The Basic Legal Requirements to Start a Franchise

The Basic Legal Requirements to Start a Franchise

Franchising generally occurs any time there is an oral or written agreement for (1) the buyer to use or associate with the sellers trademark; (2) the seller to exert certain control or provide certain assistance; and, (3) the buyer to pay for the association. 

The basic legal requirements to start a franchise can be broken down into five main categories:

  • Developing the legal document set
  • Obtaining state approval 
  • Complying with disclosure requirements 
  • Maintaining the legal documents on an annual basis 
  • Fulfilling legal obligations to franchisees   
rules, regulations, and compliance

Developing the legal document set

The first legal requirement to start a franchise business is to create a franchise disclosure document (the “FDD” or “disclosure document”). The FDD contains a series of disclosures designed to inform prospective buyers about the franchisor and the individuals in charge of the franchisor. The disclosures cover 23 specific areas and include specific disclosures as required by the federal Franchise Rule (16 CFR Parts 436 and 437). These disclosures cover many business issues, financial issues, and legal issues.  All contracts that govern the franchise relationship will need to be drafted and included in the FDD.  

No offer or sale of a franchise opportunity, or collection of payment in connection with a sale of a franchised business, can occur until the FDD is prepared by a business owner (who becomes the “franchisor”) and then disclosed to a prospect (who becomes the “franchisee”). Receipt of the FDD is acknowledged by recipients and maintained by the franchise lawyer to monitor and ensure compliance. 

The process of creating a FDD requires a partnership between a skilled franchise attorney and business leads. Disclosure requirements are nuanced and franchising is regulated by federal and state laws. A great deal of information is required to prepare a high-quality disclosure document that accurately reflects the company’s business model and systems, while also mitigating against risk. A franchise attorney will gather information from business leads to ensure the FDD accurately reflects the company’s business model and system. The collaboration is necessary so that the attorney can understand the clients risk tolerance and draft legal provisions aligned with the company’s business strategy.  Seasoned franchise attorneys can also provide guidance on many of the business and legal issues that arise in franchising.  During this process, business leads work hard to assist in the development of the FDD by providing detail, engaging in ongoing consultations, and working with their team to create some of the materials required for disclosure.  For instance, the business will develop a training program, training schedule, and operations manual for integration into the FDD.  Accounting or finance professionals will also be involved in preparation of certain financial reports. 

The 23 Items included in the FDD

The federal Franchise Rule establishes criteria for disclosures under the 23 separate areas of disclosure (known as “Items”).  The quality and content of disclosures will vary by franchise offer, but all FDD’s must include the disclosures specified under the Franchise Rule. The Items are broken down as follows:

  1. The Franchisor and Any Parents, Predecessors and Affiliates
  2. Business Experience
  3. Litigation
  4. Bankruptcy
  5. Initial Fees
  6. Other Fees
  7. Estimated Initial Investment
  8. Restrictions on Sources of Products and Services
  9. Franchisee’s Obligations
  10. Financing
  11. Franchisor’s Assistance, Advertising, Computer Systems and Training
  12. Territory
  13. Trademarks
  14. Patents, Copyrights and Proprietary Information
  15. Obligation to Participate in the Actual Operation of the Franchise Business
  16. Restrictions on What the Franchisee May Sell
  17. Renewal, Termination, Transfer and Dispute Resolution
  18. Public Figures
  19. Financial Performance Representations
  20. Outlets and Franchisee Information
  21. Financial Statements
  22. Contracts
  23. Receipts

The specific issues that must be addressed under each item (and in some cases the format of disclosure) are established by the text of the Franchise Rule.  The extent of disclosure requirements are extensive. You can learn more by reading the rule itself or explore our site for an overview of federal franchise laws.  

Issuance of the Disclosure Document

Franchising can begin with the “Issuance” of the initial franchise disclosure document.  The Issuance date is specified on the cover page of each disclosure document. By assigning an Issuance date, the drafting party (typically the franchise attorney) are asserting that the contents are in substantial compliance with the federal Franchise Rule. In many state, a franchise can be offered and sold by disclosing the FDD to a prospective buyer.  However, franchising is regulated on the state level in certain states.  These states are referred to as registration states or filing states. The degree of regulation will depend on several factors. Click here to learn more about franchise laws by state.  Its vital that franchisor’s and their sales teams understand when and where they can offer a franchise.  Typically, a franchise attorney will prepare a state-by-state list where it is okay or not okay to offer and sale franchises. 

Obtaining State Approval

If you are located in a state where franchising is regulated or you want to do business in a state that regulates franchises,  you will need to take steps to obtain state approval. Every franchisor must ensure that they have any necessary state approval before offering to sell any franchise. The FDD is a federal requirement applicable to all states and territories, but federal requirements are supplemented by state laws, rules, and regulations. This requires a state-by-state determination and should be considered while the FDD is being drafted, because additional disclosures are required in certain states. Further, addendums may be required to supersede portions of the disclosure document or franchise agreement that are inconsistent with state laws designed to protect residents of those states.  

States are often referred to as “non-registration states”, “registration states”, “filing states”, or “business opportunity states”.  A business cannot legally franchise until complying with federal franchise law and any applicable state law. Franchise attorneys can file the franchise documents and file any renewal applications. We offer a 10,000 foot view of the registration process in the franchise law section of our website, but the following map provides a quick break down of how all 50 states regulate franchises:

Map depicting franchise registration requirements on a state by state basis.

Complying with disclosure Requirements

A franchise offering can only be made through disclosure of the FDD after obtaining any necessary state approval. Disclosure of the FDD requires providing the entirety of the document, obtaining signing acknowledgment of its receipt, and observing a waiting period for the prospect to digest the document. Federal law mandates a 14-day waiting period, which must occur before: (i) any fee can be collected by the franchisor and (ii) any agreement can be executed by the franchisee. Although it may seem straight forward at first-glance, it is important to know how to calculate this waiting period. 

The 14-day waiting period is actually a 16-day period. This is because the day the FDD is provided and the day the franchise agreement is signed do not count towards the 14-day waiting period. This creates a 16 day minimum period between receipt of the FDD and forming a franchisee | franchisor relationship. There is an additional 7-day waiting period if certain changes are made to the franchise agreement. Again, the date of disclosure and the date of execution are not considered in calculating the waiting period.  

Note: Terms May be Negotiated

There is no legal prohibition on the franchisor and franchisee agreeing to negotiate the terms of the franchise agreement. In fact, in Virginia the franchisee must have a fair opportunity to try to negotiate the terms. It is common for franchisors to negotiate certain business and legal terms. Often the franchisors own terms will change over time as the franchise system evolves. However, like many areas of franchising, the implications of negotiating changes can be nuanced and are not obvious to the average person. For example, California imposes additional disclosure requirements if favorable terms are granted, including disclosure of those deal terms to future prospective buyers. Likewise, pricing discounts often must be disclosed in future iterations of the disclosure document. Newgotatiatng terms is one of the areas where a skilled franchise attorney is essential for guidance and compliance.  The cost of non-compliance can be severe and may jeopardize the entire franchise business.  

Maintaining the legal documents

The federal Franchise Rule imposes an ongoing legal obligation to update the FDD with current information.  Essentially, disclosures must be current and accurate. At minimum, the FDD must be updated each year, within 120 days of the end of the business fiscal year end.  Periodic updates are also required when certain changes occur in the franchise system or when there are certain developments with the franchise business parties. Regulating states also impose their own requirements, which may require a supplemental filing and subsequent approval before resuming franchise sales. The period of time between a change occurring and state approval is often referred to as a black-out period.  

The process  of franchising and maintaining best practices may seem complicated, but it is easily managed when business and legal work together. Attorneys help with disclosing prospects, calculating waiting periods, preparing contracts, maintaining the FDD, and filing the proper paperwork so Franchisors can lawfully conduct business in the states they desire. The annual renewals also provide an opportunity to continually improve the document set, systems, and processes. 

Fulfilling Legal Obligations to Franchisees

The contracts in the FDD will establish rights and obligations of both the franchisor and franchisee. The primary contract is referred to as a franchise agreement.  The FDD may also include other contracts like licensing agreements, distribution agreements, noncompete agreements, or more. Adhesion to the terms of these agreements is important for both the franchisor and franchisee. 

In exchange for the fees imposed, franchisors must meet their obligations to provide the degree of support promised in the franchise agreement. Likewise, franchisees must meet their obligations to operate the franchised business in accordance with the contracts and your franchise system. Its important to maintain the right balance in franchise relations and understand these obligations.  

Partner with Franchise Legal Counsel

Working with a skilled franchise attorney can help turn your concept and vision into a franchise success story.  Launching a franchise system and maintaining compliance with the legal intricacies of franchise law requires a partnership between business and legal. Your business can save time, efforts, and resources by involving an attorney at the early stages of its franchise journey. 

If you engage Waldrop & Colvin, our attorneys will work with you to ensure your brands disclosure documents and contracts accurately reflect the business model and place your business in a position to implement long-term goals and objectives. In addition to preparing the legal documents, a franchise attorney can help you succeed in the business of franchising.  This includes taking steps necessary for the franchise to be offered in any state where you want to conduct business and working closely with business and sales leads to reduce risk and help maintain compliance.  

At Waldrop & Colvin, we offer franchise legal services tailored to your needs. Don’t leave your legal compliance to chance. We will create a plan with you and help you follow the right steps to franchise your business in compliance with all legal requirements.  

Have questions? Learn more about Attorney Derek Colvin, call Derek directly at (757) 651-3490, or send him an email at [email protected].    

– Post by:

Derek A. Colvin, Franchise Lawyer

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