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Fractional Franchise Exemption – Hidden Opportunity or Hidden Risks?

Many entrepreneurs and business owners embrace the idea of franchising their business and leap into the franchise model with great hopes and expectations. Yet the regulatory burdens and costs that accompany franchising sometimes come as a surprise and lead to a franchise plan cool-off. Sometimes holding off until the business is more established and has better access to capital is the right thing to do, but under the right circumstances the business may still achieve its goal of franchising while avoiding franchise disclosure and registration requirements.

Aspiring franchisors should ask themselves two questions: (1) Is my franchise program suitable as an add-on to an existing business?; and (2) Am I willing to limit myself to only franchisee candidates with experience in my business line? If the answer to both questions is “Yes,” the fractional franchise exemption may come to the rescue!

Of the different exemptions and exclusions available under federal and state disclosure laws and rules, the fractional franchise exemption rarely gets much attention. This is a little surprising, considering it can be a great for the right type of franchise program to avoid both preparation and registration of a franchise disclosure document (FDD). Starbucks is among the most well-known businesses taking advantage of the fractional franchise exemption and operates large parts of its U.S. program on that basis. But fractional franchise programs exist in a wide variety of industries in the U.S. today, including services, transportation services, and retail.

The federal fractional franchise exemption works like this: If the prospective franchisee, its current directors or officers, or any current directors or officers of a parent or affiliate (1) has more than two years of experience in the same type of business as the franchised business; and (2) the franchisor and franchisee have a reasonable basis to anticipate that the sales arising from the parties’ relationship will not exceed 20 percent of the franchisee’s total dollar volume in the first year of operation of the fractional franchise; then (3) the relationship qualifies as a fractional franchise and is exempt from the FTC’s Franchise Rule disclosure requirements.

Because of the franchisee’s previous experience with the type of business covered by the fractional franchise program, and the fact that the franchisee will derive only a relatively small percentage of its income from the franchised business (at least to start with), the FTC and many state regulatory agencies have deemed that the franchisee doesn’t need to receive an FDD and that regulatory supervision in the sales process is also not necessary. This means that a business whose franchise model falls within the definition of the fractional franchise exemption may not need to prepare an FDD or the accompanying audited financials. Therefore, a fractional franchise exemption may allow a franchisor to start franchising faster and at a lesser cost than with a traditional franchise model.

The fractional franchise exemption may be of great benefit to some franchise systems, but it is not without its risks and limitations. The fractional franchise exemption definition above is the federal definition. Not all states with disclosure laws exempt fractional franchises. For example, Hawaii and Washington do not. Other states, such as California, New York, and Virginia, have definitions that differ from the federal exemption. California and New York require registration. These are simple registrations, but still, a requirement.

And even within the federal definition there is a lot of room for debate and discussion. What does the “same type of business” mean? What degree of certainty about the franchisee’s sales volume is necessary? For example, if the franchisee sells is selling the “same business?” Is co-branding a franchisee’s agency with the franchisor’s brand within the scope of the exemption? There are no easy answers to the questions raised, but it should be noted that the FTC has taken a rather narrow approach to the “same type of business” criterion.

At the end of the day, for the franchisor who chooses to operate based on the fractional franchise exemption, there may be significant savings for legal and auditor costs, but the franchisor must also be willing to walk away from a deal if there is concern that the candidate doesn’t fit within the definition.

There is some good regulatory news for the fractional franchise franchisor and hope for greater uniformity and clarity. This past summer the North American Securities Administrators Association published for comment a set of model franchise exemptions, which would include a fractional franchise exemption generally in line with the federal exemption, though requiring registration. Rhode Island, a state that currently does not have a fractional franchise exemption (though discretionary exemptions are usually available upon request), is also considering an exemption. Neither of these regulatory efforts will likely be the ultimate solution for the woes of the fractional franchisor, but it should make the exemption even more attractive to franchisors and franchisees that fit the fractional franchise model.

Beata Krakus is an associate in the Franchising & Distribution and Corporate Practice groups at Greensfelder, Hemker & Gale, PC, in Chicago. Founded in 1895, Greensfelder is a full-service law firm with offices also in St. Louis and Belleville, Ill. She can be reached at bk@greensfelder.com or 312-345-5004.

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