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Chapter 36
Small Businesses and Franchises
INTRODUCTION
The most common forms of business organization are the sole proprietorship and, when two or more persons
CHAPTER OUTLINE
I. General Considerations for Small Businesses
Forms of business other than the sole proprietorship limit the liability of the owner for the business’s debts
and other obligations. Limited liability is generally a necessity for those who wish to raise outside capital.
A. REQUIREMENTS FOR ALL BUSINESS FORMS
These typically include—
• Business name registration.
• Occupational licensing.
• State tax registration.
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B. PROTECTING INTELLECTUAL PROPERTY
1. Trademarks
• A factor in choosing a business name is whether the name will be used as a trademark.
2. Trade Secrets
These include information about product development, processes, and techniques, and customer
lists. Secrecy can be protected by requiring employees who have access to this data to agree to—
• Never divulge the secrets.
• Not compete by working for a competitor or setting up a competing business.
C. OBTAINING LOANS
To expand with the use of outside capital, a business can borrow funds. A lender may require a personal
II. Sole Proprietorships
The simplest form of business is a sole proprietorship. Sole proprietorships constitute over two-thirds of
American businesses. They are usually small enterprises—99 percent of those in the United States earn less
than $1 million per year.
A. ADVANTAGES OF THE SOLE PROPRIETORSHIP
Sole proprietorships are the easiest and least expensive business forms to set up.
1. Taxes
Sole proprietors pay only personal income taxes on business profits.
CASE SYNOPSIS—
Case 36.1: A. Gadley Enterprises, Inc. v. Department of Labor and Industry Office of
Unemployment Compensation Tax Services
Julianne Gresh operated Romper Room Day Care as a sole proprietorship, which owed the state
Department of Labor and Industry Office of Unemployment Compensation Tax Services unpaid contributions,
CHAPTER 36: SMALL BUSINESSES AND FRANCHISES 3
including $17,210 for items on an “Inventory List.” The state’s UC law requires a buyer of 51 percent or more
of an employer’s assets to obtain a state-issued certificate from the seller showing that all amounts owed to
the Department have been paid. A failure to obtain the certificate renders the buyer liable for any unpaid
amount. Gadley did not obtain the certificate from Gresh. The Department assessed Gadley with the amount
of Gresh’s unpaid UC debt—$43,370.49. Gadley asked a Pennsylvania state court to review the assessment.
The court upheld the assessment of liability against Gadley. The purpose of the UC law “is to ensure an
employer does not divest itself of assets without satisfying outstanding liabilities. Assets means business
assets, according to examples in the UC law. The items on the “Inventory List” constituted all of the assets
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Notes and Questions
have known of this mandate? Yes. Could Gadley have known? Very likely, yes. Information about the
documents and other steps required for the transfer of a business should have been readily and widely
Did Gadley act unethically by not obtaining from Gresh the certificate required by the state’s UC
law? Gadley does not appear to have been motivated by fraud or deceit—the events in the Gadley case
suggest that Gadley may simply have been unaware of the state’s requirement that the buyer of the bulk of a
to start a sole proprietorship than to start any other kind of business. This type of business organization en–
The major disadvantage is that the proprietor bears the burden of any losses or liabilities incurred by the
What advantages and disadvantages are associated with a sole proprietorship? A major advantage
of the sole proprietorship is that the proprietor receives all of the profits. Also, it is often easier and less costly
2. Flexibility
Sole proprietorships are more flexible to operate than a partnership or a corporation.
B. DISADVANTAGES OF THE SOLE PROPRIETORSHIP
The proprietor bears all of the financial risk of losses and liability, however, and the ability to raise capital
is limited.
1. Personal Assets at Risk
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2. Lack of Continuity and Limited Ability to Raise Capital
A sole proprietorship ends when the owner dies.
III. Franchises
A franchise is any arrangement in which the owner of a trademark, a trade name, or a copyright has licensed
others to use it in selling goods or services. A franchisee is generally legally independent, but economically
dependent on the integrated regional or national business system of the franchisor.
A. TYPES OF FRANCHISES
1. Distributorship
2. Chain-Style Business Operation
A franchise can take the form of a chain-style business operation. Here, the franchise operates
3. Manufacturing Arrangement
In this arrangement, the franchisor transmits to the franchisee the ingredients or formula to make a
product, which is marketed according to the franchisor’s standards.
B. LAWS GOVERNING FRANCHISING
There is not a solid body of appellate decisions from federal or state courts relating to franchises. Courts
tend to apply general common law principles and appropriate statutory definitions and rules.
1. Federal Regulation of Franchises
a. Industry-Specific Standards
• The Automobile Dealers’ Franchise Act of 1965 protects auto dealership franchisees from
bad faith termination. An auto manufacturer–franchisor cannot make unreasonable
b. The Franchise Rule
The Federal Trade Commission’s Franchise Rule requires—
• Material facts. Franchisors must disclose certain material facts for a prospective
franchisee to make an informed decision concerning the purchase of a franchise. All
materials must be downloadable and savable.
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ENHANCING YOUR LECTURE—
FRANCHISE EARNINGS
Entrepreneurs who are thinking about investing in a franchise almost invariably ask, “How much will I
make?” Surprisingly, current law does not require franchisors to provide any information about the earnings
potential of a franchise.
FRANCHISOR DISCLOSURE
FRANCHISEE COMPLAINTS
The failure of the FTC’s Franchise Rule to require disclosure of earnings potential has led to many
complaints from franchisees. After all, some franchisees invest their life savings in franchises that ultimately
fail because of unrealistic earnings expectations. Moreover, the franchisee may be legally obliged to continue
paying the franchisor even when the business is not turning a profit.
For instance, Thomas Anderson asked the franchisor, Rocky Mountain Chocolate Factory, Inc. (RMCF),
and his partner to pay $33,109 in past due royalties and interest to RMCF (plus court costs and expenses).a
CRITICAL THINKING
earnings estimates. Franchisors will therefore provide “low–ball” estimates. These “low-ball” future earnings
estimates will induce fewer individuals to become franchisees.
If the law required franchisors to provide estimates of potential earnings, would there be more or
less growth in the number of franchises? Explain your answer. All franchisors under such a new law
would have to provide some type of estimate of potential earnings. As a consequence, we will probably see a
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2. State Protection of Franchising
State legislation tends to be similar to federal statutes and regulations (to protect prospective
franchisees from dishonest franchisors and prohibit franchisors from bad faith termination).
a. State Disclosures
Many states require—
• Franchise Disclosure Document (FDD). This must be registered with a state official.
• State approval. Advertising aimed at prospective franchisees must be approved.
b. May Require Good Cause to Terminate the Franchise
State law may prohibit termination without “good cause” or require that certain procedures.
ENHANCING YOUR LECTURE—
FRANCHISING IN FOREIGN NATIONS
expand internationally without violating the legal restrictions that many nations impose on foreign ownership
of businesses. Although Canada has been the most popular location for franchises in the past, during the last
In the last twenty years, many U.S. companies (particularly fast-food chains and coffeehouses) have
successfully expanded through franchising in nations around the globe. Franchises offer businesses a way to
CULTURAL AND LEGAL DIFFERENCES ARE IMPORTANT
laws, and business practices can seriously complicate the franchising relationship. If a U.S. franchisor has
quality control standards that do not mesh with local business practices, for example, how can the franchisor
Businesspersons must exercise caution when entering international franchise relationships—perhaps
even more so than when entering other types of international contracts. Differences in language, culture,
THE NEED TO ADEQUATELY ASSESS THE MARKET
Because of the complexities of international franchising, successful franchisors recommend that a
company seeking to franchise overseas conduct thorough research to determine whether its particular type of
business will be well received in that location. It is important to know the political and cultural climate of the
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arbitration clause) for international franchising contracts and advise the parties about the tax implications of
operating a foreign franchise (such as import taxes and customs duties).
FOR CRITICAL ANALYSIS
Should a U.S.-based franchisor be allowed to impose different contract terms and quality control
standards on franchisees in foreign nations that are different than those imposed on domestic
franchisees? Why or why not?
ENHANCING YOUR LECTURE—
INDEPENDENT CONTRACTOR OR FRANCHISEE?
When Janet Isbell, a sales representative for Mary Kay cosmetics, lost her job, she sued Mary Kay, Inc.,
claiming that she was a franchisee and, as such, was entitled to the protections of the state franchising law.
Among other things, this law provided that a franchisor could terminate a franchising relationship only for
cause and required that the franchisee be given ninety days’ notice. Mary Kay responded that Isbell was not
a franchisee but an independent contractor.
The case eventually reached the Arkansas Supreme Court, and in deciding the issue, the court looked to
the Arkansas Franchise Practices Act. At first, the letter of the law, as spelled out in that act, was not very
The court did find one provision in the act, though, that could guide its decision. According to that provi–
training center for Mary Kay representatives and to hold meetings, Isbell’s contract with Mary Kay did not
THE BOTTOM LINE
Businesspersons should realize that the law, and not an agreement between private parties, ultimately
determines whether a franchising relationship exists. In some cases, courts have held that even though
parties have signed a franchising agreement, the franchisees are in fact employees because of the degree of
control exercised over them by the franchisors. In other cases, courts have held that a franchising
relationship exists even in the absence of a franchising contract.
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First, prospective franchisees must decide on the type of business they wish to undertake and get
information about the business from the franchisor. This information should include details about the
franchise contract.
1. Payment for the Franchise
The franchisee ordinarily pays an initial fee for the franchise license, fees for products purchased
2. Business Premises
The franchise agreement may specify whether the premises must be purchased or may be leased,
and which party will supply equipment and furnishings.
3. Location of the Franchise
4. Business Organization
Standards for the business, the form and capital structure of the business, record keeping, and
5. Quality Control
A franchise agreement may give a franchisor a degree of supervision and control over the
franchisee’s operation to protect the franchise’s name and reputation.
a. Means of Control
The contract may provide that the franchisor can make periodic inspections to ensure that
standards are maintained.
b. Degree of Control
6. Pricing Arrangements
Franchisors may require the purchase of certain supplies at a set price and may set the price at
which a franchisee resells goods. This could violate antitrust laws, however.
ENHANCING YOUR LECTURE—
WHAT PROBLEMS CAN A FRANCHISEE ANTICIPATE?
A franchise arrangement appeals to many prospective businesspersons for several reasons.
Entrepreneurs who purchase franchises can operate independently and without the risks associated with
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you have an attorney evaluate the franchise contract for possible pitfalls.
THE FRANCHISE FEE
$500,000 or more. To calculate the true cost of the franchise, however, you must also include the fees that
benefits you would realize.
Virtually all franchise contracts require a franchise fee payable up front or in installments. This fee often
ranges between $10,000 and $50,000. For nationally known franchises, such as McDonald’s, the fee may be
ELECTRONIC ENCROACHMENT AND TERMINATION PROVISIONS
you might incur if you face these types of competition in your area.
termination are reasonable and clearly specified.
Another problem that many franchisees do not anticipate is the adverse effects on their businesses of so-
called electronic encroachment. For example, suppose that a franchise contract gives the franchisee
CHECKLIST FOR THE FRANCHISEE
1. Find out all you can about the franchisor: How long has the franchisor been in business? How profitable is
the business? Is there a healthy market for the product?
2. Obtain the most recent financial statement from the franchisor and a complete description of the
business.
3. Obtain a clear and complete statement of all fees that you will be required to pay.
supplying capital or credit? In finding a good location for your business?
5. Visit other franchisees in the same business. Ask them about their experiences with the product, the
market, and the franchisor.
6. Evaluate your training and experience in the business on which you are about to embark. Are they
sufficient to ensure success as a franchisee?
terminates the contract? Find out how many franchises have been terminated in the past several years.
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IV. Franchise Termination
A franchise usually begins with a short term, such as a year, which is extended or increased if everything
works out.
A. GROUNDS FOR TERMINATION SET BY FRANCHISE CONTRACT
Termination must be for cause, such as the franchisee’s death, disability, insolvency, breach of the
agreement, or failure to meet quotas.
CASE SYNOPSIS—
Case 36.2: Century 21 Real Estate LLC v. All Professional Realty, Inc..
annual payments on the note. Four years later, All Professional stopped paying the franchise fees, made no
All Professional Realty, Inc., signed four franchise agreements with Century 21 Real Estate LLC, to
operate offices in Sacramento and Folsom, California, and Honolulu, Hawaii, under the name “Century 21 All
Professional.” The agreements required All Professional to pay royalty and advertising fees, and permitted
Century 21 to terminate the agreements for good cause, including the franchisee’s failure to operate at an
approved location. All Professional signed a note for $75,000 payable to Century 21 and agreed to make
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Notes and Questions
Despite disagreements, a franchisee might want to continue its relationship with a franchisor to increase
reasons that attracted the franchisee to the franchise in the first place might support its
Why might a franchisor want to terminate a franchise? Why might a franchisee want to continue
its association with a franchisor? A franchisor might want terminate a franchise for any of a number of
reasons. A franchisee may not be as profitable for the franchisor as might have been anticipated or as might
CHAPTER 36: SMALL BUSINESSES AND FRANCHISES 11
contract had been induced by fraud, there is a basis for a claim. But if the franchisor acted in good faith and
dealt fairly, if the franchisee entered into the contract with full knowledge of its terms, and if the contract
Does a franchisee have any recourse when a franchisor changes the terms of their franchise
ADDITIONAL CASES ADDRESSING THIS ISSUE —
Franchise Termination
Cases focusing on the termination of franchises include the following.
• Zeidler v. A & W Restaurants, Inc., 301 F.3d 572 (7th Cir. 2002) (a franchisee’s closing of its restaurant
barred it from establishing that the franchisor wrongfully terminated the franchise, even though the franchisee
asserted that the franchisor acted in bad faith by threatening termination, because the franchisee could not
show a link between the termination threats and the restaurant’s closure and the voluntary abandonment of
the franchise constituted good cause for the franchisor to terminate the agreement).
franchise agreement allowed for the termination of the franchise on the discontinuation, and thus good cause
for termination of the franchise existed as a matter of law).
change in the ownership of a franchisee’s auto dealership constituted good cause for the termination of the
franchise when the majority of the dealership’s new owner’s customer satisfaction index scores were below
average).
• Duarte & Witting, Inc. v. New Motor Vehicle Board, 104 Cal.App.4th 626, 128 Cal.Rptr.2d 501 (3 Dist.
2002) (in a Chrysler-Plymouth dealer’s suit against termination of its Plymouth franchise by Daimler Chrysler
Motors Corp., it was undisputed that the franchisor was discontinuing the manufacture of the product and the
1. Notice Requirements
There must be notice and reasonable time to wind up the business.
2. Opportunity to Cure a Breach
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B. WRONGFUL TERMINATION
Much of the franchise case law that exists concerns termination—bad faith, unconscionability of the
contract termination provisions, and so on
C. THE IMPORTANCE OF GOOD FAITH AND FAIR DEALING
Franchise statutes often cover termination, requiring good faith and fair dealing. Courts generally try to
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CASE SYNOPSIS—
Case 36.3: Holiday Inn Franchising, Inc. v. Hotel Associates, Inc.
House of Aden’s plan. When HAI applied for an extension of its franchise, Holiday Inn asked for major
damages. Holiday Inn appealed.
“honesty, trust, and the free flow of pertinent information.” House was justified in assuming that an extension
Buddy House was in construction. For decades, he collaborated on projects with Holiday Inns
Franchising, Inc. At Holiday Inn’s request, House inspected a certain hotel and estimated that the cost to get it
into shape would take more than ten years to recover. Holiday Inn refused to grant a longer franchise term,
but said that if the hotel were run “appropriately,” the term would be extended at the end of ten years. House
bought the hotel, and renovated and operated it, as Hotel Associates, Inc. (HAI). Greg Aden, a Holiday Inn
executive, planned to license a different local hotel so that he could obtain a commission. No one informed
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Notes and Questions
A jury awarded HAI compensatory damages of $13 million, but the trial court reduced this amount
to $10 million. What most likely served as the jury’s basis for its award? Why did the court reduce it?
The jury based its award on $3 million for the cost of the renovations undertaken at Holiday Inn’s request
is a wealthy, a multi-national corporation—failed to disclose significant information to House with whom it had
A jury awarded HAI $12 million in punitive damages. The state court reduced this to $1 million, but
the appellate court reinstated the original award. What is the purpose of punitive damages? Did
Holiday Inn’s conduct warrant the $12 million punitive damages award? Explain. The purpose of
punitive damages is to punish a defendant and deter similar future conduct. Yes, Holiday Inn’s conduct
supported the increased amount of punitive damages. The harm to HAI was substantial. Holiday Inn—which
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TEACHING SUGGESTIONS
paid. Many lenders insist that a sole proprietor sign a personal guaranty so that the lender will have recourse
to his or her personal assets.
1. Explain that creditors are often reluctant to permit the owner of a sole proprietorship to contract out of
different incomes.
2. Sometimes, a franchisor appears to attempt to drive its franchisee out of business by establishing a
competing business within the geographic market area. Why would a franchisor attempt to drive its own
franchisee out of business? There are several possible reasons. Perhaps the franchisor was not using
good business judgment but only asserting its power. Maybe the franchisor hoped to drive the higher priced
reduce the adverse effects of a nonprofitable undertaking. Economic realities face all of us.
3. Why do we tend to sympathize with a franchisee when a franchise arrangement is terminated
unilaterally by the franchisor? We tend to assume that the cancellation of a franchise agreement for “good
4. Remind students of the importance of agency law principles in business organizations. Even a franchise
may be deemed a principal-agent relationship if there is a close relationship between a franchisor and its
franchisee.
Cyberlaw Link
Which form of business organization would be best for a business that transacts deals only
online? What are the legal and policy issues for the design, development, and operation of a sole
proprietorship’s Web site?
DISCUSSION QUESTIONS
1. What is an entrepreneur? An entrepreneur is one who initiates and assumes the financial risks of a new
enterprise and undertakes to provide or control its management. Before going into business, however, the en–
2. Because the Internet has made it possible for sole proprietorships to do business worldwide without
greatly increasing their costs, should they be considered, for some purposes, the equivalent of other
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3. What is a franchise? A franchise is any arrangement in which the owner of a trademark, a trade name, or a
4. Does a franchisee have any recourse when a franchisor changes the terms of their franchise
agreement? Yes, there could be grounds for a breach–of–contract suit, if the changes are imposed without consent,
5. How is a franchise paid for? The franchisee ordinarily pays an initial fee or lump-sum price for the franchise
6. What is the duration of a franchise? The parties determine the duration of a franchise. Most franchises
7. What do franchise agreements generally provide with respect to a franchisee’s location and form of
doing business? Most standard franchise agreements contain detailed provisions for such areas of coverage as the
following: Business Form of the Franchise. A franchisor may specify certain requirements for the form and capital
8. How do franchise agreements generally delegate price and quality controls over the franchisee’s
business? Price Controls. Because the franchisee provides the franchisor with an outlet for the franchisor’s goods
and services, the franchise agreement may require the franchisee to purchase certain supplies from the franchisor at
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9. Should a franchisor be allowed to control the operation of its franchisee—with a goal of maintaining a
certain standard of quality—without liability for the franchisee’s conduct? No, because there should be some
responsibility (liability) assumed for the exercise of control over the franchise’s activities. Yes, because the franchisee
should be responsible for its own conduct. What would constitute a “right to control” under a franchise
10. Why might a franchisor want to terminate a franchise? Why might a franchisee want to continue its
association with a franchisor? A franchisor might want terminate a franchise for any of a number of reasons. A
franchisee may not be as profitable for the franchisor as might have been anticipated or as might be necessary to
ACTIVITY AND RESEARCH ASSIGNMENTS
1. Ask students to discuss any of their own experiences as sole proprietors. They might especially be asked to
2. Ask students about running businesses on the Internet. Is it easier to start a business in “virtual” space
than in “real” space? Is it less (or more) expensive? What are the applicable laws? Perhaps most important