Legal Steps to Franchise Your Business
Find out how to protect your brand and avoid common legal mistakes when franchising your business.
As a proven business model that’s designed to scale, franchising can seem like an attractive next step for successful entrepreneurs who are looking to grow an existing business.
Like all business ventures, though, franchising your business can have serious legal consequences when it’s done improperly. Franchising is a heavily regulated industry at both the federal and state levels, and compliance is critical. Failing to legally protect your brand or running afoul of state or federal regulators can be costly. By knowing the legal steps to franchise your business, you can avoid common mistakes and position your new franchise system for long-term success.
In this guide, we’ll explore the legal steps for franchising a business – including determining the right time to franchise, preparing the right legal documents, and knowing how to safeguard your brand.
The legal steps to franchising your business include:
- Determine if your business is ready to franchise
- Legally prepare and issue your FDD
- Develop an Operations Manual
- Register your trademarks
- Establish a corporate structure
- Open a bank account and make a deposit
- Register and file your FDD
1. Determine if Your Business is Ready to Franchise
Although it can be a great way to scale, franchising isn’t right for every business. Before franchising your company, it’s important to evaluate where your business stands – and if you’re ready to be a franchisor.
To determine whether now is the right time to franchise your business, ask the following questions:
Does franchising align with your personal and professional goals? Make sure the responsibilities that come with running a franchise system, like selling franchises and supporting franchisees, align with the lifestyle you want over the next five to 10 years.
Does your business have a solid track record? The success and financial stability of your existing business are good indicators for how successful your franchise brand will be. If it’s not ready yet, what can you do to prepare for franchising in the future?
Are you prepared to be a franchisor? Seasoning, developing and operating a franchise brand is different from running a small business. Make sure you’re ready to invest time, resources, and energy into building your brand and supporting franchisees over the next decade.
If you decide that you aren’t ready to franchise your business after evaluating your goals and finances, don’t sweat it! Instead, take time to assess your business’s strengths and weaknesses. Then, make efforts to improve the areas that will help prepare your brand for franchising in the future.
By making sure your business is properly positioned before starting the franchising process, your new brand can get started on sturdy ground.
2. Legally Prepare and Issue Your FDD
Once you’ve determined that franchising is right for your business, the first legal step to take as a new franchisor is preparing your Franchise Disclosure Document (FDD).
Designed to protect franchise buyers from being misled during the franchise sales process, the FDD is a legally mandated disclosure document governed by the Federal Trade Commission’s Franchise Rule. Containing 23 mandatory legal disclosures, franchisors are required by federal law to disclose their FDD to prospective franchisees before legally offering or selling franchises in the U.S.
What information is the FDD?
As a mandatory legal prospectus, the FDD is a key component in the franchise sales process and helps ensure your business complies with federal and state franchise laws.
Because the FDD provides prospective franchisees with enough information to make an informed decision about investing in a franchise business, the document communicates essential data about several important topics including, but not limited to, the following:
Business relationships. Defines the commercial relationship between the franchisor and franchisee.
Licensing. Explains the trademark licenses (if any) that will be granted to franchisees.
Finances. Discloses important details about the franchise system’s financial health.
Operations. Communicates how a franchised business will be controlled and operated.
Fees. Outlines royalties and other fees associated with buying a franchise.
The information contained in the FDD can help prospective buyers and franchise brokers compare your offering to competitors, negotiate certain terms in the franchise agreement, and fully understand the potential risks and benefits of buying a franchised business.
Some of the topics disclosed in the FDD include, but are not limited to:
Information about the franchisor
Costs, fees and royalties
Training and other support
Legal obligations of the franchisor and franchisee
Licensing of intellectual property
Territory structures
Training and other support provided by the franchisor
The franchisor’s financial disclosures
By providing prospective franchise buyers and brokers with your FDD before offering a franchise for sale, you can ensure that your sales process complies with federal laws – and that your franchisee candidates will have enough information to make an informed decision about investing in your brand.
To learn about all 23 disclosure items in the FDD, check out our guide to the FDD.
Item 19 Financial Performance Representations
One of the most important parts of the FDD is Item 19, which contains the franchisor’s financial performance representations.
A financial performance representation is defined as “any written or oral statement or communication made by a franchisor to a franchisee, or the public, about the actual or potential financial performance of a franchised business.” Although franchisors aren’t required to include Item 19 in their FDD, the transparency it offers can be beneficial during the franchise sales process due to its higher level of transparency.
Item 19 financial performance representations often include, but aren’t limited to, the following disclosures:
Gross sales
Cost of goods sold
Gross profits
Earnings before interest, taxes, depreciation, and amortization
KPI-driven sales
Customer data
If you decide to include Item 19 in your FDD, remember that your financial performance disclosures must comply with the federal Franchise Rule and, at the state level, with the North American Securities Administrators Association and NASAA’s Commentary for Financial Performance Representations.
Among other things, these guidelines restrict the disclaimers that can be included in Item 19. To ensure legal compliance, it’s best to work with an experienced franchise attorney when developing your FDD.
What should you do with the FDD?
Under the federal Franchise Rule, the FDD must be disclosed by the franchisor to the prospective franchisee no fewer than 14 days before signing a franchise agreement or accepting a franchise fee. When disclosing the FDD to a franchisee candidate, it’s important to make sure both parties receive a signed and dated copy of the receipt page in Item 23 of the FDD.
The time between the disclosure of the FDD to a franchisee candidate and when the franchise agreement can be signed legally is referred to as the FDD disclosure waiting period. The FTC also mandates a seven-day disclosure period for disclosing other complete agreements to the prospective franchisee, including the franchise agreement, development agreement and other similar documents.
This period may be concurrent with the 14-day FDD waiting period and is meant to address any changes to the boilerplate agreements disclosed in the FDD. A limited exemption may be made for negotiated changes initiated by the franchisee and implemented by the franchisor.
When should the FDD be updated?
The FDD should be updated at least annually, or within 120 days of your fiscal year-end, to comply with federal franchise laws. For example, if your fiscal year is based on the calendar year and ends on Dec. 31, your updated FDD should be issued no later than April 30 annually.
Franchisors are also required to update their FDD quarterly if material changes are made to the document’s contents. Inaccurate or misleading information should be corrected by updating the FDD immediately.
It’s important to note that some states have supplemental laws governing franchise filings and renewals that could impact your ability to sell franchises in those jurisdictions. For example, Kentucky, Nebraska and Texas require one-time filings while Florida, South Dakota, Utah, Virginia, Washington and Wisconsin have annual filing requirements for franchisors. Because franchise laws and filing deadlines can differ between states, consult a franchise attorney to find out when your FDD should be updated.
Failing to update or renew your FDD by the proper deadline at the federal or state level will result in the expiration of your FDD. As a franchisor, this legal mistake can be particularly costly because you will be legally prohibited from selling franchises until your FDD is reissued.
3. Develop an Operations Manual
Your franchise operations manual is the how-to guide and blueprint for your franchise system. Its purpose is to ensure your company’s systems and processes are consistent across all locations.
Although operations manuals are as unique as the franchise brands they belong to, they typically contain important information for franchisees about operating their franchised business, handling issues that might arise during their daily operations, and who to contact if they have questions or need support.
Common topics that are covered in a franchise operations manual often include, but aren’t limited to:
System standards. What are the brand standards that you hold franchisees accountable to?
Methods of operation. What daily operations should franchisees adhere to?
Supply chain information. Which vendors should franchisees use to purchase ingredients or other products necessary to run their business?
Training obligations. What training is required for various positions within the business, and who provides it?
Developing, opening and operating the business. What process should franchisees follow to develop, open and operate each franchised location?
Operations Manuals
Because franchise operations manuals can have legal implications for franchisors and franchisees, it’s important to update them regularly as your brand matures. When creating your franchise operations manual, consider including videos, quizzes and other interactive features to ensure franchisees understand its contents.
4. Register Your Trademarks
When a franchisor sells a franchise, they typically license their trademarks to the franchisee for daily use in the franchised business. Because your trademarks are the key to your brand’s success, failing to legally protect them is a step you can’t afford to miss.
When you’re getting started, it’s important to be proactive about protecting your intellectual property. Conduct trademark searches as soon as possible during the franchising process and register your trademarks with the U.S. Patent and Trademark Office as early as you can. Because trademark registration can be a complex and lengthy process, working with an experienced attorney to conduct trademark searches and initiate the registration process is a good idea.
If your trademark is not legally protectable, you may have to choose a different name for your franchise brand. Starting the trademark process early – and ensuring it’s done properly – can help prevent a legal headache when naming your business.
5. Establish a Corporate Structure
Entrepreneurs need to remember that franchising is different from small business ownership. Because of that, establishing a corporate structure for your franchise system is an important legal step in the franchising process.
A corporate structure for a franchise will typically consist of:
The current company. As a business owner, your current company is the foundation for your corporate structure.
A franchising company. In addition to your current company, establishing a franchising company is a necessary legal step for protecting your brand while selling franchises.
An IP holding company. Depending on your brand’s needs, some franchisors may establish an intellectual property holding company. Discuss this option with your franchise attorney to determine if it’s right for your business.
By establishing a corporate structure for your new franchise system, you can legally protect your existing business as well as your franchise brand. To ensure compliance with state and federal laws, make sure to work with an experienced franchise attorney when determining your corporate structure.
6. Form a Franchising Entity
As a business owner and franchisor, establishing a franchising entity can help shield your existing business from the risks associated with franchising activities.
Your new franchising entity may be owned by your current company or by a parent company. Either way, the new entity will be considered the legal franchisor and its business activities will be restricted to offering and selling franchises.
When determining the shareholders or owners of your franchise entity, remember to take into account international tax treaties, tax laws and methods for distributing income from your franchising operations to your brand’s parent company or subsidiary.
Because the legal risks associated with different types of business entities can vary from state to state, consult a franchise attorney to determine the right state to establish your franchising entity and whether to structure it as a corporation or limited liability company.
7. Open a Bank Account and Make a Deposit
Once you’ve formed a franchising entity, make sure to open a new bank account for that entity as soon as possible.
The process typically includes the following steps:
Obtain a tax identification number for the new franchising entity from the Internal Revenue Service.
Open a business bank account with your preferred U.S. banking institution.
Deposit funds to capitalize your new business.
While there is no set minimum on the amount of your initial deposit, new franchisors should be aware that in the Franchise Registration States – states that require franchisors to register their FDD with a state regulator before offering or selling franchises there – state regulators will evaluate the amount of money available in a franchisor’s bank account.
If the amount of money in your account is deemed insufficient to support a franchisee – typically, if the franchisor’s capital is low relative to the investment the franchisee is required to make – regulators may impose a financial assurance requirement on your business.
Financial assurance requirements are conditions imposed by a state regulator that restrict a franchisor’s ability to register their FDD in that state until the conditions are met. Financial assurance requirements typically include posting a bond or deferring receipt of the initial franchise fee until the franchisee’s business is open.
8. Register and File Your FDD
Per the federal Franchise Rule, franchisors are legally required to comply with federal franchise laws before legally offering and selling franchises anywhere in the U.S.
In addition to federal compliance, the Franchise Registration States and the Franchise Filing States – states that require franchisors to submit a franchise filing instead of an FDD – have supplemental laws that impose additional legal obligations on franchisors. In those states, franchisors must either register their FDD or submit specific filings with a state regulatory body before offering or selling franchises in those places. Because franchise laws can vary widely from state to state, it’s important to consult with an experienced franchise attorney before drafting or filing legal documents related to your franchise.
By taking the time to understand and comply with state and federal franchise laws before franchising your business, you can hit the ground running as a franchisor – and ensure that the road ahead is a smooth one.
If you’re ready to franchise your business, we’re here to help! Contact us to learn about our legal and franchise development services for new and emerging franchisors.
