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
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
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
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
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