The Three-Legged Stool: Franchise vs. License Agreement

Sometimes a business owner finds that others want to use some aspect of their success, perhaps just the right to use a recognized name, or perhaps ​much more. In order to protect their intellectual property rights, the owner of the successful idea will need to establish parameters and restrictions on use. Because of the numerous and often expensive requirements for establishing a franchise, sometimes the agreement is called a license instead. Caution is advised at this juncture, because regardless of what that agreement is called, there may a different meaning assigned to it under the law.

What is the difference between licensing and franchising?
Licensing typically provides the right to use a name or a system such as software.  Franchising involves the right to use the name, the business system, and the payment of initial and ongoing fees, and provides significantly more control of the recipient business to the franchisor than to a licensor.

The Federal Trade Commission (FTC) considers anyone who offers, sells or distributes goods, commodities or services to be involved in the sale of a franchise if they: a) have a trademark, name or other commercial symbol the recipient will use; b) provide significant assistance to the recipient in their method of operation; and c) charge a fee for their services (the “three leg test”).

A licensor may exhibit two of the three characteristics of a franchisor, but they may not control the business operations of the licensee.  This is the key distinction between a license and a franchise, although others may also be important.  A licensor will generally not provide the support or training that a franchisor would. In essence, the license simply allows the recipient to use licensed material or do something that would otherwise be in contravention of intellectual property law.

There are, of course, risks associated with granting someone the right to use one’s name, or mark. The owner of the business or idea who seeks to expand it may want to ensure that the parties who use their name represent a particular image to the public, and therefore may need the control that a franchise arrangement can provide.  For instance, McDonald’s wants each store to provide the same products- same taste, same appearance, etc- regardless of whether that store is in Alabama or Alaska.  Examples of non-profits using a franchise model include Catholic Charities, YMCA, Planned Parenthood and United Way.  These non-profits benefit from the arrangement in that local control results in better funds generation and buy-in, and limits the liability of the franchisor for the actions of the franchisee, yet allows the franchisor to control many aspects of the franchisee’s operations, thereby protecting its reputation, and expanding the reach of the non-profit.

Franchising allows more control over the franchisee because the franchisor can control the quality of the operation and services delivered. A franchisor has the ability to stop a franchisee who is not representing the brand appropriately by its conduct. It is, however, more expensive and time-consuming to establish and maintain a franchise than a licensing agreement.

Why it matters
Franchising is governed and regulated by the FTC, in addition to state and local laws. The laws and regulations promulgated thereunder require a franchisor to create and file a franchise disclosure document (formerly known as a franchise circular), a comprehensive document including disclosure of financial information, pending litigation and other matters that would be important to a potential franchisee. Compliance with franchising laws is time-consuming and expensive. Failure to comply, even where innocent or inadvertent, may result in liability for damages, rescission, criminal penalties, civil fines, and the award of attorneys’ fees. If an agreement meets the FTC’s three leg test, it doesn’t matter what the parties call it, the FTC will call it a franchise. A licensing agreement falls outside the FTC’s purview, and is essentially a contractual arrangement, subject to the usual laws of contract.

There are exemptions to the FTC’s disclosure requirements for franchises, including oral franchises, or franchises in which no payment exceeding $500 is required to be made to the franchisor within the first six months of operation, or certain insider arrangements.  There are still certain filing requirements, and the franchisor must also comply with applicable state laws regarding franchising, but at least it allows the franchisor to maintain the confidentiality of its finances, and it reduces the up-front and ongoing cost of compliance. However, the exemption may or may not apply to interaction with prospective franchisees, and it must be strictly maintained.

How much control is too much?
The FTC has indicated that it will not deem clauses designed to exercise reasonable control over the use of a trademark as “significant” control. Clauses that are likely acceptable in a licensing agreement include allowing the licensor to inspect goods and services offered under the mark, involvement in the design process of a product, approval of packaging and advertising to ensure the mark is used properly, and requiring access to the licensee’s facilities for the purpose of monitoring adherence to licensor’s quality standards.

Examples of a licensor exerting too much control and therefore behaving as a franchisor include the licensor prescribing site design or appearance, hours of operation, production techniques, accounting practices, personnel practices or policies, requiring specific promotional or marketing campaigns for the mark, or providing significant assistance.  Significant assistance includes training programs for personnel, sales or business methods and procedures, assistance with site selection or sourcing raw material, or furnishing detailed operating manuals.

Summary
It is critical to consider the long term plans of the organization, and how much control is necessary to ensure successful use of the mark or other intellectual property of the organization.  While franchising is costly and time consuming at the outset, it allows for much more control of the quality of individual operators.  Licensing is much less complex, and can be set up by a single licensing document.

While initial cost is important, it is just one of the considerations in making a decision about how to proceed. For an organization, it is often a question of balancing costs vs. risk of loss of reputation that comes with less control.