Franchising offers entrepreneurs the opportunity to own and operate a business backed by an established brand. But as with any business model, the legal and operational framework comes with its own terminology, some of which can feel overwhelming to those new to the industry.
At Einbinder, Dunn, Dimitri & Bayer LLP, we regularly advise franchisors and franchisees across industries. A key part of our role is ensuring clients understand the terminology that shapes their rights, obligations, and opportunities. Below, we highlight several common franchise terms that anyone involved in franchising should know.
What is a Franchise?
At its core, a franchise is a business arrangement where the franchisor grants the franchisee the right to operate a business using the franchisor’s trademark and proven business model. In return, the franchisee pays fees to the franchisor. These typically include an initial franchise fee, ongoing royalties, and marketing fees. The franchisor will exert a degree of control over the franchisee’s operations and provide support to help ensure consistency across the brand.
Franchisor and Franchisee
- Franchisor: The party granting the franchise and overseeing brand standards.
- Franchisee: The individual or entity granted the right to operate a franchised business. Franchisees are responsible for the day-to-day running of the business. While they must follow the franchisor’s operational directives and system, franchisees are not employees of the Franchisor. While a franchisee and franchisor’s business goals may be aligned in that they both want the franchisee to succeed, they also are not business partners.
The Amended FTC Rule and the FDD
In the U.S., franchise sales are governed by the Amended FTC Rule. This regulation requires franchisors to provide prospective franchisees with a Franchise Disclosure Document (FDD).
The FDD is a detailed prospectus that includes 23 mandatory disclosure items, such as:
- Information about the franchisor’s company and affiliates, and litigation involving the franchisor and/or its high-ranking employees.
- Estimated initial investment costs for new franchisees.
- Ongoing fees and expenses for franchisees.
- The franchisor’s obligations to franchisees.
- Information about a franchisee’s territory rights, and obligations to operate or be on-site at the franchised business.
For prospective franchisees, the FDD is an essential tool for evaluating whether a particular franchised business is the right investment.
Financial Performance Representations
If a franchisor makes any representation about the historic or prospective financial performance of stores within its system, it must make those representations in Item 19 of the FDD. This includes any representations regarding potential or actual sales, income, or profits. Not all franchisors provide financial performance representations in their FDD (and, thus, will leave Item 19 blank), but when included, they can help prospective franchisees create business plans in order to do their due diligence on determining if their prospective business is likely to succeed. Franchisees should be extremely cautious in relying on Item 19 in order to create a business plan – while the information in Item 19 is legally required to be accurate, it may be somewhat incomplete or misleading if not read carefully. Typically, the best source of financial data for prospective franchisees is other franchisees in the system.
Different Franchise Models
Not all franchise arrangements are the same. Some common ways that investors structure their relationship with franchisors include:
- Master Franchisor / Master Franchisee (Sub-Franchisor): A master franchisee is granted the right to sell sub-franchises in a territory and receives a portion of the fees and royalties. The master franchisee essentially takes on many of the obligations of the franchisor, including the obligation to annually update the FDD.
- Area Developer: Agrees to open a set number of units within a development territory.If an area developer agrees to open three units in a territory, typically they sign an area development agreement with a schedule to develop, and simultaneously sign a first franchise agreement. The area developer signs a new franchise agreement (the then-current version, which may change each year) for each new location it opens, at the time it begins to develop that location in accordance with the schedule.
- Area Representative: Acts as a broker or recruiter for the franchisor, earning commissions when new franchisees join.
- Single-Unit Operator: A franchisee who signs a single franchise agreement with a franchisor, in order to operate a franchised business – typically with an exclusive territory.
Why These Terms Matter
Whether you’re evaluating a new franchise opportunity, drafting agreements, or managing existing relationships, understanding these terms is critical. Misunderstanding obligations or rights can lead to disputes or missed opportunities.
We draw on decades of experience in franchising to help our clients navigate these complexities. From negotiating franchise agreements to litigating disputes, our team is committed to protecting your business interests.
If you’re exploring franchising or need guidance on your franchise relationship, contact us to learn how our experienced attorneys can help.