The franchise model is one of the most popular and effective methods to grow a business. Many of the largest brands are franchise systems. While the franchise method can enable rapid growth, it must also be respected for the substantial legal investment required to properly establish and operate the system. State and federal law provide robust remedies for persons in the position of a franchisee – whether real or not. That’s right, even an unintended franchisee can avail itself of franchise law remedies, including statutory damages, rescission, and attorney fees. Due to these remedies, it is imperative for ‘franchisor’-side parties to avoid the creation of an inadvertent franchise relationship.
What constitutes a franchise relationship? There are slight differences among the states and the federal regulations have the Franchise Rule, but generally speaking three basic elements must be present to establish a franchise. First, one party must authorize another party to use intellectual property, usually a trademark, in connection with commercial activity. Second, the offering party or party that owns the IP must retain significant control over the use of the IP, particularly the quality of the commercial activity with which the mark is used. Third, some form of payment must accrue to the owner of the IP as part of the arrangement.
How might an inadvertent franchise be created? As you can tell from the three basic elements, a common trademark license can easily enter franchise territory. In fact, a well negotiated licensing deal ought to touch on all three elements. Obviously the owner of the IP in a licensing deal wants to make money. Trademark law requires a mark owner to maintain exclusive control and use, including supervising licensees and other authorized users in terms of quality and character of their permitted use. And of course, a trademark license is by its nature a grant of a right to use intellectual property between parties. Between the two arrangements, franchise law is the trump card. If facts can establish that both a license and franchise exist, the franchise prevails, even over the express intentions of the parties to describe their relationship as a license. This is a vulnerability for the party acting as licensor / potential ‘franchisor’.
To establish a license without creating too much risk of being re-characterized as a franchise, the licensor should primarily focus on the second and third elements. The first element -the basic authorization to use another’s IP – is nearly indistinguishable in either context. The second element, control over the permitted use, is able to be defined under a license in a manner that is sufficiently narrow to avoid franchise definition. At their core, franchise arrangements involve tremendous control over the franchisee’s operations. The license on the other hand should limit the licensor’s ‘day to day’ oversight over the mark, and should emphasize all-or-nothing recourse rather than a system of corrective action. In a franchise agreement, the franchisor typically has plenty of opportunity to come into the affairs of the franchisee and change them to comply with the franchise system. Licensor’s should simply retain the right to cancel the license if they determine the use of the IP to be inconsistent with the agreement.
The third element, compensation, can also be defined differently under a license as a way to avoid franchise characterization. Typically a franchise royalty scheme will involve several components, some of which will be performance based as a way to encourage the franchisee to maximize investment into the system. Other components will be performance-independent, such as pooled marketing fees, and these are meant to coordinate the various franchisees into a coherent marketing system. Franchise royalties in general aim to promote alignment between franchisees and the franchise system. Licensors should try to avoid this ‘unified interest’ policy. Establish a licensing fee that provides a fair economic return to the licensor, but otherwise ignores the general welfare of the licensee. Flat markups are a simple way to do this. For every widget that licensee produces under licensor’s trademark, licensor receives one dollar, or whatever.
In short, licenses should remain practical and on point. If a licensor tries to control the relationship too much via a license, it may find itself facing allegations involving franchise remedies.
The Inadvertent Franchise
The franchise model is one of the most popular and effective methods to grow a business. Many of the largest brands are franchise systems. While the franchise method can enable rapid growth, it must also be respected for the substantial legal investment required to properly establish and operate the system. State and federal law provide robust remedies for persons in the position of a franchisee – whether real or not. That’s right, even an unintended franchisee can avail itself of franchise law remedies, including statutory damages, rescission, and attorney fees. Due to these remedies, it is imperative for ‘franchisor’-side parties to avoid the creation of an inadvertent franchise relationship.
What constitutes a franchise relationship? There are slight differences among the states and the federal regulations have the Franchise Rule, but generally speaking three basic elements must be present to establish a franchise. First, one party must authorize another party to use intellectual property, usually a trademark, in connection with commercial activity. Second, the offering party or party that owns the IP must retain significant control over the use of the IP, particularly the quality of the commercial activity with which the mark is used. Third, some form of payment must accrue to the owner of the IP as part of the arrangement.
How might an inadvertent franchise be created? As you can tell from the three basic elements, a common trademark license can easily enter franchise territory. In fact, a well negotiated licensing deal ought to touch on all three elements. Obviously the owner of the IP in a licensing deal wants to make money. Trademark law requires a mark owner to maintain exclusive control and use, including supervising licensees and other authorized users in terms of quality and character of their permitted use. And of course, a trademark license is by its nature a grant of a right to use intellectual property between parties. Between the two arrangements, franchise law is the trump card. If facts can establish that both a license and franchise exist, the franchise prevails, even over the express intentions of the parties to describe their relationship as a license. This is a vulnerability for the party acting as licensor / potential ‘franchisor’.
To establish a license without creating too much risk of being re-characterized as a franchise, the licensor should primarily focus on the second and third elements. The first element -the basic authorization to use another’s IP – is nearly indistinguishable in either context. The second element, control over the permitted use, is able to be defined under a license in a manner that is sufficiently narrow to avoid franchise definition. At their core, franchise arrangements involve tremendous control over the franchisee’s operations. The license on the other hand should limit the licensor’s ‘day to day’ oversight over the mark, and should emphasize all-or-nothing recourse rather than a system of corrective action. In a franchise agreement, the franchisor typically has plenty of opportunity to come into the affairs of the franchisee and change them to comply with the franchise system. Licensor’s should simply retain the right to cancel the license if they determine the use of the IP to be inconsistent with the agreement.
The third element, compensation, can also be defined differently under a license as a way to avoid franchise characterization. Typically a franchise royalty scheme will involve several components, some of which will be performance based as a way to encourage the franchisee to maximize investment into the system. Other components will be performance-independent, such as pooled marketing fees, and these are meant to coordinate the various franchisees into a coherent marketing system. Franchise royalties in general aim to promote alignment between franchisees and the franchise system. Licensors should try to avoid this ‘unified interest’ policy. Establish a licensing fee that provides a fair economic return to the licensor, but otherwise ignores the general welfare of the licensee. Flat markups are a simple way to do this. For every widget that licensee produces under licensor’s trademark, licensor receives one dollar, or whatever.
In short, licenses should remain practical and on point. If a licensor tries to control the relationship too much via a license, it may find itself facing allegations involving franchise remedies.