Franchise disclosure obligations and registration can carry significant costs of compliance and can be an administrative burden. Initially drafting a compliant Franchise Disclosure Document (“FDD”) is a time-intensive process. Then the franchisor must update the FDD annually for as long as it wishes to sell franchises. State registration of the franchisor and review of the FDD can further delay franchise sales.
Additionally, an FDD contains confidential information that the franchisor may not wish to make public, especially if the business is a particularly sensitive to competition. Franchise laws restrict otherwise legal sales practices, such as making financial performance representations outside of Item 19, which can be another frustration for franchisors.
Exemptions to the franchise disclosure and registration laws provide both seasoned and start up franchisors the opportunity to reduce these burdens and costs by either (1) avoiding registration in a state or (2) avoiding drafting an FDD at all.
In this blog post series, we summarize the exemptions available under the Federal Trade Commission Franchise Rule (“Rule”), which allow a franchisor to sell a franchise without an FDD. Any analysis of what exemptions apply to your brand is incomplete if you do not also consider the application of state law. States may not recognize the federal exemptions and may offer different exemptions to their registration requirements.
The Rule contains eight exemptions, and the focus of this post is the Insiders Exemption. The FTC created this exemption for sophisticated prospective franchisees who do not benefit from the disclosures in an FDD to the degree that unsophisticated franchisees do.
The Insiders Exemption is a great option for franchisors whose employees, directors, and owners are the best prospective franchisees.
The two kinds of “insiders” covered by the Rule are (1) officers, directors, general partners, or managers of the franchisor or (2) owners of the franchisor. The requirements to qualify as each type are discussed below.
A. Officers, Directors, General Partners, and Managers
The following are key considerations for qualifying for the exemption as an officer, director, general partner, or manager. Note that the term “manager” is used to refer to an “individual with management responsibility for the offer and sale of the franchisor’s franchises or the administrator of the franchised network” not people who are designated manager of a limited liability company.
- Officers, directors, general partners, and managers of the franchisor (together, “Officers”) are eligible for the exemption. Be sure to note that this does not include officers, directors, general partners, or managers of the franchisor’s affiliates, including operating units.
- An Officer must have at least two years of experience with the franchisor in the qualifying role.
- The franchise sale must occur within 60 days of the Officer’s experience with the company. For example, if an Officer with five years of experience with the company left the company on June 1, 2022, that Officer would not qualify for this exemption if the sale occurred on August 15, 2022.
- An Officer must seek to purchase at least a 50% ownership interest in the franchise.
The purpose of these restrictions is to ensure that the prospective franchisee has recent experience with the franchising component of the business and that the Officer will have a significant role in the new franchise.
B. Owners of the Franchisor
The following are key considerations for qualifying for the exemption as an owner.
- Owners of the franchisor (“Owners”) are eligible for the exemption, not owners of the franchisor’s affiliates, including operating units.
- An Owner must have owned at least a 25% interest in the franchisor for at least two years.
- The franchise sale must occur within 60 days of the Owner’s ownership of the company. For example, if an Owner of a 35% interest in the company sold the entire interest on February 1, 2022, the Owner would not qualify for this exemption if the sale occurred on April 15, 2022.
- An Owner must seek to purchase at least a 50% ownership interest in the franchise.
Like the rationale for the Officer exemption, the purpose of these restrictions is to ensure that the prospective franchisee has meaningful, recent experience with the franchisor’s business and that the Owner will have a significant role in the new franchise.
The Insiders Exemption allows the franchisor to develop internal candidates for franchise ownership over time. This means that the Insiders Exemption has value both as part of a long-term growth strategy and as an immediate option for people who have demonstrated commitment to the brand through several years’ experience with the franchisor company.
Manning Fulton attorneys are available to help you determine how you can utilize the Insiders Exemption in your franchise system.