Are you selling franchises or partnerships?

by | Mar 29, 2019 | Blog, For Franchisors

Part 2 of 2

You are a successful restaurateur, managing and running multiple eateries in multiple locations for several years. You started with a single location. It opened and was a hit. So you opened a second restaurant in a different location which turned out to be just as popular. You decide to protect your restaurant’s name by registering it, your trademark, with the United States Patent and Trademark Office.

A few years later, a friend of yours notices your success and asks if he can become an investor and help you open a third location. You realize that with your operations know-how and his capital and manpower, there is no reason not to open a third…So, you do.
You form a partnership, and under that umbrella, you open a restaurant using your trademark name. Your friend invests money to acquire the location, lease the equipment and buy inventory. You contribute your know-how and teach your friend everything he must know to manage this new operation. In exchange, you both agree to split the profits 50/50.  All goes well and before you know it, your third location is up and running — another success.

In Part 1 of last week’s blog on “The Accidental Franchise: Are you selling franchises or partnerships?” we discussed how to determine whether that great idea “restaurant (or any other) concept” you created and for which you took on “partners” might inadvertently be a franchise.

When do “partnerships” become franchises?

As soon as someone pays you a fee to use your trademark and system of operation, you’ve created a franchise relationship. It doesn’t matter whether you, as the owner of the brand, retain an ownership stake in each restaurant. Indeed, it doesn’t matter what you call your relationship. If it walks like a duck and quacks like a duck, it’s still a duck. Even when someone invests in your concept and together you open a store, service center, restaurant…whatever, you may well have just sold your first franchise.

What if I didn’t know I was franchising?

Call a franchise attorney now because ignorance of the law is no excuse. Get appropriate legal counsel even if you just think you may have unwittingly sold a franchise when you thought you were setting up a simple partnership. Get advice now even if you’re just having conversations with prospective “partners/franchisees” that might eventually lead to what ultimately will be considered the sale of an accidental franchise.

Why do I need a franchise attorney?

Because the sale of any franchise is regulated by various state and federal laws and guidelines and you cannot dot all the “i”s or cross all the “t”s by yourself. Before a franchise opportunity can be legally offered for sale, the seller (you and your attorney) must prepare a franchise disclosure document (FDD) which must include specific state- and/or federally-mandated information. In many states, including New York, the FDD must be registered with the state before it can be shared with any prospective franchise purchaser. Moreover, prospective buyers must receive FDDs before they pay any money to the franchisor or sign any agreement with the franchisor.

What if I accidentally sold a franchise without preparing an FDD?

Call a franchise attorney immediately because you have violated the law and consequences may be severe. Depending on your jurisdiction, the government can seek preliminary and permanent injunctions and impose civil penalties against the franchisor (that’s you as the owner).  Worse yet, if it is determined that you violated the franchise laws intentionally, some states may impose criminal penalties, including significant fines and prison terms. Even worse, any franchisee purchasing a franchise without timely receipt of the FDD, may be able to bring a lawsuit against the franchisor and its owners for rescission and restitution. If they win, you may be required to reimburse them for their entire investment costs. 

What if I’ve accidentally sold an illegal franchise? Can I fix it?

Yes. But not by yourself. There are several potential remedies. Determining which is best depends on your particular circumstances.

  1. Self-report. In some cases, it may be best to self-report violations to the applicable state authority. Good news is that some states have mechanisms in place for franchisors to report a violation and address it with the state regulators and franchisees.Do nothing. Sometimes, the best course of action is to “let sleeping dogs lie” and not report the violation.  For example, if you, as the franchisor, are no longer selling franchises and have no plans to do so in the future, you may decide not to report the violation to the state. One caveat to this approach is that if you do not self-report and the state regulators learn of the violation, the penalties imposed may be significantly greater than if you had faced the music from the beginning and brought the violation to the regulators’ attention. So you and your franchise attorney must weigh your options carefully.  
  2. Should I tell my franchisees they have an illegal franchise?The answer to that question also depends on circumstances. If your franchisees are unhappy with their investment and you advise them of the violation, you just may have opened the door to lawsuits. On the upside, however, telling franchisees of the violation may start the statute of limitations running in some states, which would drastically limit your franchisees’ time in which to bring a claim.   

When should I call a franchise attorney?

Call it an ounce of prevention and pick up the phone now. I know it sounds self-serving, but call a franchise attorney as soon as you even consider launching a partnership or franchise because you want to ensure you are not accidentally forming a franchise relationship. No matter which side of the franchising fence you sit — whether you are thinking of buying/selling a franchise or another privately-held business or practice, professional franchise counsel and paying attention to the details matters. Most issues can be addressed fairly early in the franchise/business selling/buying process, but only if you know those exposures exist. That’s why it makes sense for buyers and sellers to engage experienced franchise counsel to guide them through the franchise acquisition/disposition process. Got questions? Feel free to email them to me, Julie Lusthaus at [email protected]  and let’s talk.


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