Chapter 1: Sole Proprietorship and Franchises

Franchisee

- A purchaser of a franchise. - Economically dependant on the franchisor's integrated business system. - Can operate as an independent businessperson but can still obtain the advantages of a regional or national organization.

Franchisor

Seller of a franchise.

Chain-Style Business Operation

- A franchise operated under a franchisor's trade name and is identified as a member of a select group of dealers that engage in the feanchisor's business. - Generally follows franchisor's standard methods of operations. - May be required to obtain materials and supplies exclusively from franchisor. - ex: McDonald's, Century 21, and H&R Block

Distributorship

- A manufacturer (the franchisor) licenses a dealer (the franchisee) to sell its product. - Often, a distributorship covers an exclusive territory. - ex: auto dealerships, and beer distributorships.

Types of Franchises

- Distributorship - Chain-Style Business Operation - Manufacturing Arrangement

Grounds For Termination Set by Franchise Contract

- Usually the franchise agreement specifies that termination must be "for cause" and defines the grounds for termination. - Cause may include death or disability of the franchise, insolvency of the franchise, breach of agreement, or failure to meet specified sales quotas. NOTICE REQUIREMENTS: - Most franchise contracts require that notice of termination must be given. - A franchise must be given reasonable amount of time to wind up business (accounting, return the copyright or trademark or any other property of the franchisor.) OPPORTUNITY TO CURE BREACH: - A franchise agreement may state that a franchise may attempt to cure an ordinary, curable breach within a certain period of time after notice so as to postpone, or even avoid, the termination of th contract. - Even if the contract contains a notice-and-cure provision, if the franchisee breaches the duty of honest or is guilty of fidelity, that may be enough to allow the franchisor to terminate the franchise.

State Regulation of Franchising

State regulation varies but usually is aimed at protecting franchisees from unfair practices and bad faith terminations by franchisors. STATE DISCLOSURE: - Approx 15 states require franchisors to provide presale disclosures to prospective franchisees. Many states require this disclosure (known as the Franchise Disclosure Document or FDD) be registered or filed with a state official. - State laws may also require that a franchisor submit advertising aimed at prospective franchisees to the state for approval. May Require Good Cause to Terminate Franchise: - State law may prohibit termination without "good cause" or require that certain procedures be followed in terminating franchises. - This is to protect franchises against arbitrary or bad faith terminations.

Sole Proprietorship

- A business owned by one person. - The simplest form of business. - Usually small enterprises with revenue less than $1 million per year. Advantage: - Proprietor owns the entire business and receives all profits because she/he assumes all the risks. - Less costly and easier than starting any other kind of business with few legal formalities required. - No documents need to be filed with the government. - Can be beneficial in a lawsuit because the business is indistinguishable from the owner. - Can sell transfer all or part of the business to another party at any time and does not need approval from partners in partnership or shareholders in a corporation. - Sole proprietorship pays only personal income taxes. - Sole proprietorships are allowed to establish certain retirement accounts that are tax-exempt until the funds are withdrawn. DISADVANTAGES: - Bears the burden of any losses or liabilities incurred by the business enterprise. Has unlimited liability, or legal responsibility for all obligations when doing business. - Owners personal assets may be at risk in order to satisfy any business debts. - Lack of continuity. After the owner's death, the business dies and is automatically dissolved. - Difficult to obtain funds from loans for the business.

Manufacturing Arrangement

- Also known as processing-plant arrangement. - Franchisor transmits to the franchisee the essential ingredients to make a product either at wholesale or retail in accordance with the franchisor's standards. - ex: Pepsi Cola, other soft-drink bottling companies.

Franchises

- An arrangement in which the owner of intellectual property such as a trademark, trade name, or copyright, licences others to use it in the selling of goods or services. - Account for a significant portion of all retail sales in this country.

The Importance of Good Faith and Fair Dealing

- Generally, both statutory law and case law emphasize the importance of good faith and fair dealing in terminating a franchise relationship. - Courts usually try to balance the rights of both parties when determining whether a franchisor had acted in good faith. - If the court perceived that the franchisor has arbitrarily or unfairly terminated a franchise, the franchisee will be provided with a remedy for wrongful termination. - If a decision to terminate a franchise was made in good faith and fair dealing and reasonable notice of termination was given a court will be less likely to consider the termination wrongful. - The importance of good faith and fair dealing in a franchise relationship is underscored by the consequences of the franchisor's acts in the following case.

Regulating Franchises

- Governed by contract law. - Federal government has enacted laws that are designed to protect prospective franchising from dishonest franchisors and to prevent franchisors from terminating franchises without good cause. - Federal government regulates franchising though laws that apply to specific industries through the Franchise Rule, created by the Federal Trade Commision (FTC). - Congress has enacted laws protecting franchises (such as auto dealers and service stations) in certain industries that protect the franchisee from unreasonable demands and bad faith terminations. - Auto manufacturer- franchisors cannot make unreasonable demands of dealer-franchisees or set unrealistic quotas. If franchisor terminates a franchise because of this then the manufacturer may be liable for damages. - Federal Antitrust Laws also apply in certain circumstances to prohibit certain types of anticompetitive agreements.

Wrongful Termination

- Statutory and case law becomes important. - Generally the termination provisions are in favor of the franchisor rather than the franchisee. - The franchisee, who normally invests a substantial amount of time and financial resources, may receive nothing for the termination. - The franchisor owns the trademark and the business. - The federal and state laws discussed earlier attempt to protect franchisees from arbitrary or unfair termination of their franchises by the franchisor.

Franchise Termination

- The duration of the franchise is a matter to be determined between the two parties. - Franchise relationships may begin with a short trial period, such as a year. - Sometimes the duration of the franchises correlates with the lease of the business premises, and both are renewable at the end of the period.

The Franchise Contract

- The franchise relationship is defined by the contract between the franchisor and the franchisee. - The franchise contract specifies the terms and conditions of the franchise and spells out the rights and duties of the franchisor and the franchisee. - Either party is subject to lawsuit for breach of contract if they fail to perform its contractual duties. - Generally, statues and the case law governing franchising tend to emphasize the importance of good faith and fair dealing in the franchise relationships. PAYMENT: - The franchise ordinarily pays an initial fee or lump-sum price for the franchise license. This fee is separate from the various products the franchisee purchases from the franchisor. - The franchisor may also need to pay a percentage of the advertising cost and certain administrative expenses. - Generally, franchisors receive a stated percentage of the annual (or monthly) sales or volume of business done by the franchisee. BUSINESS PREMISES: - The franchise agreement may specify whether the premises for the business must be leased or purchased outright. - Sometimes a building must be constructed to meet the terms of the agreement. - Agreement will specify whether the franchisor or franchisee is responsible for supplying equipment and furnishing premises LOCATION OF THE FRANCHISE: - Typically the franchisor determines the territory to be served. - Some franchise agreements give franchises exclusive "territorial rights," to a certain area. - Many franchise cases involve disputes over territorial rights, and an implied covenant of good faith and fair dealing often comes into play in this area of franchising. - If the franchise contract does not grant the franchise exclusive territorial rights and the franchisor allows a competing franchise to be established nearby, the franchisee may suffer a significant loss in profits and a court may hold that the franchisor breached an implied covenant of good faith and fair dealing. BUSINESS ORGANIZATION: - The franchisor may require that the business use a particular organizational form and capital structure. - The franchise agreement may outline standards such as sales quotas and recordkeeping requirements. - Additionally, a franchise may retain stringent control over the training of the personnel involved in the operations and administrative aspects of the business. QUALITY CONTROL: - The day-to-day operation of the franchise business normally is left up to the franchise. - The franchise agreement may specify that the franchisor will provide some degree of supervision and control in order to protect the franchise's name and reputation. - Certain quality standards are stated in the contract and allow the franchisor is permitted to make periodic inspections to ensure standards are being maintained. - As a means of controlling quality, the franchise agreement often limits the franchisee's ability to sell the franchise to another party. - The franchisor has a legitimate interest in maintaining quality and protecting name and reputation. - However, if a franchisor exercises too much control over the operations of the franchises, it risks potential liability. PRICING ARRANGEMENTS: - Franchises provide the franchisor with an outlet for the firm;s goods and services. - Depending on the nature of the business, the franchisee may purchase certain supplies from the franchisor at an established price. - A franchisor cannot set the price that the franchisee will resell the goods because such price setting may be in violation of state or federal antitrust laws, or both. A franchisor can suggest but cannot mandate them.

The Franchise Rule

The FTC's Franchise Rule requires franchisors to disclose certain material facts that a prospective franchise needs in order to make an informed decision when purchasing a franchise: 1. Written (or electronically recorded) disclosures. The franchisor must make numerous disclosures, such as the range of goods and services included and the value and estimated profitability of the franchise. Disclosures must be able to save all documents. 2. Reasonable basis for any representation. This prevents any deception. 3. Projected earnings figures. Not required, but if the franchisor chooses to provides these figures they must disclose whether the figures are based on actual data or hypothetical examples. 4. Actual data. If a franchisor makes sales or earnings projections , they must disclose the number and percentage of its existing franchises that have achieved the result. 5. Explanation of the terms. Franchisors must layout and explain terminations, cancellation, and renewal provisions of the contract to the potential franchisees before the agreement is signed. Those who are in violation of the Franchise Rule are subject to substantial civil penalties, and the FTC can sue on behalf of the injured parties to seek damages.