This staff advisory opinion is issued in response to your request for a clarification of Informal Advisory Opinion 98-5 (June 24, 1998). In that advisory, we addressed whether the payment of a share of future profits by a franchisee could be considered a required minimum payment under the Rule. We stated that there is little difference between the payment of recurring profits from a franchisee-owned business to a minority shareholder-franchisor and the classic franchise arrangement, where the franchisee typically pays recurring fees, such as royalties, to the franchisor. Regardless of the business structure, the seller in each instance effectively will receive payments in exchange for the use of its trademark or other proprietary information. From the limited facts presented, however, we could not determine whether the expected profits paid to the seller would in fact total at least $500 within the first six months of operations.
You now ask for a clarification of our opinion. You apparently believe that Commission staff has previously opined that "speculative payments," such as royalties, are not deemed a required payment. If so, you question why payments of future profits are different. You then ask: "even if the payment of profits would possibly be considered a type of 'required' payment, if my client is not entitled during the 6 months after the business opens to receive a payment of his share of profits (i.e, his profits may accrue, but they won't be paid until after 6 months expires), under these circumstances, would the required payment element be present to create a franchise?"
I. Speculative Obligations To Make A Payment May Not Constitute A Required Payment
As an initial matter, your request letter raises the distinction between a speculative obligation to make a payment, on the one hand, and the obligation to make a payment of an uncertain amount, on the other. Where the obligation to make a payment is speculative, the Commission may find that the business arrangement fails to satisfy the Rule's required payment element. For example, in Advisory Opinion 97-9, Bus Franchise Guide (CCH), ¶ 6489 (1997), we concluded that the buyer's obligation to make a required payment to the seller under an option agreement appeared to be speculative. Under the option agreement, the buyer's obligation to make a payment would arise only if a third party presented a bona fide offer to purchase assets, circumstances over which neither the seller nor buyer could control. Accordingly, we found that the very obligation to make a payment was "speculative at best:"
While the Dealer must sign the Option Agreement at the time he or she enters the Program, the obligations under that Agreement would arise only if a third party presents an offer. In addition, the third party's offer must be bona fide. Further, inherent in the concept of a "required payment" is the expectation on the part of the franchisor to receive a payment as a matter of contract or by practical necessity. While the Company has the right to receive payment if certain conditions are met under the Option Agreement, the Company ostensibly can have no expectation of receiving payment because it has no control over whether a bona fide offer will be made or whether the Dealer will accept the offer. Indeed, because the decision to accept a third party's offer rests solely with the Dealer, any payment made to the Company under the Option Agreement would appear to be voluntary. Under these facts, it cannot reasonably be said that a typical Dealer commits to make a "required" payment to the Company of at least $500 by signing the Option Agreement. Id. at 9694-95.
II. Current Obligations To Make A Payment Of An Uncertain Amount May Constitute A Required Payment
Accordingly, the required payment element may not be met where the buyer's obligation to make a payment is speculative. The same does not hold true, however, where the buyer's obligation to make a future payment is clear, but the amount of the required payment is uncertain when the parties enter into their business relationship. We addressed the issue of uncertain future payments (e.g., royalties) 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. Whether a prospective payment obligation will constituted a "required payment" for Rule purposes will be determined based upon the reasonable expectation of the parties at the time they enter into the franchise relationship.
Some of the factors the Commission may consider in determining the parties' expectations including the following: First, we consider the type of industry involved and the prior operational 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 during the initial six-month period, it is reasonable to assume that the parties expect that 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.
Accordingly, current obligations to make future payments, regardless of their form (e.g., royalties, equipment purchases, and profit shares), will be deemed a required payment if the parties can reasonably anticipate, based upon the facts, that such payments will total at least $500 within the first six months of the franchisee's operations.
III. Profit Payments Made Beginning Six Months After Commencement of Business Operations May Exempt The Relationship From Rule Coverage
Although future profit shares may be deemed a required payment under the Rule, we must determine whether those payments nonetheless qualify for the Franchise Rule's minimum payment exemption. That exemption provides: "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). If, as you state, the franchisees' obligation to pay a future share of profits does not begin until 6 months after business operations actually commence, then it would appear that the minimum payment exemption is satisfied.
Please be advised that our opinion is based on all the information furnished in your request. This opinion applies only to your client and to the extent that actual company practices conform to the material submitted for review. Please be advised further 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: March 30, 1999
Franchise Rule Staff