Legal Aspects of Starting a Franchise Business

Essential legal considerations when buying or selling a franchise business.

Franchising offers entrepreneurs a path to business ownership with a proven system and established brand. However, navigating the legal complexities of franchise agreements requires careful consideration. This guide explores the essential legal aspects of starting a franchise business, from initial research to ongoing compliance.

Understanding Franchise Business Models

A franchise is a business relationship where one party (the franchisor) allows another party (the franchisee) to use its established business system, trademarks, and other intellectual property in exchange for fees and ongoing royalties. Several franchise models exist:

Business Format Franchising - The most common type, providing comprehensive systems for operating the business (e.g., McDonald's, Subway)
Product Distribution Franchising - Focuses on supplying products that the franchisee sells (e.g., car dealerships, beverage distributorships)
Conversion Franchising - Converting an existing independent business to a franchise operation
Multi-Unit Franchising - Owning multiple franchise locations under a single ownership
Master Franchising - Operating as a sub-franchisor with rights to sell franchises in a specific territory

Federal Franchise Regulations

The Federal Trade Commission (FTC) regulates franchising at the federal level through the Franchise Rule, which requires franchisors to provide prospective franchisees with specific disclosures:

Franchise Disclosure Document (FDD)

The FDD is a legal document containing 23 detailed sections about the franchise opportunity that must be provided at least 14 calendar days before any agreement is signed or money is paid. Key information includes:

Franchisor's business history and experience
Initial and ongoing fees
Estimated initial investment
Territorial rights and restrictions
Franchise obligations and support
Financial performance representations (if offered)
Current and former franchisee information
Franchisor's financial statements
Contract terms and conditions

While the FDD provides essential information, thoroughly reviewing it with a franchise attorney is crucial to understanding its implications.

State Franchise Laws

In addition to federal regulations, some states have enacted their own franchise laws, often with more stringent requirements:

Registration States - California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, Virginia, Washington, and Wisconsin require franchisors to register their FDD before offering franchises
Filing States - Florida, Nebraska, and Texas require various filings but not full registration
Business Opportunity Laws - Some states have laws that may apply to certain franchise arrangements

State laws may provide additional protections regarding termination, renewal, and transfer restrictions, making it essential to understand the specific requirements in your state.

Key Legal Documents

Several critical legal documents govern the franchise relationship:

Franchise Agreement

This binding contract outlines the rights and obligations of both parties, typically covering:

License to use trademarks and business systems
Term length (typically 5-20 years) and renewal conditions
Territory rights (exclusive or non-exclusive)
Initial franchise fee and ongoing royalty structure
Operating standards and compliance requirements
Training and support provisions
Marketing contribution requirements
Transfer and termination conditions
Non-compete clauses during and after the agreement
Dispute resolution procedures

Due Diligence for Prospective Franchisees

Before signing a franchise agreement, thorough due diligence is essential:

Review the FDD with a franchise attorney - Having specialized legal counsel is crucial for understanding contractual obligations
Speak with current and former franchisees - Their experiences can provide valuable insights about the system
Verify financial projections - Have an accountant analyze any earnings claims or financial performance representations
Investigate territorial protections - Understand what prevents the franchisor from allowing competitors nearby
Research litigation history - Patterns of lawsuits may indicate systemic problems
Examine renewal terms - Understand what happens when the initial term ends
Review termination clauses - Know the conditions under which either party can end the relationship

Negotiating Franchise Agreements

While franchise agreements are often presented as non-negotiable, some aspects may be open to discussion:

Initial investment and fees
Territory size and protection
Performance requirements
Transfer rights
Personal guarantees
Renewal terms

Negotiation success often depends on the franchisor's size, maturity, and how badly they want you as a franchisee. Newer franchisors may offer more flexibility than established systems.

Ongoing Legal Compliance

After signing, franchisees must navigate ongoing legal obligations:

System Standards Compliance - Following operational requirements and quality control measures
Intellectual Property Protection - Properly using trademarks and trade secrets
Employment Law Compliance - Managing employees according to applicable laws
Local Permits and Licenses - Obtaining and maintaining necessary business authorizations
Tax Obligations - Meeting federal, state, and local tax requirements
Insurance Requirements - Maintaining coverage specified in the franchise agreement

Dispute Resolution

Franchise agreements typically specify how disputes will be resolved:

Mediation - Many systems require attempting mediation before other remedies
Arbitration - Binding arbitration is commonly required instead of court litigation
Venue Selection - Agreements usually specify where legal proceedings must occur, typically near the franchisor's headquarters
Governing Law - The contract will designate which state's laws apply, regardless of where the franchise operates

Entering a franchise relationship is a significant legal commitment that affects your rights, obligations, and business operations for years. Working with experienced franchise counsel from the beginning can help ensure you understand what you're signing and protect your interests throughout the franchise relationship.