Sweeping the Legal Minefield of Explosive Growth

How to protect a franchise brand as the number of units increases.

By Jonathan Barber

It has becoming increasingly common to see emerging franchisors sell 50, 100, 200 or even more franchises in a year. Their concept is unique, their sales team is aggressive and their leadership usually gathers a cult following. Some of these franchisors work with franchise developers and utilize various franchise broker groups. Others handle their sales in-house and source all their leads organically.

There’s no specific formula for franchise growth as there are many ways to sell a large volume of franchises.  However, franchisors experiencing explosive growth can find themselves in a legal minefield where one small step can spell disaster.  Below are some common pitfalls and best legal practices for avoiding them.

Disclosure Compliance

A franchisor’s first few sales are usually “rough” from a legal perspective. If they worked with a franchise attorney to prepare their franchise disclosure document (FDD), they should have learned the basic disclosure rules. If the franchisor doesn’t have a system for tracking disclosures, they could run afoul of the “14-day rule.” Should they sell a franchise before 14 days have passed since disclosure, that franchisee could have serious state and federal claims, including “rescission.” Rescission and fines can effectively cripple a new franchise system before it ever gets off the ground.

Shockingly, many franchisees are given the wrong FDD, a Microsoft Word version of the FDD, a redlined version of the FDD or never even given an FDD! These mishaps are rarely intentional.  They’re usually the result of the franchisor’s sales team simply not knowing the rules.

Today, there are software and systems available to franchisors for disclosure compliance. Many franchise lawyers will also handle electronic disclosure for their franchisor clients. At a minimum, franchisors should attend the IFA Emerging Franchisor Conference and other IFA events where they can learn these basics. Franchisors should also consider enrolling their sales or development teams in the IFA Certified Franchise Executive program, which provides extensive compliance training. The best practice is to learn the basics of franchise disclosure and to attend continuing education on the topic since these laws are subject to change.

Proper Documentation

With explosive franchise sales comes a ton of documentation. FDD receipts, franchise agreements, development agreements and addenda to those agreements are some of the key documents that should be organized and easily accessible by the franchisor and their legal counsel. Additionally, franchisors should keep accurate records of franchisee applications, vendor contracts, intellectual property registrations, and state franchise registration and renewal documentation. Today, all these documents can be easily maintained in PDF format. If franchisors are utilizing electronic methods for disclosure and signing franchise agreements, those PDFs can be easily searchable.

If a franchisor doesn’t keep its franchise and related documents in order, there is a much greater chance of compliance issues arising. For instance, if a franchisor loses a franchise agreement they are at the mercy of the franchisee. This is a bad position to be in if that franchisee ever becomes dissatisfied with their franchise. On the other hand, a particular franchise unit could be awarded, transferred, re-acquired, re-sold and closed all within a 12-month period. Every year, each franchisor must update the Item 20 tables of their FDD, which state the number of units awarded, transferred, re-acquired by the franchisor and closed. A lack of documentation can lead to inaccurate numbers, which is a federal compliance issue that can easily be avoided. The best practice is to either use franchise management software or to work closely with a franchise attorney to create and maintain a document management system.

Setting Boundaries

It’s important to set boundaries with franchisees from the start. Most franchisors know what they can and cannot say in regard to financial projections. If there’s nothing in Item 19 of a franchisor’s FDD, they can virtually say nothing about the prospective financial performance of their franchise units. One situation in which it’s easy to slip up with respect to financial representations is when a prospective franchisee is trying to obtain financing. Often, a lender will require a prospective franchisee to assemble financial projections. The franchisee, in turn, looks to the franchisor for guidance in putting these numbers together.

Franchisors also need to be aware of their involvement with franchisees’ hiring practices. Franchisors often suggest staffing levels and require managers to attend training. However, some franchisors actually interview and approve their franchisees’ candidates. As the franchising community has recently seen, involvement in the hiring process can create liability for the franchisor as a joint-employer.

Many franchisors assist new franchisees with identifying a market where there’s a need or demand for that certain franchise. However, some franchisors require franchisees to use the franchisor’s in-house, affiliated or preferred real estate agents or teams in obtaining a site and negotiating a lease or purchase. These deals often fall through, and a franchisee can’t open by their deadline. These franchisees sometimes pursue claims against the franchisor for interfering with the real estate process.

The best practice for all of these claims is to define clear boundaries with franchisees and to allow them to navigate these decisions on their own.

Conclusion

There are huge opportunities for explosive franchise growth, but there are huge risks as well. A well-informed franchisor can navigate the minefield and emerge with a strong, sustainable franchise system. By following best practices, the franchisor ensures their massive growth lasts and all ships continue to rise.

Jonathan Barber is a Partner at Franchise.law, and Partner and Co-Founder of Barber Power Law Group.