FTC Franchise Rule Summary

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Franchise Services That Illuminate The Franchise Rule

Not every commercial business relationship between a company and an individual that wishes to open a satellite unit of the company is required to comply with the FTC Franchise Rule. Ultimately, it depends on whether the business relationship between the parties meets the legal definition of a franchise under the Rule. Over the years, we have worked with a number of clients that first contacted us when they discovered they may be, or were, operating an illegal franchise. The penalties for doing so can be severe, but thankfully, our expert franchise attorneys were able to correct each situation with minimal impact and financial harm to the client’s business.

In addition, we have spoken with many prospective clients over the years that have been told by a well-meaning business attorney, CPA, etc. that it would be best to not fall under the Rule. They mistakenly believe the Rule is “cumbersome and costly” to businesses, rather than understanding that franchising is the safest method of expansion since it eliminates the need for a company to engage with an attorney to research the 28 states that have Business Opportunity Laws.

They may even be forced to draft a different agreement for each state if it is determined the company meets the legal definition of a Business Opportunity in each state. Some Business Opportunity states also require the posting of a bond and/or letter of credit. Franchising ultimately exempts franchisors from the individual state Business Opportunity Laws (although a handful of the states require franchisors to submit “Exemption Notices” to the states to officially be exempted from the state's Business Opportunity Laws). For this reason, the cost to comply with the 28 states’ Business Opportunity Laws can be magnitudes above the cost to establish a legal franchise operation.

The following information will assist you in understanding what makes a commercial business relationship a franchise under the FTC Franchise Rule.

What types of relationships are covered under the Rule?

The FTC Franchise Rule covers the offer and sale of franchises. The FTC defines a commercial business arrangement as a “franchise” when it satisfies three conditions:

The franchisor licenses a trademark to the franchisee.
The franchisor exerts “significant control” or provides “significant assistance” (i.e., training) in the operation of the business.
The franchisee must make a minimum payment of at least $500 before opening the business or during the first six months of operation.

These three conditions apply to all business formats and products franchises, including self-described “distributorships.” However, if a business does not meet all three standards, it may be potentially excluded from complying with the FTC Franchise Rule Our affiliated franchise attorneys can help you determine whether your proposed business relationships meets the legal definition of a franchise.

As an illustration, a franchise exists not only when the three conditions have been met but when pledged either orally or in writing. So, if a franchisor states to a potential buyer that it sublicenses its trademark, plans to exert significant control over the business or promises to provide significant assistance to the buyer, and charges a minimum payment of at least $500 either prior to opening the business or within six months of opening, the business arrangement will be considered a franchise and subject to the FTC Franchise Rule even if the seller does not intend to fully meet all three conditions of the Rule.

These subtleties are just some of the insights you can glean by consulting with FranSource’s affiliated franchise attorneys.

The “Trademark” Element

According to the first condition of the FTC Franchise Rule, a franchisee has the right to operate a business that is “identified or associated with the franchisor’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark.” Ultimately, your trademark is essential in identifying your brand through the sale of goods or performance of services.

Here, the term “trademark” is applied in a broad sense. Besides the trademark itself, it also encompasses any service mark, trade name, or other advertising or commercial symbol. The franchisor does not need to own the trademark element, but must at least obtain the right to license the mark to others. FranSource’s affiliated franchise attorneys can guide you through the process of formally licensing your trademark or purchasing the rights or license to a trademark.

The “Significant Control” Element

For the FTC Franchise Rule’s second condition, the Rule explains a franchiser “will exert or has the authority to exert a significant degree of control over the franchisee’s method of operation, or provide significant assistance in the franchisee’s method of operation.”

FranSource affiliated franchise attorneys often assist prospective franchisors in interpreting this condition in relation to their proposed business arrangement. Franchisees’ reliance on a franchisor’s significant control or assistance is likely greater when they are relatively inexperienced in the business or when they undertake a large financial risk. Similarly, franchisees are likely to reasonably rely on the franchisor’s control or assistance if it’s unique to that specific franchisor compared to other franchisors in the same industry.

Examples of “significant control” include:
Site approval for unestablished businesses
Site design or appearance requirements
Hours of operation
Production techniques
Accounting practices
Daily operational procedures
Local advertising
Promotional campaigns requiring franchisee participation or financial contribution
Restrictions on customers
Locale or area of operation (i.e., franchise territories)

On the other hand, “significant assistance” relates to the franchisor’s role in helping the franchisee start their business, which include:

Formal sales, repair, or business training programs
Establishing accounting systems
Furnishing management, marketing, or personnel advice
Selecting sites/locations
Furnishing system wide networks and a website
Furnishing a detailed operating manual

Other factors, like inventory controls, required services, and displays of goods can also communicate “significant control or assistance.”

What does not constitute significant control or assistance?

The following items do not constitute significant control or assistance per Commission policy¹:

Trademark controls designed solely to protect the trademark owner’s legal ownership rights in the mark under state or federal trademark laws (such as display of the mark or right of inspection)
Health or safety restrictions required by federal or state law or regulations
Agreements between a bank credit interchange organization and retailers or member banks for the provision of credit cards or credit services
Assisting distributors in obtaining financing to be able to transact business

The “Required Payment” Element

The final condition of the FTC Franchise Ruleis the required payment from a franchisee to a franchisor as part of the purchasing process. When a sum of $500 or more prior to opening the business or during the first six months of operation must be paid to a franchisor or an affiliate as a condition for obtaining or starting operations, this condition has been met.

What payments constitute “required payments”?

Without consultation from trusted franchise attorneys, franchisors may not know the required payment element is not limited to a monetary deposit. Rather, the “payment” encapsulates a broad spectrum of revenue sources owed to a franchisor for the right to be associated with the franchise brand. Required payments may include:

Initial franchise fee
Rent
Advertising assistance
Equipment and supplies (including purchases from third parties in the franchisor or its affiliates receives payment as a result of purchase)
Training
Security deposits
Escrow deposits
Non-refundable bookkeeping charges
Promotional literature
Equipment rental
Continuing royalties on sales

To put it simply, a required payment can be as straightforward as a charge for equipment obtained only through the franchiser or an affiliate with no other source. Payments such as this or any other items from the above list, qualify as a “required payment.”

What types of payments do not constitute “required payments”?

The “payment” element of the franchise definition does not include “payments for the purchase of reasonable amounts of inventory at bona fide wholesale prices for resale or lease.”2 “Reasonable amounts” means amounts not in excess of those that a reasonable businessperson normally would purchase for starting an inventory or supply, or to maintain an ongoing inventory or supply.

Despite this stipulation, the Rule does allow for an “inventory exemption” regarding goods intended to be furnished to the public through lease. Franchisees — such as those in the auto or furniture rental business — can take advantage of this inventory exemption. The inventory exemption, however, does not include goods that a franchisee must purchase for its own use in the operation of the business, such as equipment or ordinary business supplies.

1. See Original Interpretive Guides, 44 Fed. Reg. 49,966, at 49,967 (Aug. 24, 1979).
2. For background information on the reasons for the inventory exemption, see Original Interpretive Guides, 44 Fed. Reg. at 49,967.

Should I franchise my business?

There are many variables that a business must first consider before embarking on a franchise development program. As an initial step in determining the viability of franchising your business, we invite you to complete our 15 Key Questions Franchise Quiz.

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