Learn About Franchise vs. License Differences - Franchising vs. Licensing A Business Decisions and the Pitfalls of Selling a Disguised Illegal Franchise
Think you may have bought an illegal, disguised franchise that's called a "license," or something else? Or are you a licensor, think you have sold illegal franchises, and want a solution?
In a recent case, the "licensor" selling disguised franchises settled with our client for $600k shortly after the Complaint was filed against it. Compared to the paltry $20k licensing fee and some royalty payments it received, it's no wonder there's a lot of head scratching going on.
Contact franchise attorney and testifying franchise expert, Kevin B. Murphy, Mr. Franchise, directly through the Franchise Attorney page of this website, or click the above email link.
What's the difference between franchising vs. licensing a business? Is a license business model really different from a franchise business model? The starting point in the analysis is to consider the legal aspects, then the business aspects. A franchise always includes a license of the brand and operating methods, along with assistance (training, an operations manual, etc.) or support (providing advice, quality control, inspections, etc.). And a license that is supposedly "not a franchise" and even states this, but contains franchise legal elements, is a disguised, illegal franchise with significant legal ramifications and risk.
In considering the legal aspects, begin with the following premise that applies to both options:
If you put someone into business (or allow them to use your business brand/mark) this transaction will normally be a regulated activity, subject to substantial penalties for noncompliance. If it looks like a duck and walks like a duck, it's a duck. This guiding legal principle (and common sense), coupled with the business aspects of selling a franchise vs. a license (discussed below) will answer most questions.
BACKGROUND OF FRANCHISE & BUSINESS OPPORTUNITY LAWS
Why does regulation exist? Arising from the ashes of documented past abuses, where tens of thousands of individuals lost all of their worth by investing in nonexistent or worthless business endeavors, the government has devised two principal consumer protection mechanisms for those who put others into a business or teach them how to enter a business:
(1) franchise disclosure-registration laws; and
(2) business opportunity laws.
The thrust of these laws is to require sellers to give potential buyers enough pre-sale information so informed investment decisions can be made before money changes hands, contracts are signed and sizable financial commitments are undertaken. Under federal regulations, a Franchise Disclosure Document or FDD covering twenty-three individual chapters and a hundred or more pages in length must be prepared and given to every potential buyer at least 14 calendar days before any contract is signed or money paid.
It doesn't matter what terms are used by the parties in contracts or other documents to describe their relationship. For example, the contract may call the relationship a license, a distributorship, a joint venture, a dealership, independent contractors, consulting, etc., or the parties may form a partnership or a corporation. This is entirely irrelevant in the eyes of governmental regulators, in particular the Enforcement Division of Federal Trade Commission (FTC) and state agencies, like the California Department of Corporations. Their focus is not on semantics, like what the contract is called, but whether a small number of defining elements are present or not. Today sellers are subject to a complex web of regulations that differ from the federal level to the state level and even differ widely from state to state.
Firms or individuals that say calling it a “license” dispenses with legal regulations are delusional and wrong for at least four reasons:
(1) Common Sense - if it was really that easy, everyone would be doing it that way. The 3,000-plus companies that are franchising may be a lot of things, but they're not stupid. Many can afford the very best legal talent available. It's not a coincidence they're all franchising and not licensing;
(2) Even if the relationship can be structured so it doesn't fall within the definition of a "franchise," the backup regulatory protection mechanism - business opportunity laws (discussed below) - will certainly apply. And complying with these is a lot more expensive than going the franchise route;
(3) Any analysis must include federal law (franchise and business opportunity) as well as applicable state laws covering the same dual prongs (franchise and business opportunity); and
(4) There used to be what was called the "unique license" exclusion. Many times incorrectly referred to as the "single franchise" exemption, it was used by a number of companies to try and skirt federal and state franchise laws. If there was: (a) just one license granted of a trademark, service mark, tradename or other commercial symbol, and (b) it was only a simple license that did not have any of the assistance, training, territories, reporting, etc. found in a franchise relationship, that used to be an exclusion under the FTC Rule. "Used to be" and "under the FTC Rule" are the key phrases here. This was deleted in the 2007 revisions to the FTC Franchise Rule, and replaced (cited in the 2007 Compliance Guide) with an even more stringent "single trademark license," citing the clothing industry as an example, where a trademark owner licenses the manufacture of textiles. It also includes "collateral product" licensing where a well-known trademark is licensed in another context, like the license of Mickey Mouse on coffee cups. So, it became "hasta la vista, Baby" under the FTC franchise rule. And the other prong, state law, must also be considered. The single license was never a recognized exemption in franchise registration states like California, etc.
But this doesn't stop ill-informed attorneys who, unfortunately, abound like never before and have no problem charging clients for documents or structures that supposedly avoid franchise regulations. In 2011, a California attorney (undoubtedly the one who drafted the document in question) incredibly claimed his client had a "100% defense" to selling a disguised franchise in 2009 to a California resident as a "license" because of the FTC's single trademark license exemption. Apparently he was not aware this exemption was eliminated by the FTC years ago, in 2007. He was equally oblivious to the fact that there were more than sufficient franchise elements present in the so-called license agreement. Nor was he aware that California never, ever recognized the FTC's single license exemption. His "100% defense" dropped all the way down to 0% and the California Department of Corporations correctly and absolutely ruled that an unregistered franchise was sold in violation of the California Franchise Investment Law. The attorney did not even try to appeal the California decision, and for (by now) very o-b-v-i-o-u-s reasons.
This "but it's not a franchise, it's just a license" reasoning reminds me of some financial planners who still advise their U.S. clients that filing U.S. income tax returns is not required under their interpretation of the U.S. Constitution. It just doesn’t work that way. Actually, let's back up a bit. It does work, but only temporarily until the IRS catches up - and they do. Then fines and penalties are substantial. Same thing applies for violations of franchise registration and disclosure laws. And in these economic times, state agencies in particular are very responsive to complaints by injured consumers. The fines and penalties help them meet increasing budgetary cutbacks.
The "licensing avoids franchise regulations" spin (which, not surprisingly, is not accepted in the legal community or by state enforcement agencies) also only works until the company gets caught. The logic (not) goes something like this: licensing arises under contract law, not franchise law and therefore franchise law doesn't apply. Sound's just like the "you don't have to file a tax return because tax laws don't apply" argument.
Here's another real life example. A license attorney prepared a dealer license agreement and ignored the FTC Franchise Rule disclosure requirements ("licensing arises under contract law, not franchise law"). The dealers became disgruntled and hired a litigation attorney who sued the company for, not surprisingly, selling disguised illegal franchises. It cost the company $750k, that is $750,000, to go to trial in federal court to answer the question "Is our license contract really an illegal franchise?"
"Is our license really a disguised, illegal franchise?" is always a very expensive question to answer. Unless spending $750k is your idea of a good investment. Trying an end run around the franchise disclosure laws by calling it a "license" or a "dealership" or "consulting" or creating labyrinth structures may appear to be a cheaper way to go initially. But, like a game of chess, the endgame is what all masters plan for right from the very beginning. It's only a question of when (not if) you will be caught or challenged.
So the issue becomes willingness to spend mind-boggling amounts down the road to defend when the disguised illegal franchise is challenged. Even if you're lucky enough to win the litigation lotto, you still lose (because you will have spent a ton in attorneys fees by then). And if you lose, you lose big-time.
In a 2008 case, Otto Dental Supply, Inc. v. Kerr Corp., 2008 WL 410630 (E.D. Ark. 2/13/08) another disguised franchise vs. a license was at issue. The company claimed it sold just a license, not a franchise and the franchise laws simply didn't apply. It made a motion for summary judgment to have the case thrown out of court.
The federal Eastern District Court ruled against the company and ordered the case forward. It said whether or not the license was really a franchise was up to a jury to decide. Jurors are like most of us, and apply common sense to the simple defining elements of a franchise. They are not swayed by semantic arguments like "licensing arises under contract law, not franchise law and therefore franchise law doesn't apply." Another very expensive franchise vs. license learning lesson.
Enforcement actions by regulatory agencies can also be very expensive learning lessons. In Current Technology Concepts Inc. v. Irie Enterprises Inc. the Minnesota Supreme Court concluded a licensing arrangement was a franchise and held the franchise company liable for damages in the amount of $1.3 million for violating the Minnesota Franchise Law. Hearing "after the fact" that the arrangement was an accidental, illegal franchise and you're liable for $1.3 million was the last thing that company ever wanted to hear.
Perhaps they got themselves into this mess by listening to statements found on the internet that franchising is expensive and licensing inexpensive. Again, if something sound's too good to be true, it usually is and this should be a big flashing red light.
A 2011-2012 Evolving Case Involving Franchising vs. Licensing
A home improvement company unfortunately sold "license agreements" without complying with franchise registration and disclosure laws.
The Illinois Attorney General brought an action against the company for violating the Illinois Franchise Disclosure and Registration law, resulting in a Final Judgment and Consent Decree.
That same day, on the opposite coast, the California Department of Corporations issued a Desist and Refrain Order based on failure to comply with California's Franchise Investment Law.
In early 2012, a licensee filed suit against the company for violating the Illinois Franchise Disclosure Act, seeking rescission, damages, attorneys' fees and court costs.
What the final financial hit will amount to in cases like this after attorneys’ fees, etc. are considered is impossible to estimate, but it could easily be in the millions.
Even big companies are ill-informed. One with a net worth in the billions used a dealer agreement and failed to comply with franchise registration and disclosure laws. At first, the company dug in it's legal heels, claiming it had not sold a franchise. Then in 2012, it quickly settled for a lotto-like amount, apparently not wanting to go to court and get a precedent-setting award against it.
And a final example in a "small" case where I did the case analysis and helped with the demand letter, legal complaint when the lawsuit was filed, etc. Another disguised franchise called a license. For licensing rights, the licensor was paid $22,500. After a well-written demand letter, followed by filing a complaint in Superior Court to initiate the lawsuit, the licensor settled very quickly, paying the licensee over $200,000. Discovering they were in the wrong and being exposed to a potentially much greater amount, along with attorneys fees, an enforcement action by the state for violating franchise laws, etc., early settlement was a no-brainer.
But having to pay over $200,000 to collect $22,500 and giving the licensee what amounted to a free ride at their expense (the licensee continues in operation, but just under a different name) - paying more than ten-times the "license" amount received - what kind of business sense is that? All this to escape having to pay around $30k to do it right as a franchise the first time?
As a footnote, believe me, this licensor is having a lot of trouble sleeping at nights, wondering when (not if) the next licensee will bring a similar action and how much it will cost to bail out of the next one. The internet statements "compare high cost franchising to low-cost licensing" don't seem very real - and they never were. And show me just one, only one, case where low-cost licensing was used to put someone in a business and was held not to be a franchise. Can't do it, and never could.
It is important to remember the roots of licensing: artwork and character licensing - where the owner (licensor) grants permission to copy and distribute copyrighted works, such as allowing Mickey Mouse to appear on t-shirts and coffee mugs. But Disney doesn't teach someone how to get into the t-shirt or coffee mug business.
The most recent explosion in licensing is the licensing of software on personal computers. Or, the owner of a trademark allows another a license to use its mark as a way of settling a trademark infringement suit. These are common and accepted forms of licensing. However, the attempt to use licensing as an end-run around the franchise laws is a corrupted use licensing was never intended for.
This is not to say licensing a business may not be a viable option in foreign (entirely out of U.S.) transactions where U.S. franchise laws don't apply - but these are a very small minority. Most transactions and contracts cover U.S. activities and residents, so the franchise vs. license question is an easy one to answer.
Even inside the U.S. there are some situations where calling the relationship a "license" makes sense. Years ago, a company selling an education concept to university professionals called their contract a license. However, to comply with applicable laws, a full franchise disclosure document was prepared and registered. For strictly marketing reasons (academic professionals were used to licenses), the "franchise agreement" was called a "license agreement" within the many pages of the FDD franchise disclosure document. This approach, of course, is 100% legal.
It's important to remember the list of required defining elements for a "franchise" is quite short, and although very limited franchise exemptions and exclusions are available (typically for the very rich and famous), the legal statutory framework was designed to pigeonhole these relationships into either a franchise or business opportunity box.
Normal agreements used to license a business contain certain control and assistance provisions. Control provisions include things like the right to inspect, requiring reports, designating territories, mandating suppliers, methods of operation, payments, etc. Assistance provisions include things like providing training, instruction, an operations manual, ongoing assistance, cooperative marketing, supply, etc. Under the regulations, the presence of ANY specified control OR assistance provision is enough to trigger the Franchise Rule, as long the money component (payment of at least $500 within six months of when operations begin) and using a common name are satisfied.
In fact, the title of the FTC Rule says it all: "Disclosure Requirements & Prohibitions Concerning Franchising and Business Opportunity Ventures." So, the smart focus is on which box is better to use, not on how to try and avoid using either box.
THE FRANCHISE BOX - REGULATION BY THE FEDS
Let's consider the franchise box. Under FTC franchise regulations that became effective in 1979, a substantial document (now called a Franchise Disclosure Document) must be prepared and given to prospective buyers for a minimum of 14 calendar days before any money is paid or contracts are signed. This document contains 23 items or chapters of information, as well as current financial statements and a copy of the actual contracts used.
As mentioned, a franchise disclosure document is designed to give prospective buyers enough pre-sale information about the company, the management team, its financial condition, the proposed contract, investment requirements, fees, trademark rights, exclusive territories, etc., so informed decisions can be made before long-term contracts are signed and financial commitments are made.
For companies that attempt to disregard federal law, the FTC Act authorizes the Commission to recover civil penalties of up to $10,000 for each violation of its Rule, plus injunctive relief, consumer redress (obtaining complete refunds of all money paid, canceling contracts), etc. Because each sale can involve multiple violations of various regulatory provisions, these fines can be substantial and far outweigh the cost of doing it right the first time.
Selling a disguised illegal franchise as a "license" can be the most expensive mistake a company ever makes. One need only consult the franchise registration filings of various states to see the significant number of companies that fall into this trap. They start out selling "licenses," operating under misguided advice in a vain attempt to save money. Then, they either get sued for selling a disguised, illegal franchise. Or they finally get competent legal advice and discover what they've really sold are illegal, disguised franchises, even though they were called a "license." And, despite what they were told, the franchise laws do apply.
The governmental agencies require these companies to offer full rescission rights (cancel the license, refund all money that's changed hands) to all persons they've sold "licenses" to. Defenses like "we didn't sell a franchise, we only sold a license" or "it's a license and a license arises under contract law, not franchise law" just don't work and never have. In the end, these companies pay a lot more (as in a large multiple) to have it done the way it should have from the very beginning.
And for those disguised franchise owners who exercise their "free pass" to get out of the license contract given by the regulatory agencies, the company ends up putting them into a competing business for free. And they have to refund all the money that was paid during the course of the "license" relationship. Instead of members of a fraternal network, the break away players become fierce competitors to the company that sold them the licenses. Not a pretty picture, or an inexpensive one.
STATE REGULATION OF FRANCHISING
Because regulation of franchising is at the federal and state level, the effect of state regulation must also be considered. The FTC Rule sets minimum standards and applies in all states, unless a particular state sets even higher standards (and some do), and then that state's law applies.
In 1971, eight years before the FTC Rule went into effect, the State of California was the first to enact a franchise disclosure-registration law where a franchise registration process is required before franchises can be offered (i.e. advertised) or sold. The California Franchise Investment Law was in response to a wave of consumer franchise complaints. Other states soon followed California’s lead, leading to a situation where companies selling franchises had to follow different rules in each franchise registration state.
To alleviate these administrative difficulties and achieve a uniform format, a group of Securities Commissioners from various states adopted a Uniform Franchise Regulation, effective in 1977, known as the Uniform Franchise Offering Circular (UFOC) format. All states requiring franchise registration adhered to the UFOC format, a sizeable document also containing 23 chapters of information. None of these states accepted what was then known as the FTC's Basic Disclosure Document.
To ease the obvious predicament created by UFOC vs. FTC format, the FTC allowed companies to use the UFOC format as an alternate to its Basic Disclosure Document. In 2007, the FTC adopted its own version of the UFOC format, known as the Franchise Disclosure Document or FDD. The FDD format became the required format in all states beginning July 1, 2008.
FRANCHISE BOX SUMMARY
Bottom line on the franchise box: By preparing a single franchise disclosure document (at a total cost of about $30,000 including strategic planning, franchise disclosure document, operations manual, etc. - see our cost to franchise a business budget), a company satisfies the federal requirement and is positioned to offer and sell franchises throughout the United States. Although certain state-specific information and disclosures may be required in the minority of states having a registration-review process (the so-called franchise registration states like California, New York, Illinois, etc.), this can normally be accomplished within a manageable number of hours per state.
THE BUSINESS OPPORTUNITY BOX
Now consider the business opportunity box. At the state level, there are approximately 24 states that regulate and register business opportunities. Unlike the franchise box, there is no such thing as a uniform business opportunity disclosure format. Business opportunity rules and registration requirements differ in each business opportunity state, so state-specific business opportunity disclosure documents must be drafted and registered in each state. Many of these states also have a "cooling off" period, usually a couple days after the sale where buyers can change their mind for any reason and receive a full refund.
For a company that's going the business opportunity route two different documents may need to be prepared and provided: the FTC's Basic Disclosure Document (if the business opportunity fits the FTC’s definition of a business opportunity) and a state's more abbreviated business opportunity disclosure document. Also, different timelines need to be observed: the FTC's 14 calendar days before, and a business opportunity state's cooling off period after.
Bottom line on the business opportunity box - if you're an attorney with a business opportunity or "licensing" client, get ready for hundreds of billable hours, you've just landed a big one. But, if you're the business paying the legal bills, it's going to be a lot less money to go the franchise route. Prepare a single, Franchise Disclosure Document, register in a state or two as expansion efforts begin, and you're essentially done.
There are also other factors to consider in the franchise vs. business opportunity analysis, including liability issues, but these are beyond the scope of this article, which is not intended to offer legal advice. Companies should consult with competent, informed legal counsel about the specifics of their particular situation before making any decision.
THE BUSINESS ASPECTS OF FRANCHISING VS. LICENSING A BUSINESS
The business aspects of the franchise vs. license and business opportunity options are relatively straightforward and make the decision even easier. It all boils down to image and credibility from a marketing standpoint. Does your company want to stand toe to toe with the likes of McDonalds, Radio Shack, H & R Block, Hilton Hotels and other franchised household names? These are the mental images formed in the mind when an average consumer hears the word franchise, along with familiar, highly-advertised slogans like "being in business for yourself, but not by yourself," "complete training," "support where and when you need it," etc.
These mental triggers, coupled with the complete package of training, start up and ongoing support services offered by franchise companies, makes a franchise a highly attractive and valuable commodity in the eyes of the prospective buyer and hence an easier sale. The same results accrue to firms that first sold "licenses" then switched to selling "franchises." Same business model, just a name change and an FDD Franchise Disclosure Document.
Guess what? These companies report they attracted considerable interest and far more inquiries when offering "franchises" compared to when they offered "licenses." So, even from a business standpoint, the franchising vs. licensing a business question is easy to answer. Then there are the financial, bottom-line considerations. Sell a franchise and you're in a league where buyers are accustomed to paying initial franchise fees of $30,000 to $45,000 and more. Sell a license and you're lucky to get half of these amounts. In addition, and as discussed above, a "license" is almost always an illegal franchise in disguise, a ticking time bomb creating significant legal issues and exposure because the FTC Rule (and corresponding state franchise registration and disclosure laws) were not followed.
THE BUSINESS ASPECTS OF FRANCHISING VS. BUSINESS OPPORTUNITIES
Business opportunity ventures, when compared to franchises, suffer from definite image problems that translate into difficult marketing issues. If you ever need proof of this, just attend any business opportunity show or expo. You'll see a host of fly-by-night opportunities such as worm breeding in backyards, exotic plants raised in glass bowls, condom vending machines (not a bad idea these days) and the like, all promoted by loud, fast-talking, high-pressure salespersons. Does your company really want to be associated with these companies and the reputation they project? Poor image, coupled with the fact that business opportunity ventures typically provide little training and no ongoing support, make them a much more difficult sale to prospective buyers. In a business opportunity, the buyer is just thrown a ball, and it's entirely up to them how to run with it.
From both a legal and business perspective, the franchise vs. license choice should be an easy one to make. Doing it right the first time will save money and significant legal headaches down the road. The individuals prevalent on the internet who claim (via very unprofessional-looking websites) that merely calling the relationship a "license"dispenses with the franchise laws are not doing you any favors.
In fact, they are paving the way for a future lawsuit. They are not looking through the lens of an expert with almost three decades of experience who has seen first-hand the havoc these disguised illegal franchises cause. They are also not recognized experts in their field nor have they taught other attorneys in this subject area. Instead, they are attempting to make easy money - at your expense. From the most basic, common sense perspective, if it looks like a Duck, talks like a Duck and walks like a Duck - . . . it's a Duck . . . or a Franchise!.
In a recent case, the "licensor" selling disguised franchises settled with our client for $600,000 shortly after we filed the Complaint against it. Compared to the relatively small $20,000 licensing fee and royalty payments it collected, this was yet another "go-figure" example where there's a lot of head scratching going on.
The ultimate irony here is companies that sell illegal franchises by calling them a license are only shooting themselves in the foot. The marginal savings achieved by doing it the wrong way creates a ticking, legal time bomb of epic proportions. Also, they can only sell a "license" at a 50% discount because the value of a license is considerably less than a franchise. By doing it right to begin with, they could have charged $30,000 to $45,000 as a franchise fee, which would have paid the franchise costs and avoided future franchise vs. license issues.
For advice on a specific franchising vs. licensing issue, contact our franchise attorney and franchise expert through the Franchise Attorney page of this website.
Franchise Attorney Franchise Expert MBA - Kevin B. Murphy - Mr. Franchise & Former Franchise Owner - 11/12/2008
I have a publication I started earlier this year with a partner. Each zip code gets its own version of our directory by direct mail twice per year. We have successfully launched this in four zip codes and are negotiating our first license agreement out of the area. What are the pros and cons to a shorter or longer term for this agreement. What would be the difference between a 5 year renewable term or a 10 year renewable term, for us, and what would be the difference for the licensee?
First question I have is – where are you located? If you are in the U.S. or other jurisdiction that has franchise laws, beware! Most so-called license agreements are really franchises in disguise. Selling a disguised franchise by calling it a license can be the most serious and costly mistake your firm ever makes. There’s a good article about the franchise vs. license (franchising vs. licensing) topic on the Franchise Foundations website at:
Going back to your question about 10-year vs. a 5-year term, the answer depends on the provisions of the contract. Generally speaking, a longer term means you can enforce provisions like payment, non-compete, etc. for a greater period of time. On the other hand, depending on how the contractual relationship is structured, you may want a shorter term. For example, if the person isn’t doing a great job and you’ve granted them a protected territory, or they’re just a pain to work with, or the protected territory has grown where it can support more than one person, then having a shorter term is better. The key is good strategic planning when it comes to structuring the relationship.
From the buyer’s perspective most of the same reasoning applies. Shorter terms are generally preferred, especially if they’re trying to learn the business then go independent. Again, most of these issues can be dealt with if adequate planning and thought goes into structuring the contract.
Any other questions, feel free to contact me through the Franchise Foundations website below.
Kevin B. Murphy, B.S., M.B.A., J.D.
"Enlarge the place of thy tent, and stretch forth the curtains: spare not, lengthen thy cords and strengthen thy stakes" Isaiah 54:2
Copyright 2013, Franchise Foundations, a San Francisco professional law corporation. The information you obtain at this franchise website is not, nor is it intended to be, franchise legal advice. You should always consult a franchise attorney - franchise lawyer for individual advice regarding your own situation and franchise disclosure documents. Use experienced FranchiseLawyers and FranchiseAttorneys for advice with your franchise legal documents and needs. Use an experienced MBA Franchise Expert for help with franchise consulting issues.
Last Franchise Website Update: October 15, 2013
Celebrating 30 Years of 100% Experience and Excellence in Franchising