Franchise or License Agreement? Part 2

As I talked about last week, a simple test determines whether the franchisee’s business is substantially associated with the franchisor:  If the former uses the latter’s trademark to identify its business, it is substantially associated with it.

Fees  include payments made by a franchisee to a franchisor when signing a franchise agreement and payments made for training and assistance, royalties, or inventory.

Business relationships that do not satisfy these conditions may be licensing arrangements, distributorships, dealerships, or any one of a variety of other business arrangements, but the distinctions between these arrangements and franchise operations are also subtle and sometimes treacherous.

For instance, a licensing arrangement exists when an independent business operating under its own trade name undertakes to sell products manufactured by a trademark owner and pay the manufacturer a percentage of the sale proceeds. Dealerships and distributorships exist when an independent business operating under its own trade name purchases – typically at wholesale prices – and resells the products of a manufacturer or supplier, with minimal interference by the latter.

In such cases the key is not whether the business entities entering into the arrangement intend to establish a specific relationship – for example, a distributorship rather than a franchise. The key is rather whether they operate independently, even though one buys and sells goods produced by the other under a trademark.

The relationship between franchisor and franchisee, by way of contrast, is a dependent one, as evidenced by the arrangements regarding marketing, training, and the like.

In the real world of business, however, such distinctions are not always apparent, and any business entity that grants another the use of a trademark may unwittingly stray over the line and establish a franchisor-franchisee relationship in the eyes of the law.

When this happens, the franchisor becomes subject to many details of state law that do not apply to companies establishing licensing or other business arrangements, on pain of substantial civil, administrative, and even criminal penalties.

For example, franchisors must prepare uniform franchise disclosure documents and get them approved by the state Department of Corporations before launching operations, and they must give prospective franchisees at least ten business days to study their offering circular and any attendant contacts before signature.

They must also get the department’s approval for any “material modifications” they propose to make to existing agreements before presenting them to franchisees. Material modifications may include new provisions reducing or enlarging the rights or obligations of either franchisor or franchisee, including new or increased royalties or fees or rights to engage in internet commerce.

As you may surmise from all this, state law presumes that in the relationship between franchisor and franchisee, the former has the advantage, and it goes to great lengths to protect franchisees. It follows that companies establishing franchise operations must step carefully – a good thing for entrepreneurs to know when weighing the options available to them for growing their companies.

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