Inadvertent Franchising: How to Protect Yourself and Your Business

Inadvertent Franchising: How to Protect Yourself and Your Business

Inadvertent franchising is an easy mistake to make

Franchising is a popular method for expanding one’s business. It’s so popular, in fact, that it’s heavily regulated. Every year, countless business owners learn their proposed business models or license arrangements are legally classified as franchises. We call this “inadvertent franchising” and it can result in substantial legal and financial consequences.

How does inadvertent franchising happen?

Imagine a fictional company called Rob’s Burgers. The company is doing well, and its owner, Rob, is looking for ways to expand. He’s not interested in franchising just yet, Instead, he’d like to let his friend, Mark, who runs a hotdog and hamburger stand, sell Rob’s Burgers trademarked burgers.

This isn’t a franchise, of course. Mark isn’t opening a new Rob’s Burgers location and he’s not receiving mentorship or ongoing support. Instead of franchising, Rob is just licensing Mark to sell his product in exchange for a portion of the sales.

The only problem is, this is legally classified as a franchise – even if Rob calls this a “licensing arrangement,” or a “distributorship.” By entering into this agreement, Rob has become an inadvertent franchisor.

If it walks like a duck and quacks like a duck…

The Federal Trade Commission (FTC) and state authorities classify many contractual relationships as franchises, even if those in the contract, like Rob and Mark, don’t realize it.

A contractual relationship can be considered a franchise if it:

  • Grants the use of your trademark to sell or distribute goods and services of your brand
  • Offers assistance or control over a third party’s business
  • Requires the payment of a royalty fee

In Rob’s case, his “licensing arrangement” allows Mark to use his trademark to sell burgers and requires Mark to pay a royalty fee. This means their arrangement is legally a franchise. Whether or not they knew about this law, or had any intent to violate it, Rob and Mark may be liable for franchise violations including:

  • The freezing of assets
  • Cease and desist orders
  • A ban on selling franchises

Franchise laws vary from state to state

Each state has its own franchise and business opportunity law. In Florida, for example, Florida Statute 817.416 (referred to as the “Florida Franchise Act”) outlines for key elements that denote a franchise:

“(b) The term “franchise or distributorship” means a contract or agreement, either expressed or implied, whether oral or written, between two or more persons:
1. Wherein a commercial relationship of definite duration or continuing indefinite duration is involved;

  1. Wherein one party, hereinafter called the “franchisee,” is granted the right to offer, sell, and distribute goods or services manufactured, processed, distributed or, in the case of services, organized and directed by another party;
  2. Wherein the franchisee as an independent business constitutes a component of franchisor’s distribution system; and
  3. Wherein the operation of the franchisee’s business franchise is substantially reliant on franchisors for the basic supply of goods.


(c) The term “goods” means any article or thing without limitation, or any part of such article or thing, including any article or thing used or consumed by a franchisee in rendering a service established, organized, directed, or approved by the franchisor.”

Florida’s law clearly outlines what is and is not a franchise, but not all states are so specific. New York’s definition, for example, is considered one of the broadest in the country. The full text can be found here, in section 3, but to paraphrase:

A franchise will be found in New York when there is a grant of a right to engage in the business of offering, selling or distributing goods or services, the payment of a franchise fee and either: (1) a marketing plan or (2) trademark.

With such a broad description as New York’s, there is an increased risk of contractual agreements being classified as franchises. When this is the case, the penalties can be severe.

California is one of the strictest states when it comes to penalties for inadvertent franchisors. In the state, the Department of Corporations (DOC) closely monitors franchisor-franchisee agreements and may assess penalties of $2,500 per violation. This somewhat modest penalty is only part of the process, however. The DOC has the authority to require inadvertent franchisors to furnish violation notices to all of its franchisees, rescind all agreements related to the franchise, and refund any franchise fees.

Are you at risk of becoming an inadvertent franchiser?

The answer can often be unclear. Proposed business arrangements, licenses, and contractual relationships can potentially leave you at risk.

A good first step is to consider if your agreements can in any way be considered a franchise. Ask yourself, do your agreements:

  • Grants the use of your trademark to sell or distribute goods and services of your brand
  • Offers assistance or control over a third party’s business
  • Requires the payment of a royalty fee

If the answer to any of these is yes and you want to learn more about the risks and liabilities associated with inadvertent franchising, contact us today. At Escalante Yormack Law, we have years of experience handling every aspect of franchise law.

Escalante Yormack Law

Adam Yormack, Esq., is the principle attorney at Escalante Yormack where he focuses on corporate and commercial litigation, franchise, and real estate law. You can reach Adam directly at adam@eylawyers.com.

Escalante Yormack Law, 5201 Blue Lagoon Dr., 200, Miami, FL 33126 | 305.514.0046

Disclaimer

The materials in this article are provided for informational purposes only and not for the purpose of providing legal advice. You should contact your attorney to obtain advice with respect to any potential questions or concerns, etc.