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Posted on Sep 09, 2014

I’M BUYING A FRANCHISE: DO I NEED A BUSINESS ENTITY? Business Entities In Franchising, And Their Limitations

By Brian A. Loffredo, Esq.

 

The answer is yes. If you plan to buy a franchise, you should strongly consider setting 

up a business entity from which to operate your business. Business entities serve an 

important role in the business world because they offer their owners protection. However, 

in the franchise world, business entities have some weak spots that franchisees should 

keep in mind.

 

One of the most common reasons business owners form business entities is to protect 

personal assets. Because business entities maintain a separate legal existence, business 

owners can use their entities to transact business, instead of obligating themselves 

personally. An entity can enter into contracts, incur debts, sue and be sued. It can take 

out loans, open bank accounts, own property, enter into leases, and engage in a wide 

variety of other business-related activities. The business entity conducts the activities of 

the business, and the owners therefore remain insulated from personal liability to third 

parties. 

 

However, while a business entity serves an important role in protecting franchisees, 

franchise owners should be aware that those protections are not absolute. Franchisees 

will almost never be permitted to escape liability from one important actor – their 

franchisor. This is because most franchisors require their franchise owners to sign 

personal guarantees if a business entity is used.

 

Personal guarantees come in different forms. However, under most personal guarantees, 

the signer agrees to be personally liable to the franchisor for their business entity’s 

obligations under the franchise agreement. Personal liability to a franchisor can manifest 

itself in many ways. For example, if the franchised business entity defaults on its 

royalty obligations, the franchisor can seek payment from the franchise owner. If the 

franchised business entity is terminated by the franchisor for any reason, the franchisor 

can seek breach of contract and other damages directly from the franchise owner. If the 

franchise owner attempts to compete with the franchisor after the franchise agreement has 

terminated, the franchisor may be able to enjoin the owner from engaging in competition. 

At the licensing stage, franchisees often misunderstand whether they are personally liable 

under their franchise agreements. This typically happens when a franchisee is pressed 

for time, and has not yet set up a business entity by the time he signs the franchise 

agreement. The franchisee proceeds with signing because the franchise agreement 

specifically states the franchise can be transferred into a business entity at a later date. In 

this situation, many franchisees understand they are personally obligated on the day they 

sign the franchise agreement, but believe this personal liability will disappear when the 

business gets transferred into their newly-formed entity. 

 

Unfortunately, the transfer almost never extinguishes personal liability. While most 

franchise agreements allow the franchise to be transferred into business entity, they do 

not specifically release the franchisee from personal liability. The transfer therefore 

obligates the new business entity, while the business owner also remains personally 

liable. 

 

As set forth above, most franchisors require their franchisees to be personally liable if 

they enter into the franchise agreement using a business entity. So the transfer situation 

described above does not put franchisees in a worse position than they would have been 

in had they originally used a business entity at the outset. However, the problem is that 

many franchisees enter into franchise transactions believing that a business transfer will 

relieve them from liability. Had they fully understood their personal liability would 

remain throughout the duration of the franchise agreement, they may not have proceeded 

with the transaction. For such individuals, the business transfer provisions can be 

misleading and can cause surprise down the road.

 

Franchisees should always consider using a business entity from which to conduct 

their business. Business entities serve a useful purpose in the business world, and allow 

franchisees to protect themselves from third-parties. However, the protections will 

typically not protect franchisees in disputes with franchisors. Franchisee must understand 

this reality, so that they can gauge risk and understand their exposure to problems down 

the road.

 

If you have any questions regarding the content of this article, or any other franchise 

law matter, please contact Brian Loffredo at 301.575.0345 or by e-mail at 

bloffredo@offitkurman.com.

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