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Franchising as a Growth Vehicle—the Risks of Improper Classification

Should I franchise my business? Is it the right time? Is franchising the right growth vehicle for my business model? Does franchising fit with my ambitions, tendencies, preferences and general corporate culture?

While some business owners get into the game knowing that they intend to franchise their concept, many business owners weigh these and related questions in deciding whether or not franchising is right for them—and rightfully so. Franchising is a highly regulated legal structure, and adopting a franchise model too late, too soon, or just inappropriately altogether, can have drastic legal consequences.

Most legal cases in this arena deal with companies who inappropriately offer “licenses” in an attempt to avoid the strictures of state and federal franchise laws. However, a recent case gaining national attention deals with a company that improperly labeled employees as franchisees—attempting to use the franchise structure to avoid the legal and tax implications of having employees.

In Awuah v. Coverall North America, Inc., the Massachusetts Supreme Judicial Court held that Coverall’s purported franchisees were actually employees. As a result, Coverall was liable for payment of wages, worker’s compensation insurance, and other fees that had been inappropriately passed on to the individuals who signed its franchise agreements. Coverall was also prohibited from collecting (and was required to reimburse) franchisee fee payments, since they effectively amounted to payments by the employees to “buy their jobs.” Even though the employees’ purported franchise agreements contained their consent to these payments, state law prohibited employers from using contracts to avoid their employment-related obligations.

So, what does this mean for active and would-be franchisors?

The answer depends on the structure of the franchise relationship. Among other things, it appears that Coverall collected payments from its employees’ customers, and then remitted payments to its employees with royalty fees taken off the top. This, of course, contrasts with more traditional franchise fee structures, under which franchisees actually run their own businesses and pay fees out to the franchisor.

As a result, for franchisors who actually follow the franchise model—treating their franchisees as independent business owners and drafting their franchise agreements and related documentation accordingly—Awuah v. Coverall is not likely to come into play. However, in order to avoid the implications of Awuah v. Coverall, franchisors do need to understand and appropriately adopt and implement a true franchise system—and not merely pay lip service to the franchise laws and regulations. As this case makes clear, courts will disregard contractual formalities where the form and substance of the parties’ relationship implicate a particular statutory regime that provides for certain rights and remedies.

This article is provided for informational purposes only, and does not constitute legal advice.

Jeff Fabian is the owner of Fabian, LLC, a boutique law firm serving active and prospective franchisors and franchisees. Visit fabianlegal.com or thefranchisecafe.com for more information.

Franchise Fridays for April 15, 2011: Top Franchise and Small Business News of the Week

Applebee’s said that it will switch to pouring apple juice from single-serve containers served at the table and store non-alcoholic and alcoholic beverages in completely separate and identified containers.

Don’t Forget: Compliance Beyond Federal and State Laws

Without discounting the importance of compliance with these types of laws, it is the continuation of this disclosure that is the focus of this article. Depending on the nature of the franchise, there are numerous types and categories of laws and regulations that could potential apply to franchise operations. Franchisors need to be aware of these laws so that they can be adequately disclosed in the FDD, and franchisees (active and prospective) need to be aware as well so that they do not run afoul in operating their franchised business. Depending on the nature of the franchise, the following are some industry-specific laws and regulations of which franchisors and franchisees may need to be aware: