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Setting up Your Second Location Can Create an Accidental Franchise

When entrepreneurs become successful at one retail location, their thoughts often turn to opening another location or “licensing” the business concept to someone else to operate additional locations.

What they don’t realize is how easy it is to become enmeshed with state and federal securities laws and incur significant liabilities.

Be very careful when setting up a third-party model — it is easy to create an accidental franchise or violate the North Carolina Business Opportunities Act, and incur significant liabilities.

Franchises are governed by the Franchise Rule, enforced by the Federal Trade Commission. It requires significant disclosures to protect potential franchisees from fraud. You will need to have standard operating procedures that can be repeated in another location by another person. You will have to prepare a franchise disclosure document (FDD) which can cost tens of thousands of dollars.

An accidental franchise is created when the business model includes these three elements:

  1. The business will be substantially associated with your trademark;

  2. The Licensee pays fees to you greater than $500 (whether called royalties or something else); and

  3. You require the affiliated business to operate under a marketing plan or system that you provide, such as providing training on the sale of the trademarked products or services, exercising significant control over the business operations of the licensee, granting exclusive territories, or having sales quotas for the licensee.

North Carolina does not have a franchise law (except cable television services), but licensing schemes must comply with the North Carolina Business Opportunity Sales Act. This Act requires a registration and disclosure and may be applicable depending on the structure of the business model.

A North Carolina “business opportunity” is the sale or lease of any products, equipment, supplies or services for the purpose of enabling the purchaser to start a business. The seller must also represent one of the following four things:

  1. That the seller will provide locations or assist the purchaser in finding locations for the use or operation of vending machines, racks, display cases or other similar devices or currency-operated amusement machines or devices, on premises neither owned nor leased by the purchaser or seller; or

  2. That the seller may, in the ordinary course of business, purchase any or all products made, produced, fabricated, grown, bred or modified by the purchaser using in whole or in part the supplies, services or chattels sold to the purchaser; or

  3. The seller guarantees that the purchaser will derive income from the bus-op which exceeds the price paid for the bus-op; or that the seller will refund all or part of the price paid for the bus-op, or repurchase any of the products, equipment, supplies or chattels supplied by the seller, if the purchaser is unsatisfied with the bus-op and pays to the seller an initial, required consideration which exceeds two hundred dollars ($200); or

  4. That the seller will provide a sales program or marketing program which will enable the purchaser to derive income from the bus-op which exceeds the price paid for the bus-op.

True licensing, distributorship and dealership arrangements are not franchises because they lack at least one of the three elements. A proper licensing agreement might give rights to use a trademark on a product or service for a percentage of sales, with no direction on how sales are obtained. A distributor is generally a separate, non-affiliated business that operates under its own trade name. Often the distributor buys at a wholesale price and sells at a retail price. A distributor may offer competing goods. Neither party is substantially involved in the business affairs of the other.

Creating an accidental franchise can give your licensee cause to terminate the agreement and force you to reimburse their investments. If your business model also violates the NC Business Opportunities Act, you could be subject to an attorney’s fees and triple damages, as well.

At the same time, trademark owners need to ensure their trademarks don’t fall into a period of non-sue and need to be able to control quality of goods or services offered under the trademark.

If you are ready to grow, contact a business attorney to make sure your structure will yield a productive harvest!

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