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 a 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 Fractional Franchise Exemption. The FTC created this exemption because not all prospective franchisees benefit from the disclosures in an FDD, especially when the prospective franchisee has prior experience in a similar industry and when the new business will be only a fraction of the franchisee’s total sales.
The Fractional Franchise Exemption is dependent upon the specific characteristics of a prospective franchisee. Thus, a franchisor is more likely to implement this exemption on a-franchisee-by-franchisee basis rather than as a general strategy. However, some significant companies like Starbucks, hotels, or airports utilize this exemption regularly.
Fractional Franchise Exemption
There are three requirements for the Fractional Franchise Exemption to apply: (1) the prospective franchisee has a minimum level of experience (2) in the same type of business as the franchisor and (3) the new product or service line will account for less than 20% of the prospective franchisee’s first year of gross sales.
A. Minimum Level of Experience.
The prospective franchisee must have at least two years of experience in the same type of business as the franchisor. This prior experience helps the franchisee understand the economics of the industry and anticipate issues in providing similar goods and services. The prior experience can be held by the franchisee entity, its current directors or officers, or any current directors or officers of a parent or affiliate. This allows an experienced company to create a subsidiary or affiliate to hold the new franchise agreement for liability limitation purposes without compromising its ability to seek the exemption. The officer’s or director’s experience still counts even if it was with a former company. Additionally, the required two years of experience does not need to have been within a certain period.
For example, if a holding company of a quick service restaurant specializing in healthy foods has a CEO with experience in selling smoothies and juices, then that experience would be relevant in determining if the quick service restaurant entity could become a fractional franchisee of a brand selling smoothies and juices.
B. Same Type of Business.
The type of business factor is the most subjective and the one that franchisors should evaluate with caution. The purpose of this factor is to ensure that the prior experience is truly transferrable to the new line of business. “Same type” does not mean offering identical goods and services, but it does mean selling competitive goods or being in a business that would ordinarily be expected to sell the competitive goods and services. Determining the scope of how similar those goods and services are to the new franchise opportunity requires judgment. One way to ask this question is “Will the franchisee’s prior experience in a similar industry directly help her to operate the new business?”
An example in the Statement of Basis in purpose for an earlier version of the Rule shows how the FTC has analyzed this question:
If for example, the prospective franchisee has operated a hardware store for the past 10 years, but has never sold lawn care equipment before, he will still be in the business represented by a franchise to sell lawn care equipment because hardware stores commonly carry such goods and the franchisee can be expected to have some familiarity with comparable goods. In contrast, a gasoline station dealer would not be in the business represented by a car rental franchise because the experience of selling gasoline would not give the franchisee any familiarity with the problems of renting cars.
Another example provided by the FTC is of an ice cream shop:
[A]n independent ice cream store owner might qualify as a fractional franchisee if he or she were to enter into a franchise relationship with an ice cream cake supplier. However, the ice cream store owner would probably not qualify as a fractional franchisee if he or she were to enter into a franchise relationship to expand the product line to include items not typically found in ice cream stores, like greeting cards.
In practice, however, the FTC’s view of the similar business can be quite subjective and far from obvious. You should consult with an attorney to determine if the new franchise is in the same type of business as the prospect’s previous experience.
C. 20% Percent of First Year Gross Sales
The purpose of this factor is to ensure that the prospective franchisee is not dependent on the new business line for its overall business success. The 20% limitation considers incremental sales gain over existing sales in the franchisee’s entire similar business line, including operations at multiple locations. So if the prospective franchisee operates three hardware stores and intends to offer the lawn care equipment franchise at only one of the stores, the projected sales of the lawn care equipment would be compared to the total sales of all products sold at all three hardware stores.
Projections can never be certain, but franchisors have the burden of showing that they are reasonable. It is best practice for the franchisor to have the prospective franchisee prepare its own analysis of its business to see if the 20% threshold is exceeded. Then the franchisor should evaluate these projections based on its own data and industry understanding. However, to avoid issues of making an inadvertent financial performance representation, the franchisor should not provide comments on the franchisee’s projections or share its internal projections.
The exemption will still apply in situations where the franchisee’s actual sales exceeded 20% in the first year if the projections were reasonable, supported by plausible assumptions, and in good faith. This is a protection for both franchisors and franchisees. It is also important to note that under the Rule the 20% limitation only applies during the first year of operations, meaning that the new franchised business can grow to exceed 20% of the franchisee’s total revenue in future years.
The Fractional Franchise Exemption allows both the franchisee and franchisor to enter a franchise relationship with less risk than in a traditional offering. The franchisor has less risk of its franchisee failing because the franchisee has relevant business experience and is not dependent on the franchisor’s brand to keep its other businesses open. These same factors make the offering more attractive to the franchisees because they are not dependent on the new franchise for success.
Manning Fulton attorneys are available to help you determine how you can utilize the Fractional Franchise Exemption in your franchise system to reduce the costs and burden of franchise sales compliance.