Avoiding the Inadvertent Franchise: A Guide to Franchise Fees
April 23, 2009
Copyright 2009. All rights reserved. If the first thing that comes to mind when you hear the word franchise is McDonald's, think again. Companies large and small frequently create relationships with individuals or other businesses to sell or distribute products and services that may fall under the franchise umbrella. Certain types of insurance agents, car dealerships and even trademark licensees are all examples of business relationships that state statutes and courts have deemed franchises.
Parties often memorialize their business relationships in a contract with terms that describe, among other things, the ways a party can purchase products for resale, use trademarks in advertising, distribute manuals, receive training on the product or service, and terminate the relationship. But state and federal franchise laws may trump the contractual terms of these relationships.
Because of these state and federal franchise laws, the inadvertent creation of a franchise can be problematic. If a company is considered a franchisor, federal law and some states mandate that the franchise be registered, by filing an offering circular, or make disclosures to prospective franchisees.
Also, a franchise act may subject a company to requirements regarding the tenure of the franchise relationship. For example, in many states, a company cannot terminate a franchisee at will. Rather, it may only do so for "good cause," or "just cause" or some other breach of contract. A franchisor must also give notice to the franchisee before termination, which can mean waiting between 30 days in Michigan to 90 days in Arkansas before the termination can become effective. The law may also specify the form of the notice. The damages available to a franchisee for a franchisor's violation of any of the franchise requirements can be costly, sometimes subject to trebling, and could include an award for attorney fees.
This article will explain the general elements of a franchise, which typically includes the payment of a franchise fee. This article will then address the different types of costs, or even activities, that may be considered a franchise fee, giving rise to a franchise relationship governed by state or federal franchise laws.
Defining a Franchise - Federal and State Franchise Laws
There are various laws with a range of application to franchise relationships. Under the Federal Trade Commission (FTC) rule, a franchise is "any continuing commercial relationship or arrangement" in which (1) the franchisee obtains the right to operate a business or sell or distribute goods or services identified with the franchisor's trademark; (2) the franchisor exerts or has authority to exert significant control over or assistance in the franchisee's method of operation; and (3) the franchisee makes or commits to make a required payment as a condition to obtain or commence operation of the franchise.[1] While only the government can pursue actions under the FTC rule, a state and/or private citizens may have the option to pursue claims under the different state laws.
Franchise laws vary by state, and are often titled state Franchise Act, Franchise Practices Act, Franchise Investment Law, or are encompassed within a state Deceptive Trade Practices Act, or "little FTC Act," which governs certain business opportunities.[2] For states with separate franchise acts, the elements of a franchise are similar to the FTC rule and (1) give the franchisee the right to distribute goods or provide services under a marketing plan prescribed or suggested by the franchisor; (2) require the payment of a franchise fee; and (3) allow the franchisee to associate its business with the trademark or other symbol of the franchisor. Some states substitute a community of interest in the marketing of goods or services between the franchisor and franchisee for the first element. The definition of a "community of interest" varies from state to state and typically requires a "substantial financial interest in common" between the franchisee and franchisor.[3] Generally, a majority of states require a franchise fee.
The Franchise Fee
Many state statutes define a franchise fee as a direct or indirect payment to purchase or operate a franchise. For example, the Minnesota Franchise Act defines a franchise fee as "any fee or charge that a franchisee or subfranchisor is required to pay or agrees to pay for the right to enter into a business or to continue a business under a franchise agreement." [4] Direct payments are usually straightforward and include fees paid by the franchisee at the commencement of and/or during the business relationship. Indirect fees may be other costs incurred by or paid by a retailer in connection with the business relationship.
A state statute may delineate the expenses that constitute an indirect fee. The Minnesota Franchise Act further defines a franchise fee as "including, but not limited to, the payment either in lump sum or by installments of an initial capital investment fee, any fee or charges based upon a percentage of gross or net sales whether or not referred to as royalty fees, any payment for goods or services, or any training fees or training school fees or charges."[5] In other states, courts have decided that certain payments for on-line computer service, required payments for advertising promotion, and the purchase of sales material all constitute franchise fees.[6] Furthermore, the threshold amount that constitutes a franchise fee ranges from state to state.
Sometimes, state statutes describe what does not constitute a franchise fee, excluding inter alia, a franchisee's purchase of goods at a bona fide wholesale price from the franchisor or the purchase of promotional or demonstration supplies at fair market value.[7] Despite legislative attempts to clarify franchise fees, questions still arise and the issue of fees often is the subject of litigation.
Potential Indirect Franchise Fees
1. Training Costs as Franchise Fees
A potential source of franchise fees are costs a retailer incurs to receive training on a product or service. Some states, such as Minnesota, expressly include certain training costs as franchise fees; however, a state's express inclusion of training fees in the definition of franchise fees is not always dispositive. Even in Minnesota, if the training is not required to enter into the business relationship, the expense a retailer incurs for the training is an ordinary business expense and not a franchise fee.[8]
In other states, however, training costs may be considered indirect franchise fees. Particularly in cases where the required training is "firm-specific," e.g., where the training a technician receives on a specific copy machine does not allow him to service a different machine, a court may consider the price a retailer pays for training to be a franchise fee.[9]
Ordinary travel expenses incurred to attend a mandatory training generally are considered business expenses, and do not convert a free training into a franchise fee.[10] On the other hand, if the cost of purchasing the franchise includes charges to offset the costs of training, the training costs may fall within the definition of franchise fees.[11]
2. Costs of Advertising
Although a marketing plan or a community of interest in marketing is a requirement for creating a franchise, some state statutes expressly exclude advertising expenses from franchise fees, while in other states those same expenses may be considered franchise fees. Generally, advertising costs are not franchise fees if the retailer benefits from the advertising payments.[12] If the costs of advertising are reasonable and have a reasonable business purpose, they are not franchise fees, but ordinary business expenses.
An example of ordinary business expenses are agreements that require a retailer to effectively promote sales by advertising, but do not specify a required spend on advertising or reserve a right of approval. In those cases, if the advertising expenses are paid to a third party, they are not considered franchise fees, but ordinary costs of business.[13] Required advertising fees paid directly to a manufacturer, however, particularly those that are wholly disproportionate to the value the retailer receives may be held to be franchise fees.[14]
Under Minnesota law, marketing "co-op" agreements often fall under the category of ordinary business fees. Under these agreements, a manufacturer and retailer share the expenses of a particular marketing program. As long as a retailer is not required to enter into these agreements as part of the right to sell the manufacturer's products, the payment directly benefits the retailer, and the manufacturer does not receive income or profit from the fee, the co-op agreement is not a franchise fee.[15]
3. Minimum Purchase Requirements
Generally, the requirement that a retailer purchase goods at the bona fide wholesale price from a manufacturer is not a franchise fee, but may be subject to a determination of reasonableness and other factors.[16] To determine reasonableness, a manufacturer should look to current market research and valid business purposes, as well as the normal inventory of a retailer, or how much inventory a retailer sells.[17] Moreover, the existence of a minimum purchase requirement is not a franchise fee if the business relationship does not terminate because the retailer does not sell a minimum volume of a product.[18]
4. Payments Made to Third Parties
Across jurisdictions, a wide range of other indirect expenses are not franchise fees if the retailer pays them to a third party. The underlying premise is that the good or service must be for the benefit of the franchisor to be an indirect franchise fee.[19] In none of the following circumstances were the expenses or services considered franchise fees:
- Money new distributor paid to a former distributor to purchase equipment for the operation of the distributorship;[20]
- $30,000 paid to predecessor for rights to franchise;[21]
- Retailer conducting free warranty repairs for customers is not a franchise fee because not done for benefit of manufacturer;[22]
- Retailer conducting a training school for other dealers not service rendered to manufacturer;[23] and
- Money spent on improvements to gas station convenience store paid to a contractor.[24]
Conclusion
Determining whether a cost is a franchise fee is a highly fact intensive and statute specific exercise. A few principles, however, will help navigate the complicated laws and make it easier to avoid creating an inadvertent franchise relationship. First, where possible, avoid making the business relationship contingent on purchasing a mandatory or set amount of products or services. Second, when charging fees for services or products, make sure those fees are commercially reasonable or based on the actual costs associated with the products or services. Third, remember that fees paid to third parties are typically ordinary business expenses, not franchise fees.
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