Top 7 Legal Risks for New Franchisors to Avoid

 

Expanding your business through franchising can be an effective growth strategy. However, there are several legal risks that new franchisors need to consider before offering franchises. Failing to properly prepare can open your business up to lawsuits, fines, and damage to your brand’s reputation. 

 

In this comprehensive guide, we will cover the top 7 legal risks for new franchisors and provide actionable insights from franchise lawyers to help reduce your liability exposure. With proper planning and guidance from an attorney skilled in franchise agreements, new franchisors can safely expand while protecting their business interests.

 

Holon Law Partners has 100+ years of combined experience guiding clients through complex cases and legal intricacies. Our approach is empathetic, customized, and client-centered with a focus on you and your unique business needs. To schedule a consultation with us, call our team at  (866) 372-0726 or email us at: info@holonlaw.com. 

Risk 1. Violating FTC Franchise Disclosure Rules

One of the most serious mistakes a new franchisor can make is failing to follow the Federal Trade Commission (FTC) Franchise Rule. Under federal law and most state laws, franchisors must provide all prospective franchisees with a Franchise Disclosure Document (FDD) before finalizing the franchise agreement or accepting any payments.

 

A franchise lawyer can ensure your FDD complies with all applicable disclosure laws. This detailed document contains 23 specific categories of vital information about the franchisor, the franchise system, fees, estimated expenses, litigation history, intellectual property, and more. Failing to properly disclose all required information leaves franchisors vulnerable to lawsuits and regulatory penalties.

 

The FTC requires that FDDs are updated with all material changes within 120 days. Ongoing non-compliance with disclosure rules can result in fines of up to $49,569 per violation.

 

Risk 2. Inadequate Franchise Agreements  

The franchise agreement is the legally binding contract between franchisor and franchisee. While disclosure documents provide information to franchisees, the agreement itself outlines the terms, rights, responsibilities, and limitations for both parties under the franchise relationship.

 

Without properly crafted franchise agreements, new franchisors leave themselves open to legal disputes over territory encroachment, brand standards, fees, transfers/renewals, early terminations, non-competes, and more. Key legal provisions are needed to protect the franchisor’s trademarks, trade secrets, and proprietary systems.

 

Franchise attorneys can customize agreement terms to match your business model and growth objectives while limiting legal exposure. Provisions should not only protect initial franchisees but also address changes of ownership throughout the term. 

 

Standard agreements fail to address the nuances of each franchise system. Off-the-shelf and do-it-yourself templates cannot substitute for tailored contracts prepared by competent franchise attorneys with intimate knowledge of regulatory environments and case law precedents in your state.  

 

Risk 3. Deficient Financial Performance Representations

Unlike independent small businesses, franchisees invest in your brand because they expect their location to generate profits consistent with your own corporate-owned locations or existing franchises. Documented financial performance representations (FPRs) provide validation of the franchise opportunity to attract qualified investors.

 

However, franchisors often run into legal trouble by making informal claims of potential earnings that go beyond the data provided in their FDD. This includes speculative projections, unclearly defined “statements of possibility,” exaggerated success stories, hypothetical scenarios of best/worst case performance and more. 

 

The FTC Franchise Rule only requires FPRs if you voluntarily make an earnings claim. But once provided, great care must be taken to ensure representations are truthful, substantiated, stated in the proper format, and provide all contextual details.

 

This includes basing claims on a reasonable sample of existing franchised and corporate-owned outlets. Statistics should be clearly formatted and cover operating costs to prevent prospects from basing decisions solely on potential gross sales. Without proper legal guidance, even well-intentioned FPRs can draw regulatory scrutiny and lawsuits from underperforming franchisees.

 

Risk 4. Insufficient Quality Control Standards

The reputation and brand integrity of franchise systems depend heavily on consistency across the franchise network. Customers patronize franchises because they expect the same quality experience whether visiting franchised or company-owned locations. 

 

Franchisors protect their trademarks with quality control provisions integrated into the franchise agreement. However, simply including standards in a contract does little good if they are not actively enforced. Documented policies and procedures should cover factors like:

 

• Facility design, décor and trade dress

• Products and services offerings

• Pricing guidelines  

• Sanitation and safety measures

• Staff training requirements

• Record keeping and reporting procedures

• Periodic inspections 

 

Franchise lawyers can help craft detailed quality control standards while advising on pragmatic enforcement given available resources. Proactive measures are key to preventing brand dilution. Should legal disputes arise down the road, documented system standards and evidence of compliance efforts demonstrate good faith by the franchisor.

Risk 5. Inadequate Training and Support

Insufficient training and operational support expose franchisors to legal claims of breach of contract. Franchisees invest in branded business opportunities with the expectation of full guidance on successfully operating outlets. When lacked adequate pre-opening preparation or struggling franchises don’t receive responsive field support, franchisees can take legal action against the franchisor.

 

Common allegations made against those neglecting training and support duties include:

 

• Failure to provide adequate initial training

• Ongoing lack of field support

• Delays responding to requests for assistance

• Refusal to allow owners and staff to attend training programs

• Not updating training/operations manuals with changes to the business model

• Charging excessive fees for additional or remedial training

 

While classroom instruction lays the groundwork, every franchise system should have field support representatives to provide onsite training, coaching, and troubleshooting to franchisees when issues arise.

 

Documented system standards combined with evidence of good faith efforts to assist franchisees can help franchisors demonstrate compliance should legal actions arise. Franchise agreements should also include clauses limiting liability for franchisees unwilling to implement recommended changes.

 

Risk 6. Improper Advertising Claims

Like financial performance claims, advertising can attract prospect franchisees but also creates legal risk if not properly vetted. Franchisors often tout the strength of their brand, the satisfaction of existing franchisees, and opportunities in “hot” emerging markets in their marketing materials which draw in outside investors.

 

However, ad claims should not overpromise or imply guaranteed success. Just like performance representations, the FTC Franchise Rule requires advertisers to have a reasonable basis for making any statements about their franchise. This includes both factual and forward-looking claims.

 

Common promotional claims that often draw regulatory and civil allegations when exaggerated or unsubstantiated include:

 

• Brand power, consumer demand and growth potential  

• Profitability of existing franchisees

• Commitment to franchisee success and satisfaction

• Available territories and market opportunities

• Competitive advantages over rival franchises

 

While ambitious marketing attracts prospects, it also invites greater scrutiny. Franchise ads should focus on factual information that reinforces the franchisor’s credibility. Investing in professional guidance for ad compliance now prevents much larger expenses later countering allegations of fraud.

 

Risk 7. Insufficient Ongoing Compliance Procedures

Given the franchise relationship lasts 10, 15 or 20+ years, occasional compliance check-ups are insufficient. Franchisors need structured processes to repeatedly confirm that legal obligations are continuously met over time. Operational realities and business needs evolve, so periodic renewal of compliance initiatives is a must.

 

Here are some examples of recurring compliance vulnerability areas:

 

• Updated Financial Disclosure Documents: Not only within 120 days of material changes, FDDs should be revisited at least annually to confirm still accurate and address any emerging compliance gaps.

• Advertising and Performance Claims Scrub: Ads and marketing materials like website content and sales presentations/pitches should be reviewed semi-annually to remove outdated or non-compliant claims.  

• Franchise Agreement Revisions: While custom contracts offer more protection initially, agreements need reassessed every 2-3 years against legal precedents to confirm terms still mitigate evolving risks like technology changes and employment law.

• Ongoing Training & Support Investment: As networks expand, increased personnel, technologies, site selection data and support infrastructure must match growth to maintain brand standards and satisfy contractual duties owed franchisees.

 

Setting reminders to revisit compliance across all operational areas prompts franchisors to reassess standards in light of recent events. Proactively investing resources demonstrates good faith efforts to uphold legal duties to franchisees.

Assessing Early-Stage Franchise Compliance Risks

Launching a franchise requires coordinated legal, operational and financial preparation across an organization. Business owners exploring expansion via franchising should start by discussing foundational franchise law compliance with counsel before committing to vendor contracts or recruiting franchisees. 

Structuring Franchise Agreements to Incentivize Performance

Franchise agreements form the legal backbone governing the daily franchise relationship over their 10-20 year durations. Properly structured terms not only protect brands but motivate franchisees meeting performance quotas via incentives like exclusivity rights, fee discounts for renewals, and first rights to open additional locations.

Key Provisions to Customize in Franchise Agreements  

While boilerplate franchise agreements provide a strong starting point, several provisions require customization to the brand’s growth objectives, compliance risk factors, and enforcement capabilities. Tailoring contract terms now prevents disputes and brand damage down the road.  

Weighing Corporate Managed vs Franchised Ownership Models

Franchising shifts daily oversight duties to third-party owners instead of salaried teams managed internally. Balancing corporate vs franchised units involves factors like capital needed for growth, brand control preferences and real estate development models. Lawyers advise on structuring expansion initiatives suitable for each brand’s objectives.

Projecting Supply Costs Across Multi-Year Franchise Agreements 

Long-term franchise agreements complicate budgeting asgredient and materials supply costs fluctuate over time. Underperformance risks increase if original sales or expense estimates fall short. Analysis should factor multiple economic scenarios using both fixed and variable pricing structures.

Key Due Diligence Questions Prospective Franchisees Should Ask

 

Beyond verifying required FDD disclosures, prospective franchisees buying into emerging systems should independently investigate items franchisors often initially downplay like: anticipated openings diminishing territory exclusivity, approval processes for transfers/renewals, conditions enabling early contract termination, and limitations on challenges to monthly program fees.

Frequently Asked Questions

1. When Should New Franchisors Engage A Franchise Lawyer? 

Engaging qualified franchise attorneys early allows sufficient lead time to develop compliant franchise disclosure documents, system standards, training programs, marketing materials and legally sound contracts before recruiting franchisees. Delayed counsel often forces delays while fixing non-compliant programs or disputing allegations by state regulators or investors. 

2. What Recurring Legal Services Will Franchisors Need Long-Term?

Initial setup addresses immediate risks but franchisors need ongoing support revising agreements, updating disclosures, monitoring emerging case law precedents, and renewing overall system compliance as networks expand over time. Expect needs for counsel on disputes, strategic growth decisions and evolving regulatory landscapes across states/countries.

3. How Much Control Do Franchisors Have Over Franchisees Day-To-Day?

Franchisees manage their own operations but franchisors do have wide discretion around requiring brand standards and quality controls be met. However “actual control” over HR and some daily management decisions establishes a joint employer environment opening additional liability risks franchisors aim to avoid.

4. Can Franchisors Face Penalties Even If Franchisees Are The Ones Directly Violating Laws? 

Yes, as the principal brand representative, franchisors face direct regulatory action or participate in resolving franchisee-created disputes. Proactive compliance and franchisee selection reduces shared risks, but overall responsibility ties to the brand’s leadership.

5. What Are The Consequences If A Franchisor Violates Disclosure Laws?

State regulators or franchisees can also seek rescission of the franchise agreement itself or collect significant damages from non-compliant franchisors. Even inadvertent oversights create serious financial and reputational risks if not addressed quickly.

Working with a Franchise Attorney Mitigates Risk

 

Expanding a successful business model through franchising can accelerate growth. However, legal risks need mitigated to prevent profit-damaging disputes or regulatory actions. Franchise lawyers offer tailored guidance for new franchisors seeking to minimize liability exposure.

 

Holon Law Partners has 100+ years of combined experience guiding clients through complex cases and legal intricacies. Our approach is empathetic, customized, and client-centered, focusing on you and your unique business needs. To schedule a consultation with us, call our team at  (866) 372-0726 or email us at: info@holonlaw.com.