INFORMAL STAFF ADVISORY OPINION 98-5
This staff advisory opinion is issued in response to your request for our views concerning the applicability of the Franchise Rule's minimum payment requirement to a license agreement. 16 C.F.R. § 436.2(a)(2).
In your letter, you state that your undisclosed client wants to offer its "system" to investors. Each investor will form its own corporation, will be the majority shareholder, and will be primarily responsible for operating the business. Your client will license the use of its trademark, will provide support and controls over the business, and will be the minority shareholder.
You further state that neither the investor nor its corporation will be obligated to pay any fees to your client (or to an affiliate) for a period of at least 6 months after the business begins operations. The license agreement, however, will require investors to purchase equipment and other assets necessary to operate the business. These purchases will be from independent third parties. You also state that any compensation to your client will come either from payments made more than six months after the business begins operation or from your client's share of profits from the business.
You ask whether this arrangement satisfies the Rule's minimum payment requirement. You contend that the minimum payment element is not present as contemplated under the Rule because your client either must "wait for the success of the business or for at least a six-month period after the business begins."
II. THE MINIMUM REQUIRED PAYMENT ELEMENT
We start our analysis by noting that the definition of the term "franchise" contains no minimum payment requirement: "The franchisee is required as a condition of obtaining or commencing the franchise operation to make a payment or a commitment to pay to the franchisor . . . ." 16 C.F.R. § 436.2(a)(2). Thus, as long as the franchisee makes, or commits to make, any payment whatsoever, the business relationship constitutes a franchise.
We must then determine whether the franchise falls within the Rule's minimum payment exemption. That exemption states: "The provisions of this part shall not apply to a franchise . . . [w]here the total of payments . . . made during a period from any time before to within 6 months after commencing operation of the franchisee's business, is less than $500." Id. at § 436.2(a)(3)(iii).
Based upon your letter, it appears that investors will make three types of payments. First, pursuant to the license agreement, investors must purchase certain equipment and other assets necessary to operate the business. Although these purchases are a pre-condition to operating the business, they apparently are not purchased from your client or from an affiliate.(1) Accordingly, such payments are not deemed "required" payments, as contemplated by the Rule. Id. at § 436.2(a)(2).
Second, investors will pay your client accounting and consulting fees. However, you state that such fees will be payable more than six months after the business begins operation. These payments appear to fall within the Rule's minimum payment exemption. Id. at § 436.2(a)(3)(iii).
Finally, your client will earn a share of the profits by virtue of its minority shareholder interest in the business. We see little difference between the proposed arrangement, where your client will receive recurring profits from the business through an ownership interest, and the classic franchise arrangement, where an independent franchisee typically pays recurring fees, such as royalties, to the franchisor. Regardless of the business structure, the licensor in each instance will effectively receive payments in exchange for the use of its trademark or other proprietary information. The question remains, however, whether your client will receive at least $500 in profits within the first six months of operations.
This is not the first time that we have been asked to consider whether prospective, unspecified payments constitute minimum required payments under the Rule. In Advisory 93-12, Bus. Franchise Guide (CCH), ¶ 6456 (1994), we noted that nothing in the Rule requires the amount of payments to be fixed at the time of execution of a franchise agreement. As long as payments total at least $500 within the initial six-month period, the definitional element of a minimum required payment is satisfied.
Further, it is the Commission's policy to interpret all of the exemptions and exclusions to the Franchise Rule narrowly in order to protect investors. Thus, it is the burden of the franchisor -- or licensor in this instance -- to prove that it falls within the minimum payment exemption. Accordingly, franchisors should err on the side of caution and provide prospective franchisees with disclosure documents, unless they can establish beforehand that they will qualify for the minimum required payment exemption.
Whether a prospective payment will constituted a "required payment" for Rule purposes will be determined based upon the reasonable expectations of the parties at the time they enter into the franchise relationship. In Advisory 93-12, we set forth some of the factors the Commission may consider in determining the parties' expectations. First, we consider the type of industry involved and the prior financial history of the specific franchisor and any existing franchisees. Where such evidence indicates that a typical franchisee in that industry generates sufficient income to require payment of at least $500 in fees during the initial six-month period, it is reasonable to assume that the parties expect the minimum payment requirement will be met. Id. at 9363.
Second, we consider the sales price of the franchisor's goods or services, the likely demand for such goods or services, and the specific level of the royalty or license fee. In some industries, especially those which offer high-priced goods, the franchisees' ability to generate revenues, and thus pay a license or royalty fee of at least $500 within the first six months, may be reasonably assured. Similarly, in other industries a low sales price -- that might suggest low revenues and thus minimal license fees paid to the franchisor -- might be offset by high demand for the products sold or services performed. We also consider the percentage rate used to calculate such fees. For example, low demand might be offset by a high royalty percentage rate. Id.
Third, we consider any representations made by a franchisor to the prospective franchisee about potential income. Where a franchisor makes direct or indirect earnings representations, from which the franchisee can reasonably conclude that he or she can expect to earn sufficient income to pay license or royalty fees of at least $500 during the six-month period, we will hold the franchisor to those representations and conclude that the minimum payment requirement is satisfied. Id.
Your letter does not provide us with any information from which we can determine the parties' reasonable expectations regarding profits during the first six months of operation. For example, your letter is devoid of any details about the particular industry, the experience of potential investors, or the earnings history of existing businesses in the industry. Further, we have no knowledge of the demand for your client's goods or services, the typical level of earnings from the sale of comparable goods or services by other business, or the specific percentage of profits your client will receive. Finally, we have no information to draw any inference about whether the licensees are led to believe they will achieve, or expect to achieve, a certain level of earnings. For these reasons, we cannot determine whether your client's license arrangement will satisfy the minimum required payment element.
Please be advised that the views expressed in this letter are those of the FTC staff. They have not been reviewed, approved, or adopted by the Commission, and they are not binding upon the Commission. However, they do reflect the opinions of the staff members charged with enforcement of the Franchise Rule.
Date: June 24, 1998
Franchise Rule Staff
1. We assume that the franchisor does not receive any payment from the third-party supplier, which would be deemed an indirect source of income to the franchisor.