Avoiding the illegal franchise
What is an illegal franchise?
An “illegal franchise” refers to a business relationship that meets the legal definition of a franchise but is being operated under a different label—often as a licensing, consulting, or distribution agreement—without complying with franchise laws.
The Legal Definition of a Franchise
Under federal law, franchising occurs anytime the following three elements are present:
- Promise to Provide a Trademark: The buyer will obtain the right to operate a business that is identified or associated with the seller’s trademark, or to offer, sell, or distribute goods, services, or commodities that are identified or associated with the franchisor’s trademark
- Promises to Excerise Significant Control or Provide Significant Assistance: The seller will exert or has authority to exert a significant degree of control over the buyer’s method of operation, or provide significant assistance in the buyer’s method of operation
- Requires Payment: As a condition of obtaining or commencing operation of the business, the buyer makes a required payment or commits to make a required payment to the seller or its affiliate. In Virginia, this includes any direct or indirect payment of at least $500.
If these three elements are present, its a franchise! This is true regardless of what the parties call the arrangement and regardless of rather the agreement is written or oral.
The Trademark Element
A franchise involves the right to operate a business that is identified with, or associated with, the franchisor’s trademark. This includes the right to offer, sell, or distribute goods or services tied to that mark. The term “trademark” is interpreted broadly and includes service marks, trade names, and other commercial symbols used for branding or advertising. This is commonly referred to as the “trademark” or “mark” element of a franchise.
The franchisor does not have to own the mark outright but must at least have the authority to license it to others. The ability to use the franchisor’s mark—whether in selling products, offering services, or including the mark in the business’s name—is a core component of a franchise relationship. Notably, a supplier can avoid being classified as a franchisor under the FTC Rule by expressly prohibiting the distributor from using its mark.
The Significant Control or Assistance Element
The “significant control or assistance” element is more fact-specific because it depends on the particular details of the relationship between the parties, rather than a fixed or formal set of rules. Whether control or assistance is “significant” requires evaluating how much influence the franchisor actually has over the franchisee’s day-to-day operations and whether the franchisee reasonably relies on that influence.
What is "Significant"?
The more franchisees reasonably depend on the franchisor’s control or support, the more likely that control or support will be deemed “significant.” This can vary widely depending on factors such as the franchisee’s experience level, the nature and scope of the control or assistance, the specific industry involved, and how central that control is to the operation of the business. Because these factors differ from case to case, courts and regulators must assess the totality of the circumstances, making this element highly dependent on the specific facts and context of each arrangement.
The FTC Compliance Guide provides some insight with factors to be considered when determining whether there is significant control or significant assistance.
Significant types of control include:
- site approval for unestablished businesses;
- site design or appearance requirements;
- hours of operation;
- production techniques;
- accounting practices;
- personnel policies;
- promotional campaigns requiring franchisee participation or financial contribution;
- restrictions on customers; and
- locale or area of operation.
Significant types of assistance include:
- formal sales, repair, or business training programs;
- establishing accounting systems;
- furnishing management, marketing, or personnel advice;
- selecting site locations;
- furnishing systemwide networks and website; and
- furnishing a detailed operating manual.
Additionally, the Compliance Guide provides that, to a lesser extent, the following factors will be considered when determining whether “significant control or assistance” is present:
- a requirement that a franchisee service or repair a product (except warranty work);
- inventory controls;
- required displays of goods; and
- on-the-job assistance with sales or repairs.
Promotional Activities Alone Are Not Significant
Promotional activities alone are not considered “significant” assistance. This means that simply giving a trading partner things like in-store displays, sales kits, product samples, or other marketing materials to help boost sales doesn’t meet the threshold for a franchise relationship. The same goes for advertising. Without other types of support or control, these promotional efforts don’t count as “significant” under franchise law.
Other Exclusions
Certain activities do not constitute significant control or assistance, as a matter of FTC policy. Specifically:
- trademark controls designed solely to protect the trademark owner’s legal ownership rights in the mark under state or federal trademark laws (such as display of the mark or right of inspection);
- health or safety restrictions required by federal or state law or regulations;
- agreements between a bank credit interchange organization and retailers or member banks for the provision of credit cards or credit services; and
- assisting distributors in obtaining financing to be able to transact business.
The Payment Element
Under the Federal Trade Commission (FTC) Franchise Rule, one of the key elements that defines a franchise is the payment of a franchise fee. Specifically, this is any required payment of at least $500, made either before or within six months of beginning operations. This fee can take many forms, like:
- An up-front lump sum payment;
- Royalties or ongoing fees;
- Required purchases of products, services, equipment, or software;
- Training fees, marketing contributions, marketing collateral, or even lease payments
State Law Adjustments
While the FTC sets the minimum national standard, many states with franchise registration or disclosure laws have their own definitions and stricter thresholds for what constitutes a franchise fee. For example:
- Some states do not use the $500 threshold and may consider any required payment—regardless of amount—as satisfying this element.
- A few states may be more aggressive in determining whether a payment qualifies as a disguised franchise fee (e.g., requiring purchases that benefit the franchisor).
- Others may look at whether the payment is truly voluntary, and if not, may treat it as part of a franchise relationship.
Because of these variations, a business model that avoids federal franchise classification by staying under the FTC’s $500 threshold may still be treated as a franchise under state law, exposing the parties to state-specific registration, disclosure, and compliance requirements.
Payment Exclusions
The “payment” element of the franchise definition does not include money spent on buying a reasonable amount of inventory at true wholesale prices for resale or lease. “Reasonable” means the amount a typical businessperson would buy to either start up or maintain a normal level of inventory. This exception, known as the “inventory exemption,” also covers items meant to be leased to the public—such as vehicles or furniture in rental businesses. However, the exemption does not apply to goods the franchisee must buy for its own use in running the business, like equipment, tools, or general business supplies.
What is the Significance of a Relationship Legally Being a Franchise?
Franchises are sold through a structured process that involves several key steps designed to ensure both parties understand their rights and obligations. Typically, the franchisor first provides the prospective franchisee with a Franchise Disclosure Document (FDD)—a legal document that details important information about the franchise system, fees, obligations, financial performance, and risks. This disclosure is required by federal law with supplemental requirements by many states to promote transparency and protect buyers.
Offering franchises without providing a proper FDD can lead to serious legal and financial consequences at both the federal and state levels, affecting both the business (franchisor) and individual sellers involved.
Learn more about the consequences of offering and selling a franchise without following federal and state disclosure and registration laws.
How to Report an Illegal Franchise
To report a suspected illegal franchise to the Federal Trade Commission, you can submit a complaint online through the FTC’s complaint assistant at reportfraud.ftc.gov. When filing, provide detailed information about the business, the franchise offer, and why you believe it violates franchise laws, including any supporting documents or communications. The FTC uses these complaints to identify patterns of illegal activity and may investigate, but it does not resolve individual disputes or provide legal advice. Reporting to the FTC helps regulators monitor and enforce compliance with federal franchise disclosure requirements.
In states that require franchise registration and disclosure, suspected illegal franchises can be reported to the state regulatory agency, often the Attorney General’s office or the Department of Business Oversight. Each state typically has an online complaint form or a process for submitting complaints via mail or email. When reporting, it’s important to include detailed information about the company, the offer, and any supporting evidence. State regulators may follow up for additional information and can take enforcement action if violations are found. Reporting to state authorities is critical in protecting consumers and ensuring franchisors comply with state-specific franchise laws.
Meet the Author
Derek A. Colvin
Derek is a graduate of Penn State Law and Old Dominion University. He started his legal career in 2009 as a prosecuting attorney before entering private practice.
Derek currently serves business clients as a partner at Waldrop & Colvin, the law department for your business. His practice focuses on SMB client legal services and franchise law.
Derek is laser-focused on delivering efficient and effective solutions for business legal needs. As a seasoned litigator and experienced business attorney set on thinking critically and communicating effectively, Derek is well-suited to advise and protect your business.
Derek often serves as outside general counsel providing transactional support for business owners. He represents SMB independent owners, as well as franchisors, and franchisees as a franchise attorney.
Primary Practice Areas: Franchising | Franchise Law (Franchisor Legal Support & Franchisee Legal Support), SMB Mergers & Acquisitions, Entity Formation and Governance, Lease Negotiations, Trademark Registration, Dispute Resolution and Civil Litigation & Outside General Counsel Support