Licensing v. Franchising: Why It's Important to Understand the Difference
Co-Author: Katie McLaughlin
Licensing v. Franchising
Licensing and franchising are very similar in some respects. Both mechanisms allow a business to build its brand by granting the right to use their trademarks in different markets. Licensing agreements are not regulated, whereas franchise agreements have significant federal and state regulations. For example, franchises must comply with very strict federal laws requiring certain disclosures, timelines for a cooling off period, and uniform disclosure formats. Complying with all these federal and state laws takes considerable time, expert advice from a franchise attorney, and the process can be expensive. Because of these requirements, its often tempting for a business to license its marks rather than franchise—but the consequences of using a licensing agreement when it really should be offering a franchise are significant. This article discusses the differences between licensing and franchising and the consequences that could occur if a business offers a license agreement when it really is making a franchise offering.
The Difference between Franchising and Licensing
Licensing is an arrangement in which the entity that owns the trademark (the “Licensor”) grants another entity the right to use the trademark under certain conditions ( who is known as the “Licensee.”) With licensing, the grant is concerned about using the trademark correctly. For example, a licensor may grant the right to use a trademark for a logo, but the agreement limits the licensees’s use of trademark so that the logo can’t be altered or put on a product that the licensor does not agree with. The licensor is mainly concerned with protecting the goodwill and reputation of the trademark.
1. Trademark Use
3. Payment of a Fee
In comparison, while a franchise agreement also grants the franchisee the right to use a trademark and puts limits on manipulation and use of that trademark, a franchise agreement will also call for a number of other things such as territory boundaries, royalty payments, types of products or services offered in conjunction with the mark, and trade dress requirements. Trade dress refers to the “look and feel” of a business. A good example of trade dress is the look and feel of a chain restaurant. Most, if not all, Chic-fil-a drive throughs have the same layout with the location of the menus, speakers, windows, and lanes. The interior looks the same between locations as well. This is because the franchisor is able to establish certain trade dress requirements within the franchise agreement and the right to use the trademark.
A franchise has three characteristics. If any of the following characteristics are missing, the relationship is not a franchise.
1. A grant of the right to use another’s trademark to offer, sell, or distribute goods or services
2. Significant assistance to or control over the grantee’s business
3. Payment of a required fee
1. Right to Use Trademark
Most franchises explicitly grant the right to use a trademark. However, just because an agreement does not contain a trademark license, or the agreement explicitly denies a license, does not prove the trademark element is missing. A trademark license may be implied in agreements where branded products or services account for a large portion of the licensee’s sales. Essentially, a trademark owner grants an implied trademark license to a distributor or dealer that is authorized to sell these branded products or services for a significant portion of its overall sales.
It’s important to note also that a federally-registered trademark is not required to satisfy this element. Use of a trade name or trade dress alone may be enough to satisfy the trademark requirement.
2. Significant Assistance or Control
When a licensor provides significant assistance to or control over the licensee, the relationship has evolved into that of a franchisor-franchisee. Examples of significant assistance and control include the following:
Any number of controls can place a business into the franchise category
Requiring the licensee only sell licensor products
Providing formal business training programs
Providing site location assistance
Placing restrictions on site location
Imposing interior and exterior design requirements
Furnishing an Operations Manual
Required display of goods
Hours of Operation
In some situations, only one of these examples, or even the promise of assistance, may be enough to establish the relationship reaches the level of a franchise.
If any of these controls are in place, then it’s likely the business qualifies as a franchise for purposes of the Federal Rule. Licensors, on the other hand, do not utilize any of these controls. They may only protect their trademark by providing quality control standards and location inspections. The licensor cannot choose the new location, provide an operation manual or control all the products the licensee sells. The licensor cannot tell the licensee which services or products to provide (or not provide), provide guidance on how to run the business, or control the look and feel of the establishment. The licensor is allowed, however, to require the licensee improve the quality of goods being sold, but the licensor may not require the licensee order products from one specific supplier.
3. Payment of a fee
Generally, payment is a common characteristic between licensing agreements and franchise agreements. This element does cause much discussion when courts are analyzing the distinction between licensing and franchising agreements. The payment of the fee requirement is met when the franchisee pays to the franchisor, or one of its affiliates, more than $500 within six months of opening for business. The types of payments that are included in this calculation are rent, franchise fees, advertising assistance, training, security deposits, escrow deposits, payments for services, continuing royalties, promotional literature, and nonrefundable bookkeeping charges.
Legal Consequences of Accidental Franchise
These franchise laws can be complicated, and violations carry significant punishment. Violating federal franchise laws could result in a felony, even if the violating party was not aware that any franchise laws were being violated. Because franchise laws are strict liability, it is not a defense if the individual did not know about the franchise laws or they did not believe they were a franchise.
Violating these federal franchise laws is a felony.
If a business offers licensing of its trademarks, whether the trademark is federally registered or not, then it is paramount that the business understands that an accidental franchise could occur, and perhaps even be likely. It is not private individuals that would bring a suit against a business for operating a franchise in violation of the FTC franchise rule, it would be the FTC itself. And, as in the case of Federal Trade Commission v. Prophet 3H, Inc., the FTC successfully assessed multi-million dollar penalties against the health care company for violating the franchise rule.
When it comes to determining whether a business is illegally operating as a franchise in violation of the FTC rule, courts generally make the licensing or franchise determination on a case by case basis. It’s important to note though that even if a licensor denies the existence of a franchise in a written agreement, courts can still determine the license agreement was actually a franchise. This means that even if your licensing agreement states explicitly that the agreement is not a franchise and no franchisor/franchisee relationship exists between the parties, those provisions are legally meaningless if a franchise really does exist. In other words, if it looks like a franchise, then it may be a franchise even if the agreement denies it.
Deciding Between a License and Franchise Agreement for Your Business
It is tempting for business owners who are interested in growing their concept to skip over the necessities of franchising and instead offer a licensing opportunity. Without knowing the risks, it seems that licensing can be a more affordable and easier option. But before making this decision, it is important to audit the intentions of how and why the business will grow. If the company desires to have any of the controls listed above, then there’s no question about it—the business cannot license out its marks as an alternative to franchising. Franchising a business is an extensive undertaking, no doubt, but there are hundreds of companies and individuals who have successfully navigated through the federal franchise laws and gone on to grow their businesses across the country. Before becoming an attorney, I did it, and did it successfully. And if you’re interested in talking through the process, reach out. I’d be happy to help.