Chapter 30: Sole Proprietorships and Private Franchises 1
Chapter 30
Sole Proprietorships and Private Franchises
Introduction
The most common forms of business organization are the sole proprietorship and, when two or more persons are involved, the partnership and the corporation, with the limited liability company becoming increasingly popular. In this chapter, the basic features of sole proprietorships are briefed, and some of their advantages and disadvantages are spelled out. There is also a discussion of private franchises.
Chapter Outline
I.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.
•Sole proprietorships are more flexible to operate than a partnership or a corporation.
•Sole proprietors pay only personal income taxes on business profits.
B.Disadvantages of the Sole Proprietorship
The proprietor bears all of the financial risk of losses and liability.
Case Synopsis—Case 30.1: Quality Car & Truck Leasing, Inc. v. Sark
Michael Sark Sr. operated a logging business as a soleproprietorship. To acquire equipment for the business, Sark (and his wife Paula) borrowed money from Quality Car & Truck Leasing, Inc. When the business encountered financial difficulties, Sark became unable to pay his creditors, including Quality. The Sarks sold their house (valued at $203,500) to their son Michael Jr. for $1 but continued to live in it. Three months later, Quality obtained a judgment against the Sarks for $150,481.85 and then filed a claim to set aside the transfer of the house to Michael Jr. as a fraudulent conveyance. The court issued a decision in Quality’s favor. The Sarks appealed, arguing that they were not actually Quality’s debtors.
A state intermediate appellate court affirmed. The Sarks “are clearly judgment debtors to Quality Leasing and *** the judgment has not been satisfied.”
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Notes and Questions
What advantages and disadvantages are associated with the 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 to start a sole proprietorship than to start any other kind of business. This type of business organization entails more flexibility than does a partnership or a corporation. A sole proprietor pays only personal income taxes on profits. Sole proprietors can establish tax-exempt retirement accounts in the form of Keogh plans.
The major disadvantage is that the proprietor bears the burden of any losses or liabilities incurred by the enterprise. The sole proprietorship also lacks continuity on the death of the proprietor. Another disadvantage is that the opportunity to raise capital is limited to personal funds and the funds of those who are willing to make loans.
Why did the Sarks take the unethical step of fraudulently conveying their home to their son? What should they have done instead? The Sarks may have taken the steps that led to the dispute in this case to save their home and its value for themselves and their son. They may have been motivated by embarrassment or humiliation for their predicament.
Instead of the unethical step of fraudulently conveying their home to their son, the Sarks might have attempted to downsize to a smaller residence. Or they might have attempted to renegotiate the terms of their mortgage, or obtain a second mortgage or initiate a home equity line of credit. Or they might have simply sold the house themselves and applied the proceeds against their debt. If none of these options were possible, they might have tried to renegotiate their debts and the terms with Quality and their other creditors..
1.Personal Assets at Risk
Creditors can satisfy a sole proprietor’s business debts through his or her personal assets. The liability is unlimited.
2.Lack of Continuity and Limitations on Funding
A sole proprietorship ends when the owner dies.
II.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
Franchises can take the form of distributorships, in which a manufacturer licenses a dealer to sell its product, often in an exclusive territory.
2.Chain-Style Business Operation
A franchise can take the form of a chain-style business operation. Here, the franchise operates under the franchisor’s trade name as part of a select group of dealers. There are normally standardized practices and required levels of performance. Materials and supplies often must be bought from the franchisor.
3.Manufacturing or Processing-Plant 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 demands of dealers-franchises or set unrealistically high sales quotas.
•The Petroleum Marketing Practices Act of 1979 protects gasoline station franchisees.
•Federal antitrust laws prohibit certain types of anticompetitive agreements.
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.
•Written or electronic disclosures.Information must include the range of goods and services and the value and estimated profitability of a franchise.
•Reasonable basis for representations at the time they are made.
•Projected earnings. If these are provided, it must be indicated whether the figures are based on actual or hypothetical examples.
•Actual data. If projections are based on actual data for a specific location, the number and percentage of existing franchisees that have achieved the results must be disclosed.
•Explanation of terms. This includes termination, cancellation, and renewal.
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.
•Disclosures. Costs of operation, recurring expenses, profits earned, and facts substantiating these figures must be disclosed.
•State deceptive trade practices acts. These may apply to certain franchisor actions.
b.Requirements for Termination
State law may prohibit termination without “good cause” or require that certain procedures.
Enhancing Your Lecture—
Franchising in Foreign Nations
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 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 few years, franchisors have expanded their target locations to Asia, South America, Central America, and Mexico.Cultural and Legal Differences Are Important
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, 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 maintain the quality of its product and protect its good reputation? If the law in China, for example, does not provide for the same level of intellectual property protection, how can a U.S. franchisor protect its trademark rights or prevent its “secret recipe or formula” from being copied?
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 target country, as well as the economic trends. Marketing surveys to assess the potential success of the franchise location are crucial in international markets. Also, because complying with U.S. disclosure laws may not satisfy the legal requirements of other nations, most successful franchisors retain counsel knowledgeable in the laws of the target location. Competent counsel can draft dispute settlement provisions (such as an 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 helpful. The act’s definition of a franchise, for example, did not shed any light on the case at hand. The court did find one provision in the act, though, that could guide its decision. According to that provision, the act applied only to a franchise that contemplated or required the franchisee “to establish or maintain a place of business in the state.” Although Isbell had rented storefront space in a Little Rock mall to use as a training center for Mary Kay representatives and to hold meetings, Isbell’s contract with Mary Kay did not require her to do so. Therefore, under Arkansas law, she was an independent contractor, not a franchisee.aThe 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.
a. Mary Kay, Inc. v. Isbell, 338 Ark. 556, 999 S.W.2d 669 (1999).
Additional Background—
Law and the Franchisee
A franchise arrangement appeals to many prospective businesspersons who want to be financially independent and yet feel more comfortable working with an established product or service and a management network that is regional or national in scope and that has been in place for some time. Although franchises have a relatively high survival rate (90 percent) as compared to small businesses (20 percent), franchise agreements and operations may cause some franchisees to suffer considerable financial losses.
Nearly all franchise contracts require a franchise fee payable up front or in installments. Some franchise arrangements hide franchise-fee payments in long-term supply purchase requirements that typically continue for the duration of the franchise agreement. These purchase requirements will usually require the franchisee to purchase supplies (including generic products such as napkins and plastic flatware) at a premium price from the franchisor. The franchisee may also be required to contribute monies for advertising expenses which are actually in excess of the franchisee’s bona fide pro rata share. This excess is also an implicit franchise fee.
The franchisee will often suffer significant negative consequences if the franchise is terminated by the franchisor. Unfortunately, the courts have not yet made a clear statement as to what a franchisee’s rights are upon termination. Some courts have held, for example, that if a franchise investment is substantial and the relationship between the parties is an established one, then the franchise cannot be terminated until a reasonable period of time has elapsed. How the term “reasonable” is defined, of course, will depend on the particular circumstances of each case. In any event, a potential franchisee should always be sure to obtain all the relevant details of the business and of the franchise agreement before paying for the franchise in order to avoid many unnecessary financial and legal problems.
III.The Franchise Contract
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.
A.Payment for the Franchise
The franchisee ordinarily pays an initial fee for the franchise license, fees for products purchased from or through the franchisor, a percentage of sales, a percentage of advertising costs, and some administrative expenses.
B.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.
C.Location of the Franchise
The franchisor determines the franchisee’s territory. Territorial rights are often disputed, and the implied covenant of good faith and fair dealing may apply.
D.Quality Control by the Franchisor
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.
1.Means of Control
The contract may provide that the franchisor can make periodic inspections to ensure that standards are maintained.
2.Degree of Control
A franchisor may set quality standards, but the tighter the control, the more likely the franchisor may be responsible for the acts of the franchisee and his or her employees.
E.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 products that have never been marketed before. Additionally, the franchisee can usually rely on the assistance and guidance of a management network that is regional or national in scope and has been in place for some time. Franchisees do face potential problems, however. Generally, to avoid possibly significant economic and legal problems, it is imperative that you obtain all relevant details about the business and that you have an attorney evaluate the franchise contract for possible pitfalls.The Franchise Fee
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 $500,000 or more. To calculate the true cost of the franchise, however, you must also include the fees that are paid once the franchisee opens for business. For example, as a franchisee, you would probably pay 2 to 8 percent of your gross sales as royalties to the franchisor (for the use of the franchisor’s trademark, for example). Another 1 to 2 percent of gross sales might go to the franchisor to cover advertising costs. Although your business would benefit from the advertising, the cost of that advertising might exceed the benefits you would realize.
Electronic Encroachment and Termination Provisions
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 exclusive rights to operate a franchise in a certain territory. Nothing in the contract, though, indicates what will happen if the franchisor sells its products to customers located within the franchisee’s territory via telemarketing, mail-order catalogues, or online services over the Internet. As a prospective franchisee, you should make sure that your franchise contract covers such contingencies and protects you against any losses you might incur if you face these types of competition in your area.
A major economic consequence, usually of a negative nature, will occur if the franchisor terminates your franchise agreement. Before you sign a franchise contract, make sure that the contract provisions regarding termination are reasonable and clearly specified.
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.
4.Will the franchisor help you in training management and employees? With promotion and advertising? By 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?
7.Carefully examine the franchise contract provisions relating to termination of the franchise agreement. Are they specific enough to allow you to sue for breach of contract in the event the franchisor wrongfully terminates the contract? Find out how many franchises have been terminated in the past several years.
8.Will you have an exclusive geographic territory and, if so, for how many years? What plans does the franchisor have in regard to telemarketing, electronic marketing, and mail-order sales to customers within the territory?
9.Finally, the most important way to protect yourself is to have an attorney familiar with franchise law examine the contract before you sign it.
IV.Franchise Termination