Successful businesses often fund expansions by appointing dealers or licensees to operate their business or sell their goods or services in new territories. However, a common mistake that these businesses make is they think they are operating under a licence arrangement or dealership arrangement, only to discover that they are an ‘accidental franchise’.
An accidental franchise is where a distribution, licence or dealership arrangement is deemed by law to be a franchise arrangement and inadvertently the licensor has become a franchisor who is now subject to additional regulations, disclosure and compliance obligations.
The purpose of this blog is to explain:
- the differences between a licence and a franchise arrangement;
- the advantages and disadvantages of each business model; and
- how to determine whether your business is operating as a franchise.
What is a licence arrangement?
A licence arrangement is where a licensor grants a licensee the right to access and use certain property belonging to the licensor in accordance with the terms and conditions of the licence agreement. Under a licence arrangement the underlying ownership in the property is not sold or transferred by the licensor to the licensee.
Licence arrangements are often used to grant a licensee the right to use the licensor’s intellectual property assets in the licensee’s business, such as a licensor’s trade marks, copyrighted materials, patents, designs and trade secrets. There are numerous examples of products and merchandise manufactured and sold by distributors and retailers under a licence arrangement. For instance, the Australian Football League (“AFL”) appoints licensees, distributors and retailers to produce, distribute and sell merchandise, apparel and accessories featuring the trade marks of the AFL and its clubs.
Licence arrangements are attractive to both licensees and licensors because they are less expensive to set up than franchise arrangements. Generally, there are fewer ongoing fees and the relationship between licensees and licensors is largely governed by contract law. Under a licence arrangement, the licensee, distributor or dealer exercises control over their own marketing strategies and operating systems and procedures.
What is a franchise arrangement?
A franchise arrangement is an agreement which documents the legal relationship between a franchisor and franchisee. The franchisee’s obligations under a franchise agreement are usually more onerous than under a licence arrangement as the franchisor exercises substantially more control over the franchisee’s business operations, management and marketing activities. The franchisor usually provides the franchisee with an operations manual which sets out in detail the specifications, standards and procedures with which franchisees must comply in order to operate their franchised business.
In Australia, franchising is governed by the Franchising Code of Conduct (“the Code”) which is a mandatory industry code under the Competition and Consumer Act 2010 (Cth). The Code regulates Australian franchisees and franchisors.
The Code requires a franchisor to provide a potential franchisee with a disclosure document before entering into the franchise agreement which details the financial and business history of the franchise and current franchisees. The Code also requires that a franchisor provide a franchisee with certain rights in the franchise agreement, including a 14 day cooling off period, procedures for terminating the franchise and a dispute resolution mechanism.
Although a franchisee has less independence in the operation of their business and franchising involves high setup costs for both franchisor and franchisee, a franchise model offers a number of key benefits for franchisees, such as:
- ongoing training and support;
- bulk buying power;
- rights to trade under an established brand name;
- proven and standardised business practices; and
- access to a national advertising and marketing network.
Examples of notable franchises in Australia include McDonald’s, Fernwood Fitness, Jim’s Cleaning Group and KFC.
How to determine if you are in a licence or a franchise arrangement?
The Code sets out a number of criteria for determining if a business arrangement falls within the definition of a franchise agreement. If the arrangement falls within the Code’s definition of a franchise agreement, then the business is deemed to be a franchise regardless of whether the parties call the arrangement a dealership, distribution or licence agreement. The four key criteria for a franchise agreement are as follows:
- there is an agreement between the parties;
- a right has been granted by a franchisor to a person or company to operate a business supplying or distributing goods or services in Australia under a system or marketing plan that is substantially determined, controlled or suggested by the franchisor or its associate;
- the operation of the business consists of or is associated with a trade mark owned, used, licensed or specified by the franchisor; and
- the franchisee will pay the franchisor or its associate a fee under the agreement (e.g. royalty payment, upfront licence fee, marketing fee etc).
In order to fall within the definition of a ‘franchise agreement’, all of the above criteria must apply. Licence agreements are often considered a cheaper alternative to franchise agreements. However, if a business is deemed to be a franchise, and the business has not complied with the Code, then the franchisor can be liable to pay penalties of up to $63,000 for each breach of the Code.
Choosing the right model for your business
Whether a licence or franchise arrangement is the best model for your business will depend on a number of factors, including your objectives, budget, risk appetite and the level of control you wish to exert over your business operations.
For potential franchisees, purchasing a franchise business is a less risky way to start a small business because the franchise has a ‘right out of the box’ business operating model, an established and recognised brand, ongoing training and business support, bulking buying power and a marketing network. However, franchises involve much higher set-up and ongoing costs, and franchisees have less control over the operations, product selection and marketing of the business.
For potential franchisors, there are advantages and disadvantages in franchising a business. The main benefits of franchising are:
- majority of the franchise setup costs and ongoing marketing costs are paid for by the franchisees: this avoids funding the business expansion through debt or equity financing;
- the franchisee owns the franchised business and therefore is more incentivised to ensure the success and profitability of the business compared to a salaried employee;
- the franchisee is responsible for the day to day operation of the franchised business, freeing the franchisor to focus on business strategy and product development; and
- franchised businesses typically grow quicker than independent businesses.
However, the main disadvantages of franchising a business include loss of day-to-day control of the business, the need to allocate significant resources to support and train franchisees, the legal, financial and reputational risks associated with poor performing or rogue franchisees, and additional regulations, disclosure and compliance obligations.
For a business looking to expand, franchising or licensing arrangements are often very attractive operating models. Each type of arrangement has its own advantages and disadvantages; however, the choice of whether to enter into a licence or franchise arrangement will depend on the requirements and objectives of each business.
As selecting the right operating model can have profound financial, reputational and legal consequences for your business, it is important that you understand the key differences between the two structures. However, the difference between the two operating models can sometimes be difficult to determine.
It is important to properly plan any business expansion by seeking specialist legal advice. If your business wishes to avoid being labelled an ‘accidental franchise’, it is important that you structure your business arrangement to fall outside the ambit of the Code.
If you require legal advice in relation to the best operating structure for your business, contact a business lawyer at Vault Legal today on 1300 002 212 or email us at firstname.lastname@example.org.
Key words: franchisor, franchisee, franchise agreement, licence, licensor, licensee, licence agreement, trade mark and intellectual property.