes is the inclusion of an 'option to convert' clause in its contracts with investors or franchisees. For example, suppose Cupcakes tells you that after a certain number of units have proven successful in non-metropolitan markets, the company wants to begin franchising. Can management do that? And if so, must existing joint venture partners convert to franchisees?

The answer is that the company needs to include in its agreements with unit owners an 'option to convert' clause. It is critical that this is deemed an option, and not a mandatory conversion clause. A 'mandatory' conversion may be interpreted as the current offer of a franchise to be opened at a later date. Accordingly, if the clause is mandatory, or exercisable at Cupcakes' discretion, there is risk that the FTC or one or more registration states will interpret the arrangement as a franchise from the outset of the relationship and thus impose sanctions for failing to register and disclose in accordance with the requirements of the FTC Rule and state registration and disclosure laws.

Conclusion

If a client presents you with a proposed deal structure that satisfies the statutory definition of a franchise, there are a limited number of ways to restructure the deal to avoid such a determination. The most direct path is to eliminate one of the three elements of the franchise definition. However, as discussed above, there are certain risks that follow from avoidance techniques, and may result in your client being deemed to be a franchise. The second path is to structure the relationship in such a way as to take advantage of one of the exemptions available under the FTC Rule. The nominal franchise fee exemption and the fractional franchise exemption are both bright-line rules that allow your clients to be structured as a franchise, but without the expense or resource necessities associated with disclosure law compliance. In the end, it is important to counsel your client that avoiding franchise laws may cost as much or more than complying with such laws.

Jeffrey Kolton is a principal with Franchise Market Ventures LLC in New York City. He can be reached at [email protected]. Matthew Gruenberg (partner) and Kevin Hein (associate) are attorneys with Snell & Wilmer L.L.P. in Denver. Gruenberg can be contacted by telephone at 303-634-2081, and by e-mail at [email protected]. Hein can be contacted by phone at 303-634-2015 and by e-mail at [email protected].