LICENSING vs.
FRANCHISING
A
short discussion about greatly lowering the cost of business expansion through
low cost licensing rather than investing in the huge expense of
franchising. See who qualifies!
By
Robert Townsend, Attorney At Law.
Tel. 310 207 0180
[Please note: If you wanted LICENSING IN A NUTSHELL, press here to change].
What you Have to Know
·
There are Many Ways to Skin a Cat. Though this article discusses
“licensing versus franchising” as methods of expanding a business,
it is important to note that these are just two paradigms that can be used. There are many other methods to use, and
each factual situation will dictate the best possible expansion avenue to
pursue. Maybe more than half of
my clients pursue something other than licensing or franchising once they learn
what is available…and usually at a 60-75% savings in costs in legal fees.
Why Consider “Licensing”?
·
Licensing is Lower Cost and Can Be Done Quickly. If you are thinking about expanding your
operation through franchising, licensing may be an alternative because (1) it
is substantially less expensive, and (2) it
takes about ten to fifteen business days to complete rather than months and
months for franchises. Also, no
past audited financial records showing successful performance are required in
licensing.
·
Business Goals Often Can Be Met. It is often possible to draft a license
agreement that achieves the goals of the licensor and does not violate the
various franchising laws.
·
A Key Question: Is this the right time to expand a
business?
1. In a time when America’s work force is
being down sized and people are being laid off, either due to slow economic
conditions, outsourcing of jobs, or the competition of low wage immigrate
workers, in most businesses the market for selling licenses (or franchises) is
correspondingly expanding, because these displaced people need a way to
replace their lost “living wage”.
2. Consequently, the market for selling licenses
in most businesses is expanding in difficult economic times.
3. The size of the market for potential licensees
buying a license is often many times larger than buying a franchise,
because licenses are usually much less expensive than franchises. Therefore,
there are more people available in the marketplace that can afford licenses or
opt to buy licenses rather than pay the high cost franchises in times of
economic uncertainty.
·
Existing Businesses as Potential Licensees. Existing businesses often buy a
license and add the product or service to that existing business; this allows
the licensee to keep his “bread winner” business going while he
tests the licensing operations and thus reduces the risk on the acquiring the
license.
·
Much Less Work on Daily Basis. The day-to-day business operation of a
licensor is customarily much less work and complex than the business of being a
franchisor. If you become a
franchisor, you generally have to give up the operations of your own business
and enter the full time business of being a “franchisor”.
·
Avoid Complex Government Regulation. There is little or no government
regulation in licensing, and there is substantial and complex government
regulation in franchising. But keep
in mind, that no matter what expansion format you use, there is someone who may
call it a “franchise”. You can have your five year old son and six
year old daughter sell lemonade at two different stands outside your house, and
there is someone who will allege that they are franchises. That is just a fact you have to live
with in a world where there are too many attorneys with not enough to do.
A Quick Overview of Licensing
·
Licensing is a business structure and method of expanding
the distribution of goods and services.
Rather than create a franchising business structure with the substantial
costs involved, an entrepreneur who wishes to expand its business may be legally able to use a licensing
legal structure. Usually a quick no-charge telephone
conversation with experienced counsel can tell you if licensing will work in a
particular situation. (Note: I do this several times a day.)
·
As in franchising, in licensing there can be (i) an initial
upfront fee, (ii) continuing royalties, (iii) monthly license fees during the
term of the agreement, (iv) exclusive territories, and (v) long or short term
agreements.
Difference between Franchising and Licensing
·
Franchising and licensing as a means of expanding a business
are often confused with one another.
However, franchising and licensing come from two distinct areas of the
law. Franchising is based on
securities law and licensing is a form of contract law.
·
What does this mean to the non-lawyer? It means that if one takes up
franchising as a means of expanding a business, then compliance with the
franchise laws, like the securities laws, requires registration of the
franchise in the applicable jurisdictions.
On the other hand, licensing is merely a contract between two
independent contractors and franchise registration is not required.
·
Here is the effect: It’s in the pocket book! Franchising creates more work for
lawyers in complying with all the registration requirements, and consequently
it is far more expensive to go the “franchising route” than down
the licensing road which requires substantially less legal work.
·
It is simple as that!
If the factual situation is right for both formats, franchising is
substantially more expensive than licensing!
Why Do Franchises Have To Be Registered?
·
In general, the primary difference between a
license and franchise situation is the amount of control that the franchisor or
licensor exercises over its franchisees and licensees, respectably.
·
A franchise has to be registered, because the
control by the franchisor over the franchisee is what is suppose to make the
money for the franchisee; i.e. if you do what the franchisor says, then you
will make money. Buying a franchise
is like buying a security; i.e. the control over whether or not the buyer of
the franchise or security makes money is in the hands of a third party; for the
security situation it is in the control of the people who operate the company
that issues the security, and for the franchise the control is in the
franchisor who dictates how the franchise operates to make money.
·
Thus, the government requires disclosure of
the risks
to the potential franchisees just like the government requires a disclosure of
the risks in buying a new stock issue.
There are government requirements of registration of both franchises and
securities for the same reason; i.e. to protect the public and give the public
full disclosure of all risks before purchasing.
There are Two Types of
Franchises
·
In practical terms there are two types of franchises: (a)
intentional franchises and (b) unintentional franchises.
·
The first type is the situation where someone wants to
expand their business and decides to intentionally use the franchising
mechanism to do it and comply with the registration laws.
·
The second type is the predicament where in the effort to
expand the business, franchises are inadvertently created (sometime called
“hidden franchises”).
These hidden franchises are often spawned from a poorly advised and
drawn distribution agreement, license agreement, and other marketing
formats. These are the franchises
that get people into trouble!
·
The problem is that both types of franchises have to be
registered in the appropriate jurisdictions, and the consequences of failing to
do so is often substantial civil penalties and/or criminal punishment. There
have been many entrepreneurs that have served substantial prison terms for selling
unregistered or improperly registered franchises.
·
So this area of the law is nothing to “trifle
with”, so to speak.
·
If you go the licensing route sometimes in certain
situations it is easy for a licensing format to slip into an unintentional
franchising structure either by poor draftsmanship of the licensing documents
and/or the inappropriate use of business applications in company
operations. If a licensor slips
into the franchise arena, he needs to either (a) immediately comply with
franchise laws or (b) re-adjust the operations to comply with the licensing
laws and avoid the franchise laws.
AN IMPORTANT
VISUAL AID IN UNDERSTANDING LICENSING
THE THREE-LEGGED FRANCHISE STOOL
The Legal Definitions of a Franchise So Everyone Can Understand It
You have to learn about the “Three-Legged
Franchise Stool”. You have to know what franchising is to know
how to lawfully avoid franchising,
and you have to know how to avoid franchising to create a licensing or other
mode of business expansion. Consequently
since we have been talking about franchises and need to know about them, we
better make it understood just what constitutes a “franchise”. First, I have to tell you the various
States and Federal definitions of a franchise are pretty clear, but the
application of the facts to these definitions is highly mercurial. You may have trouble ever getting any
two franchise lawyers to agree on whether or not franchise law compliance in
various situations has been met.
Federal
Definition of the Federal Trade Commission
·
THREE ELEMENTS. The FTC “Franchise”
definition has three key elements: (1) the franchisee’s goods and/or
services are to be offered and sold under the trademark of the franchisor; (2)
the franchisor requires the franchisee to make a minimum payment of $500, and
(3) the franchisor maintains significant
control of, or provides significant
assistance to, the franchisee’ operation methods.
Author’s Note:
This is important! Think of
each of these three elements as a leg on a stool with three legs. This visual aid will help understand the
discussion of licensing below. THE
THREE-LEGGED FRANCHISE STOOL!
·
Common Name Leg. The element (or leg of the three- legged franchise stool) of the use of the trademark or common name is clear for
the purposes of this discussion.
You want your trademark or common name to be the rudder that moves your
business expansion.
“McDonalds” is the most famous example of the common
trademark name of franchises.
·
Fee Leg.
The element (or leg) of payment of a fee means that franchisee must pay the franchisor at least $500 as
a condition of obtaining the franchise or of beginning initial operations. Any payments made at any time before or
within six months after beginning operations shall be aggregated (combined) to determine if the $500 element is
present. These payments may be a
requirement of the franchise agreement, or a secondary agreement (e.g.
agreement to purchase goods only supplied by franchisor.).
·
Operations and Marketing Control Leg. As to the element (or leg) of “significant control or assistance in
franchise operations or marketing”, the key word is
“significant”.
Franchisor actions that trigger the application of the concept of
“significant control” are (for example): operations manuals, site
approval, personnel policies, accounting procedures, co-op advertising,
operations training, etc.
The
States’ Definitions of Franchise
(The Three Categories)
·
The FTC basically sets a minimum standard of what a
franchisor must disclose to a prospective franchisee. Then it leaves it up to each State to
add any laws it deems necessary to protect the potential franchisee. Thus, each State has its own franchise
laws which include the definition of franchise that must be followed. I have used three categories to describe
the various types of franchise laws of the States. They are:
1.
Category I. In California, Illinois, Indiana,
Maryland, Michigan, North Dakota, Oregon, Rhode Island, and Wisconsin, a
franchise is defined as having three essential elements: (a) A franchisee is
granted the right to engage in the business of offering, selling, or
distributing goods or services under a marketing plan or system prescribed in
substantial part by a franchisor, (b) the operation of the franchisee's
business is substantially associated with the franchisor's trademark or other
commercial symbol designating the franchisor or its affiliate and (c) the
franchisee is required to pay a fee.
Please
understand this! Except for
Categories ll. and lll. below, a Category l. license agreement will in general
be applicable in almost all the country, because almost all the States in the
country are Category 1 States.
For instance, an agreement drafted to comply with the Category I States
will be applicable in all the 44 Category 1 States. The six States those are included in
Categories ll. and lll. require some changes in the documentation.
NOTE:
For example, I prepare a California License Agreement (where I practice) and that License Agreement is usable in 44
States…almost all the country.
In some of the other 6 States that license agreement has to be
“tweaked” to comply with the laws of those States.
2.
Category II. Hawaii, Minnesota, South Dakota,
and Washington have a broader definition of franchise which include three
primary elements:.(a) Franchisee is granted the right to engage in the business
of offering or distributing goods or services using the franchisor's trade name
or other commercial symbol or related characteristic (b) franchisor and
franchisee have a common interest in the marketing of goods or services, and
(c) franchisee pays a fee.
3.
Category III.
Virginia and New York are different than other States. New York, for instance, the (a)
franchisor is paid a fee by the franchisee, and (b) is either essentially
associated with the franchisor's trademark or the franchisee operates under a
marketing plan or system prescribed in substantial part by the franchisor.
HERE
IS THE QUESTION:
How Do You Create A License Without
Creating A Franchise?
There are two key things that
have to be done to create a license in a business opportunity situation that
does not constitute a franchise:
1.
Eliminate one leg of
the Three-Legged Franchise Stool.
Usually the One Leg you cannot eliminate is
getting paid for all the work!
Unless the initial fee is under $500, you ordinarily cannot eliminate
the leg that requires the Licensor receive a fee or payment, because getting paid is the primary reason for
establishing the licensing structure.
Consequently, there usually remains a choice of two legs to eliminate:
(a) using a common trademark or common name, or (b) the Licensor’s
“somewhat” control over the operations and marketing of the product
or services involved.
2.
And make sure that the
Licensee is an independent contractor in its relationship to the Licensor.
See info on Independent Contractor issue below.
(Interesting Observation. I have found that there are few
franchise lawyers that will want to do licensing because (i) licensing legal
work pays only a fraction of the legal fees paid for franchise work, and (ii)
logically and for fair reason they have little or no experience in actually
doing a license as their “mind set” is franchising law as this is
their area of specialization.
(Warning to “Do-It-Yourself”
People. I want to make
this clear to anyone considering Licensing without using an experienced
attorney: Do not try and do this
yourself without your legal counsel. There are NO forms on the internet that
will get the job done! I have
reviewed “do it yourself” documents from time to time, and they are
always on the road to trouble.
And further, it is very difficult to get them straightened out, because
they have all this “wrong stuff” already done before it can be done
“right”, and the “wrong stuff” is always out there to
create liability to the poor soul who tried to do it himself.)
The “Big Question”: What Leg Do You Eliminate?
In its most simple terms, first you
have to decide what your business vision is in setting up the licensing model:
branding a name (“branding”) or providing assistance in marketing
of products or services (“Non-Branding”).
Branding
Situations
·
The branding situation usually (though not always) occurs
where you require the licensee to use
your trade name and/or logo as the name of licensees business.
·
When you eliminate the licensing of the trademark or common
name then the effect may be to eliminate the “branding” feature.
Non-Branding
Situations
·
Non-Branding is where the Licensor does not permit the Licensee to use Licensor’s trade name,
trademark, and/or logo as the name of Licensee’s business or in a
substantive or primary way.
·
Where the object is to sell product or services and this can
be done without branding, then allowing the licensee to operate under its own
name may be the avenue to take, because here the Licensor can exert certain
limited controls on operations and marketing that assist the Licensee in
successfully selling the products or services of the Licensor.
·
The application here is a license to distribute goods and
services in a manner that is designed to produce profits for Licensor and
Licensee.
·
Look out! The Licensor’s controls cannot
reach the status of “significant” controls, and thus the controls
cannot be such that the Licensee loses its legal capacity as an independent
contractor, or else the Licensee may become an employee or agent of the
Licensor with dire consequences.
(See Below)
The Independent Contactor
Issue
·
The independent contractor issue is the basis of the legal
relationship between the Licensor and the Licensee. They are bound by a contract entered
into between them as two independent contractors.
·
In
General. The Internal
Revenue Service and the income taxing authorities of the various states have
guidelines to ascertain if the relationship between two parties is that of
employer-employee, principle and agent, or two independent contractors that
have entered into a contract for work or sale of goods or services. The essence of being an independent
contract is that (in this case) the Licensor cannot tell the Licensee how to do
the work required but can only tell him what the job is that needs to be done
under the contract. For instance,
one may not tell another the hours to do the work, equipment to use in doing
the work, the sequencing of the work, the customers for the work, etc. There are approximately 20 points in the guidelines to which an
independent contractor should comply to maintain that status.
·
Consequences of
Violating Independent Contractor Status.
The consequences of violating the independent contractor status of the
Licensee is (i) the IRS or a State will rule that the Licensee is an employee
of the Licensor and will seek all back withholding taxes plus interest and
penalties (this usually happens after about five years of operations, so the
taxes, etc are huge!), and (ii) that in the event that that Licensee incurs
civil liability for a tort (e.g. an accident) the Licensor will be held
responsible because the Licensee is deemed an agent of the Licensor…and
not an independent contractor.
·
Creates
Franchise. Also, the violation of the independent
contractor status of the Licensee may throw the structure from a lawful license
into an unregistered franchise situation.
If the licensee is truly an independent contractor and can do his work
in his licensed business in the manner, time, hours, and use of equipment etc.
that he chooses, then he will be a licensee. If there is even slightly more control,
then Licensee may slip into the area
of being involved in a franchise, and what Licensee thought was a license
arrangement may well be a franchise situation and Licensee is now a franchisor
that has not complied with the franchise laws.
The Business Opportunity
Statute Issue
·
Some States have what are called “Business Opportunity
Laws” or “Seller Assisted Marketing Plan” (SAMP) laws. These laws require the registration of
certain business opportunities offered in the State. They are of fairly recent vintage, as
laws go, and they were created to protect the people against the plethora of
fraudulent “business opportunities” that flood the media. The registration usually is not
difficult to do, but it may be costly (not as costly as franchising) and time
consuming.
·
DEALING WITH
THEM! One offering a business opportunity in
these States must either (i) avoid the factual situation that brings one within
these laws, (ii) obtain a waiver of these laws in the States where waivers are
acceptable, (iii) comply with the requirements of registration, or (iv) use a
combination of the above remedies. Check with counsel of the applicable State. The terms of the License Agreement will
often determine the path to take with regard to these statutes.
· At present there is no Federal legislation on business
opportunity laws, but for a couple of years now a proposed law has been out for
comment from the public.
A Synopsis: The Keys to Licensing a Business
Opportunity
1.
Create
Leverage So Licensee WANTS to Do What Licensor wants. An
additional key is to know the specific elements needed by the client to obtain
the similar or equivalent results as a Licensor that one might achieve as a
franchisor, and this is usually achieved by making conditions available so that
the licensee without coercion truly and voluntarily wants to do things the
licensor’s way.
2. Realize that Sometimes You Have to Franchise. Sometimes a potential Licensor must
accept the facts that in some situations using the licensing model in the
particular State cannot be done.
Sometimes he has to either (a) use a different business model, or (b)
register as a franchise. My
approach in preparing license agreements for licensing business opportunity
situations is to (a) first prepare get a list from the client of everything the
client (Licensor) would like in it [This
usually pertains to controls over the Licensee.], and then (b) go through
the list and see what the client really
needs and make cuts accordingly to be legally compliant, and (c) then I make
the cuts [or additions] to the agreement which make it lawful, and any
disagreements on my cuts are sorted out between the client and me.
3.
Selling the
Licenses. Selling the licenses, of course, is the
“bottom line” key. I
have given some of my clients some direction that has proved helpful for those
who wish to market their licenses themselves. There are many and effective means of
selling licenses that a Licensor can do on
a very limited budget. On
the other hand, there are many professionals that can be of great help, either
taking over the marketing or assisting the licensor who wants to stay on top of
the process. . You can develop your own relationship
with license marketing people. There are many, maybe in your
neighborhood.