Learn the common mistakes franchisors make that can expose them to litigation.
KEY TAKEAWAYS:
- Franchisee lawsuits are often preventable, so it’s important for franchisors to take steps to avoid litigation before it happens.
- Although compliance plays an important role in preventing lawsuits, building the right foundation to support franchisees’ success is also critical.
- By following best practices and avoiding common mistakes, you can bolster your brand’s legal resilience while creating a win-win situation for you and your franchisees.
Getting sued is never a fun experience – and that’s especially true for franchisors.
Although lawsuits with franchisees are sometimes unavoidable, the good news is that litigation is often preventable. From building a rock-solid legal foundation for your business to homing in on compliance and structuring your brand to support franchisees’ success, there are plenty of steps you can take to limit your exposure to costly, time-consuming legal disputes as a franchisor.
In this article, we’ll discuss three common reasons why franchisees sue franchisors and explore best practices for mitigating the risk of litigation.
Common Categories of Lawsuits Against Franchisors
Understanding the reasons why franchisees sue franchisors is critical for avoiding disputes. Below are three factors that franchisees and their lawyers often look for when filing lawsuits against franchise brands.
1. Compliance Violations
As a franchisor, keep in mind that some attorneys actively seek reasons to sue franchise systems. Often, their first point of attack is to scrutinize compliance. To mitigate the risks of a compliance-related lawsuit, it’s critical to build a franchise system that complies with federal and state franchise laws.
Lawsuits against franchisors sometimes make claims about deficiencies or misrepresentations in the franchisor’s Franchise Disclosure Document (FDD). Although disclosure errors often aren’t the cause of the dispute, they can still open the door to litigation.
To avoid disclosure mistakes, consult an experienced franchise attorney to discuss best practices for safeguarding your brand, including but not limited to the following:
- Document reviews. Schedule routine legal reviews of your franchise documents, including your FDD, to identify errors, inconsistencies, compliance gaps and outdated information.
- Timely updates. Update your FDD disclosures, along with the contents of your franchise documents, with new and accurate information as quickly as possible.
- Signed receipts. Always require a signed receipt page when you disclose your FDD to a franchisee candidate. If you deliver your FDD electronically, obtaining and securely storing the candidate’s electronic signature must be part of the disclosure process.
Because the FDD is a mandatory legal document that is regulated by the Federal Trade Commission, it’s important to work with a franchise lawyer to ensure that your disclosures comply with federal laws.
Registration Issues and Compliance Gaps
The franchise industry is regulated at the federal and local state levels. Because franchise laws can vary widely between locations, franchisors sometimes make errors when registering or updating important legal documents and filings in different jurisdictions.
To avoid compliance mistakes that can lead to litigation, consult a franchise lawyer to discuss regulations in the places where you do business, including but not limited to the following:
- Registrations and filings. Certain states, known as the franchise registration states, require franchisors to register their FDD with a local authority before offering or selling franchises. Other states may have specific one-time or annual notice filing requirements.
- Expirations and renewals. Under the federal Franchise Rule, the FDD expires 120 days after the end of a franchise entity’s fiscal year and must be renewed. Many states have additional requirements, so it’s important to know the FDD expiration and renewal deadlines and other important renewal dates where your franchise system operates.
- Updates and amendments. To stay compliant, always keep the contents of your FDD and other franchise documents current. Work with a franchise lawyer to update or amend your filings and registrations to avoid errors.
- Conflicting laws. Be wary of areas where laws might conflict between locations. For example, franchisees may be bound by laws in both their state of residence and the state where their franchise business operates.
Because U.S. franchise laws are complex and may differ between locations, working with a seasoned franchise attorney can help you develop a thorough compliance system and fill in legal gaps wherever your brand operates.
Check out our FranIQ dashboard to stay on top of your brand's compliance process.
2. Unit Economics
At a basic level, franchisees are in business to make money. When a franchisee feels unsupported or their unit economics fall short of their expectations, legal disputes can arise. Because of that, it’s important to support franchisees in their success and set realistic expectations early on.
Misaligned Expectations
As a franchisor, it’s critical to avoid overselling your franchise offering. Instead, be honest with candidates about your brand’s opportunity profile – that is, the specific benefits your brand provides to franchisees.
When determining your offering’s opportunity profile, consider the following:
- What are your startup costs?
- Should franchisees expect to replace or supplement their current income?
- Are there opportunities for franchisees to scale into new territories?
- Will franchisees have legacy-building opportunities?
By being upfront about unit economics, you can ensure that your franchisees’ goals, expectations and capital are aligned with your offering while limiting exposure to disputes.
Financial Representations
Because mismatched expectations are a common catalyst for lawsuits, making accurate financial performance disclosures and avoiding unauthorized sales statements can be helpful for limiting legal exposure as a franchisor.
To avoid mistakes related to your FDD, work with a franchise attorney to address common disclosure issues including, but not limited to, the following:
- Item 19. Including accurate Item 19 financial performance representations in your FDD can potentially mitigate the risk of fabricated claims from franchisees about unauthorized financial disclosures outside the scope of the FDD.
- Unauthorized sales statements. Preventing staff and outsourced sales representatives from making unauthorized financial performance representations is critical for ensuring compliance with franchise regulations.
- Pro forma. Because pro forma documents and statements can open the door to certain types of litigation, seek the advice of an attorney before making them available to candidates or franchisees.
- Item 7. Overestimating your offering’s estimated initial investment could mitigate exposure to lawsuits. Clarifying system standards, rejecting overspending and seeking legal counsel to document franchisee deviations may also be helpful.
- Reserve capital. Requiring franchisees to have enough reserve capital to launch and operate their franchise business can help mitigate legal exposure.
- Local marketing. Defining franchisees’ local marketing obligations can establish clarity about investment expectations and potentially prevent disputes.
Although FDD disclosures might not directly cause legal disputes with franchisees, they can be used for leverage in litigation. Because of that, it’s important to seek help from a qualified franchise attorney when preparing and updating your FDD.
3. Operations and Support
One of a franchisor’s primary obligations is to ensure that their franchisees are successful. Because franchisees and their attorneys often point to day-to-day operations issues in lawsuits against franchisors, it’s important to develop strong systems of support for franchisees and prioritize their economic success from day one.
To avoid operational mistakes that can expose a franchisor to litigation, consult a franchise attorney to evaluate areas of your business including, but not limited to, the following:
- Training. Providing strong initial training and ongoing education for franchisees can mitigate the risk of claims about inadequate training.
- Supply chain. Making sure your supply chain is efficient and provides value to franchisees can potentially mitigate the risk of some disputes.
- Support cadence. A routine check-in process to monitor franchisee compliance and business activity, such as profit and loss statements and local marketing, can be a smart strategy for preventing disputes.
- Brand development fund. Clarifying how your brand development fund is used, and how it benefits the franchise system, can potentially limit legal exposure.
- Franchisee alignment. Ensuring that your franchisees’ goals, lifestyle, values and capital are aligned with your brand can potentially mitigate the risk of some disputes.
By paying attention to warning signs that a franchisee might not be a good fit and creating a business structure that sets franchisees up for success early on, you can mitigate legal exposure while building validation to support future growth.
Closing Thoughts
Although there’s no foolproof way for franchisors to avoid being sued by disgruntled franchisees, you can mitigate the risk of litigation by complying with federal and state regulations and structuring your franchise system in a way that supports your franchisees’ success.
When creating the legal foundation for your franchise system, always consult an experienced franchise attorney. They can help you develop a competitively positioned FDD that complies with federal laws while ensuring that your brand adheres to all federal and local state franchise regulations wherever it operates, including registration and filing requirements in different states.
It’s also important to avoid making unauthorized sales statements during the franchise sales process. By accurately communicating your offering’s unit economics and opportunity profile in ways that comply with franchise laws, you can ensure that your franchisees’ goals, capital and expectations will be aligned with your brand’s performance in the real world.
Finally, by working with a seasoned franchise lawyer and other credible professionals to develop robust ongoing training and support systems, you can build validation and position your franchisees for success early on while mitigating legal exposure.
Frequently Asked Questions
Although franchisees have various reasons for suing franchisors, three common categories of lawsuits franchisors face include compliance violations, unit economics, and gaps in operations and support.
Successful franchise brands balance the franchisor’s obligations with their franchisees’ expectations and unit economics. Imbalances in the franchisee-franchisor relationship often stem from a breakdown of that balance, resulting in gaps between expectations and real-world performance.
Although there’s no sure-fire way to avoid lawsuits from dissatisfied franchisees, franchisors can limit their legal exposure by working with an experienced franchise attorney to bolster their regulatory compliance, improve unit economics, and strengthen their operations and systems of support for franchisees.
