The Basics About Buying a Franchise in California

OVERVIEW

While a lot of people are familiar with the words “franchise,” “franchisor,” and “franchisee,” more often than not, if you asked them to explain the difference between those three terms, they’d have trouble doing so. For most people, when they hear the word “franchise,” they think of the giant ones like McDonald’s, Wendy’s, or 7-Eleven. So, they seem to know what a “franchise” is, but not much more than that. To understand franchises, you have to start by understanding those three words.

The franchise describes the business itself, the franchisor is the owner of the brand/business system that someone may want to buy into, and the franchisee is the person who wants to own and operate a franchise.

Thus, for example, if you wanted to own and operate your own KFC restaurant, KFC would be the franchisor, you, the independent owner and operator, would be the franchisee, and your KFC location would be the franchise.

As you can probably imagine, franchises are often attractive options for people who want to own their own businesses, but not necessarily start from the ground up. By purchasing a franchise, a potential franchisee is buying into a proven business model with instant brand recognition and a system for operating on a day-to-day basis. Of course, the larger the franchisor (e.g., McDonald’s, Burger King, KFC, etc.), the more true that statement is. But even small, regional franchises provide a systematic set of instructions on how to operate.

That, in fact, is the point. Large or small, all successful franchises share certain things in common, the most important of which is the opportunity to sell goods or services with regional, national, or even international name recognition and a proven business model or system. Because purchasing a franchise represents a major investment for someone looking to own their own business—meaning that there is often a lot of money at stake—there is a lot of room for fraud and abuse. That’s where the law comes in.

The purpose of this article is to provide some basic information to a potential franchisee regarding the myriad important issues that come with making such an important decision. Those issues includes things like:

what a Franchise Disclosure Document (“FDD”) is and how to read one;
how much control a franchisor typically asserts over various aspects of the business;
the franchise agreement, including some of the things that can and can’t be included;
disclosures that the FIL require a franchisor to make in its FDD;
whether the business you’re looking into is operating an illegal franchise (e.g., its operating as a “licensor” instead of as a “franchisor”); and
whether a franchisor is in compliance with California’s Franchise Investment Law (“FIL”).

CALIFORNIA’S FRANCHISE INVESTMENT LAW

Franchises are governed by both federal and state law, but in the case of California, the state laws are actually much more stringent than the federal franchise laws. In California, franchises are overseen by the California Department of Financial Protection & Innovation and governed primarily by two separate sets of California statutes: (i) the Franchise Investment Law (Corp. Code, § 31000 et seq.); and (ii) the California Franchise Relations Act (Bus. & Prof., Code § 20000 et seq.).

Under California law, a business meets the definition of a franchise (and therefore the franchisor must comply with the state’s franchise laws) if it:

grants someone a right to engage in the business of offering, selling, or distributing goods or services;
under a marketing plan or system prescribed by the franchisor;
where the operation of the business is substantially associated with an advertising/ commercial symbol or mark (e.g., a trademark, service mark, or trade name) of the franchisor; and
the franchisee (i.e., the person buying a franchised business) is required to pay a fee for the right to enter into (or conduct) the business.

THE FDD

The Franchise Disclosure Document is the cornerstone document that lays out, in plain English (or, where applicable, other languages), sufficient information about the franchisor to enable a potential franchisee to make an informed decision about whether to invest in the franchise. The FDD also happens to be required by both federal and state franchise laws. The FDD—a document that is almost always well over 100 pages—is divided up into 23 separate “items,” including:

the business experience of the franchisor’s executive team (Item 2);
pending litigation or claims (Item 3);
initial fees that are paid at the outset—i.e., the “buy in” fees, as well as all “other” ongoing operational fees (Items 5 and 6, respectively);
the total amount of a franchisee’s (estimated) initial investment (including those initial fees referenced above) (Item 7);
the territory that the franchisee has exclusive rights to (Item 12);
renewal, termination, and transfer rights (Item 17); and
contracts—e.g., the franchise agreement, product supplier agreement, or a software license agreement (Item 22).

Franchise Fees at a Glance

Since the fees that a franchisee is expected to pay the franchisor plays such an important role in a franchisee’s decision as to whether to buy a franchise or not, it’s not surprising that those fees are the subject of not just one, but two entire Items of the FDD (or three if you count Item 7, which isn’t discussed here.

Initial Fees (Item 5)—The fees that a franchisee pays up front just to get started with the franchise are covered by Section 5 of the FDD. Those fees often include a: (i) franchise fee, which is the amount a franchisee must pay to buy into the franchise (this fee is almost always 5 or 6 figures); (ii) site selection fee, which is the fee charged for the franchisor to help the new franchisee choose the best location within the franchisee’s territory; and (iii) technology fee (to get set up with a franchisor’s proprietary software).

Other Fees (Item 6)—The fees that a franchisee can expect to pay on an ongoing basis are covered in Section 6 of the FDD, and often include: (i) royalties (sometimes a flat rate per month, and sometimes a percentage of gross or net sales); (ii) advertising & marketing contributions (to cover, for example, the TV commercials that a franchisor might run; (iii) technology fees (to keep current with a franchisor’s proprietary software); (iv) audit fees (to cover franchisor costs to review the franchisee’s books); (v) transfer / successor franchisee fees (to cover what happens if a franchisee wants out of the business); (vi) training fees; and (vii) reimbursements for supplies or similar items.

The FDD is so important, in fact, that the law requires the franchisor to provide the complete FDD to the potential franchisee at least 14 days before they sign any agreement or any money is exchanged.

FRANCHISOR CONTROL

No matter where you are, when you walk into a McDonald’s, it will look like almost every other McDonalds that you’ve ever visited. Setting aside certain regional variations, you can expect to be able to order a Big Mac, a Quarter Pounder with Cheese (or, as fans of Pulp Fiction know, the Royale Cheese), and Chicken McNuggets. You can also expect to see not only the same burgers, buns, and shakes, but also the same colors, décor, posters, cups, bags, and food containers.

A certain amount of control is necessary (and perfectly legal). After all, the very thing that makes a franchise attractive to most franchisees—a proven business model with instant brand recognition and a system for operating on a day-to-day basis—requires a certain level of control over methods of operation, branding, and quality. If that sort of control wasn’t permitted, and each franchisor could operate his or her McDonald’s the way they wanted to, there would be little similarly, if any, amongst the various McDonald’s located throughout the world. In short, it is that franchisor control that gives most franchises their value.

THE FRANCHISE AGREEMENT

Every franchisor that has registered a franchise with the Department of Financial Protection & Innovation (or its predecessors) includes as one of the contracts in Item 22 of the FDD a franchise agreement. The franchise agreement is the operative contract between the franchisor and franchisee concerning all aspects of how the franchisee is expected to operate the business, as well as how much it will pay the franchisor on an ongoing basis.

It is in the franchise agreement where you’ll find provisions regarding:

a franchisee’s designated territory;
requirements regarding day-to-day operations;
sourcing/use of required supplies and vendors;
ongoing payments, such as royalties or advertising contributions (this is in addition to such information’s inclusion in Item 6 of the FDD);
use of the franchisor’s trademarks, patents, and other intellectual property;
the term of the franchise (i.e., how long the franchisee is obligated to the franchisor);
renewal, sale, and termination rights; and
use of certain software or technology.

There are, of course, certain things that are not permitted in a franchise agreement under California law. The most obvious example of such a provision is non-competition clauses. Non-competition clauses—provisions that prohibit someone from engaging in a competing business once a franchise has expired—are legal in several states, but not in California (except under very limited circumstances specified in the Business & Professions Code).

REQUIRED DISCLOSURES

You don’t need to look any further than the FDD itself to understand the disclosures that franchisors are required to provide to prospective franchisees under California’s FIL. In fact, each of the 23 Items referenced above represents a different set of mandatory disclosures. At the risk of repeating some of the information already provided above, the FDD requires disclosures regarding all of the following “Items”:

Item 1—The Franchisor: the franchisor, its corporate structure, former names, affiliates, etc.;
Item 2—Business Experience: the franchisor’s management/executive team (i.e., the principals of the franchisor), including their histories, business experience, etc.
Item 3—Litigation: litigation that the franchisor is currently involved in, as well as any pending or potential claims that the franchisor is aware of;
Item 4—Bankruptcy: bankruptcies that the franchisor, its affiliates, or any of its executive team have filed;
Item 5—Initial Fees: initial fees required to get started, including any franchise, license, or technology fees, etc.
Item 6—Other Fees: ongoing fees that will be expected once you become a franchisee, such as royalties, advertising contributions, training, technology, etc.
Item 7—Estimate Initial Investment: the total initial investment that a franchisee needs to be make to actually get started (beyond the fees referenced in Item 5), including things like: (i) build-out costs; (ii) site selection; (iii) signage; (iv) opening inventory and supplies; (v) training; (vi) utility deposits; (vii) business license fees; (viii) retail or office rental space; and (ix) insurance;
Item 8—Restrictions on Sources of Products and Services: the various restrictions regarding the products, services, and supplies being offered by the franchise (e.g., McDonald’s serves food); this is also the section that will include information about: (i) required servicers or suppliers; (ii) lease requirements, computer and technology requirements; (iii) required advertising and marketing limitations; and (iv) insurance;
Item 9—Franchisee’s Obligations: the franchisee’s various obligations as spelled out in specific sections of the franchise agreement (which itself is reflected in Item 22);
Item 10—Financing: whether the franchisor has a financing program in place for franchisees so that they can finance the fees referenced in Items 5, 6, and 7;
Item 11—Franchisor’s Assistance, Advertising, Computer Systems, and Training: the franchisor’s obligations, both before and after the business opens, including things like: (i) site selection; (ii) training, whether in-person or otherwise, including written materials like manuals and video seminars; (iii) technology; and (iv) advertising;
Item 12—Territory: the franchisee’s territory (including whether it’s exclusive or not);
Item 13—Trademarks: the status of the franchisor’s trademarks (i.e., whether they’re actually registered or not), as well as limitations on both the franchisor’s and the franchisee’s rights regarding the trademarks; this section will also reference any litigation that might be pending that relate to trademarks (in addition to such litigation also being referenced in Item 3);
Item 14—Patents, Copyrights, and Proprietary Information: similar to Item 13, except it addresses intellectual property other than trademarks;
Item 15—Obligation to Participate in the Actual Operation of the Franchise Business: whether the franchisee is personally required to manage/oversee the day-to-day aspects of the business, and if applicable, any limitations on who the franchisee can employ;
Item 16—Restrictions on What the Franchisee May Sell: what the franchisee is permitted to sell (e.g., if a McDonalds franchise, franchisees can’t make up or revise the menus to offer additional food items);
Item 17—Renewal, Termination, Transfer, and Dispute Resolution: like Item 9, addresses in chart form sections of the franchise agreement that discuss renewal, termination, transfer rights, and dispute resolution;
Item 18—Public Figures: whether the franchisor pays any public figures to promote the franchisor’s goods or services, and whether such public figures are investors or part of the franchisor’s management team;
Item 19—Financial Performance Representations: the financial performance of both he franchisor itself, as well as expected and prior performance of the franchised outlets as a whole; franchisors cannot make any representations about financial performance unless they’re included in this Item;
Item 20—Outlets and Franchisee Information: contains five required tables addressing the total number of operating franchises, along with the number that have closed, been transferred, or were terminated;
Item 21—Financial Statements: includes the franchisor’s audited financial statements;
Item 22—Contracts: contains copies of all operative agreements, including most importantly, the franchise agreement; other types of contracts might include: (i) credit card authorizations; (ii) ACH agreements; (iii) user agreements; (iv) operating or shareholder agreements; or (v) assignment of leases, etc.; and
Item 23—Receipts: contains a signed document indicating the date the prospective franchisee received the FDD.

UNREGISTERED FRANCHISES

Because franchises are tightly regulated in California, much more so than most other states (most of which mirror federal franchise law), many trademark owners mischaracterize their relationships with their licensees to avoid having to register as a franchise and be subject to the safeguards built into the FIL. Determining, therefore, whether a business that you might be considering as an investment option is subject to the FIL is a big deal, primarily because the FIL is intended to protect the would-be-investor/franchisee.

Whether or not a business will be considered a franchise (and thus must register with the Department of Financial Protection & Innovation) hinges entirely on whether the business arrangement fits the applicable statutory definition. You’ll recall that under the FIL, a business is considered a franchise if it meets the requisite four elements (e.g., a right to engage in a business, under a marketing plan or system, etc.). In fact, regardless of how the owners of a business refer to themselves, if all four of those elements are met, the law requires that business to register as a franchise with the Department of Financial Protection & Innovation.

Establishing the existence of the first, third, and fourth elements is typically very easy. For example, if a mark’s owner is giving you the right to use their mark (e.g., a logo) to operate your own business, then it won’t typically be hard to establish the first and third elements. And the fourth element is also an easy one. If you were charged for using the mark, whether as an initial buy-in, or on an ongoing basis, then that element will be deemed established.

Which leaves the second element. Of those four elements, the one that a lot of franchise deniers (i.e., businesses who insist that they aren’t franchises) use to support their arguments that they’re not subject to the FIL is the second one—engaging in a business under a marketing plan or system required by the owner of the mark. Fortunately, there is a lot of material out there regarding that second element that both the Department of Financial Protection & Innovation and the courts in California look to. For example, in 1994, the Department of Corporations (the predecessor dept. to the current Department of Financial Protection & Innovation) published the “Commissioner Release 3-F” (the “Release”), which was intended to help test whether a business was operating as a franchise or not (i.e., whether the business fell under the FIL).

The Release, for example, provided a number of examples provisions that previously resulted in a finding that a business met the second element (i.e., that a franchise existed). Among those examples were businesses where the franchisor:

controlled pricing of the goods or services;
placed restrictions on the use of certain types of advertising;
provided detailed instructions regarding methods of operation;
provided for uniformity in appearance;
assigned exclusive territories;
limited the right to sell competing products;
required approval for signage or advertising; and/or
provided training (regardless of whether such training was live or on audio/video).

While none of those, or other, factors were necessarily considered determinative, those were types of provisions that tended to lean toward meeting the second element. The Release went on to explain that the perception of the public was an important consideration such that a franchise would exist in business arrangements that were “. . .presented to the public as a unit or marketing concept. . .[that] operated with the appearance of some centralized management and uniform standards regarding the quality and price of the goods sole, services rendered….” Indeed, franchises have been found to exist even where the marketing plan or system at issue was recommended (as opposed to being required) by the mark’s owner. (See Release, I(B)(2)(e).)

In short, it’s very difficult for a business that allows others to use its marks, symbols, or trade names in exchange for money to operate in California and NOT be considered a franchise, and thus be subject to the FIL.

COMPLIANCE WITH THE FIL

Given how ripe for fraud and abuse buying a business that someone else can exert control over can be, it is important for a would-be franchisee, like you, to ensure that the franchisor is in compliance with the laws aimed at protecting investors.

Ensuring that a franchisor that you might be interested in exploring a business opportunity with can be as simple as checking to see if the franchisor’s business is registered with the Department of Financial Protection & Innovation. One way to do that is to check the Department of Financial Protection & Innovation’s website (https://docqnet.dfpi.ca.gov/search/), but that can be tricky because the website isn’t always up to date.

Another obvious way is to ask the owner for a copy of their latest FDD. If they don’t have one, they’re not registered.