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.