Franchise disclosure obligations and registration can carry significant costs of compliance and can be an administrative burden. Initially drafting a compliant Franchise Disclosure Document (“FDD”) is a time-intensive process. Then the franchisor must update the FDD annually for as long as it wishes to sell franchises. State registration of the franchisor and review of the FDD can further delay franchise sales. Additionally, an FDD contains confidential information that the franchisor may not wish to make public, especially if the business is particularly sensitive to competition. Franchise laws restrict otherwise legal sales practices, such as making financial performance representations outside of Item 19, which can be another frustration for franchisors.
Exemptions to the franchise disclosure and registration laws provide both seasoned and start up franchisors the opportunity to reduce these burdens and costs by either (1) avoiding registration in a state or (2) avoiding drafting an FDD at all.
In this blog post series, we summarize the exemptions available under the Federal Trade Commission Franchise Rule (“Rule”), which allow a franchisor to sell a franchise without an FDD. Any analysis of what exemptions apply to your brand is incomplete if you do not also consider the application of state law. States may not recognize the federal exemptions and may offer different exemptions to their registration requirements.
The Rule contains eight exemptions, and the focus of this post is the Minimum Payment Exemption. The FTC created this exemption for practical reasons – it did not wish to regulate transactions where the franchisee’s initial personal financial risk was low. This exemption is valuable to franchisors that can afford to delay collecting their fees in exchange for avoiding the expenses of preparing an FDD.
Minimum Payment Exemption
The Minimum Payment Exemption allows franchisors to sell franchises without preparing an FDD if certain payments made by the franchisee during a specific window are below a threshold amount.
What is the amount of the minimum payment?
The exemption applies when a franchisee is not required to pay more than $615. This amount is adjusted for inflation by the FTC every four years.
When is the payment made?
The relevant period is any time before the franchisee commences operations to six months after the franchisee commences operations (the day that the franchisee first makes its goods or services available for sale). The time before the franchisee commences operations will include the signing of the franchise agreement and the time spent preparing to open, such as a selection of a site, construction and build-out, purchases of inventory and equipment, and early marketing efforts.
What counts as a payment?
Below is a description of what qualifies as a payment for purposes of determining if the amount counts towards the exemption minimum of $615 (“Qualifying Payment”):
1. The Qualifying Payment is made to the franchisor or its affiliate.
The payments that are obviously made to the franchisor are fees like the initial franchise fee and royalty. Structurally, this means that franchisors that use this exemption will delay the payment of an initial franchise fee and the royalty until the franchisee’s seventh month of operations. If the franchisor or its affiliate are also an approved supplier of a good or service that a franchisee will be required to purchase to open or operate, those amounts will also be Qualifying Payments. For example, Qualifying Payments include proprietary inventory purchased from the franchisor and rent payments due to the franchisor’s affiliates if those payments are due within the first six months of operation.
- The Qualifying Payment includes commitments to make a required payment.
This has a significant impact on promissory notes made between the franchisee and the franchisor. Franchisors can use promissory notes to bind franchisees to paying an initial franchise fee and six months of royalties beginning the seventh month after franchisee opened for business. However, if the terms of the note allow the franchisor to accelerate payments to be due during the first six months of operations, then the amounts covered by the note are “commitments to make a payment” under the law, even if the accelerated payments are never triggered.
- The Qualifying Payment must be required.
Calling the fee optional in the franchise agreement is not enough to avoid being classified as a Qualifying Payment. If the payment is practically required, whether because the goods and services supplied by the franchisor or its affiliate are essential or because they are not realistically available from a third-party supplier, then the payments will be Qualifying Payments.
The Minimum Payment Exemption is a strategic option for franchisors that (1) offer concepts that are rapidly opened, (2) do not need to provide franchisees with extensive pre-opening support (like training and site selection assistance), or (3) do not collect significant royalty payments during the franchisee’s first months of operations. Under these circumstances, the costs saved by not preparing an FDD may outweigh the delay in collecting fees from franchisees.
Manning Fulton attorneys are available to help you determine how you can utilize the Minimum Payment Exemption in structuring your business offering.