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 Large Investment 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.
Large Investment Exemption
The large investment exemption targets sophisticated franchisees that (1) invest in concepts that require a significant investment and (2) can independently cover that amount. If a franchisee will initially invest at least $1,233,000 (adjusted periodically for inflation) in the franchise and signs an acknowledgement of such containing the Rule’s required language, the large investment exemption will apply.
The below factors are important in determining who must make the investment and in calculating the amount.
A. Types of Qualifying Expenses. The expenses that count as the initial investment are those that are typically disclosed in Item 7 of the FDD, such as the buildings, furnishings, fixtures, signage, equipment, computer systems, business licenses, training, grand opening marketing expenses, etc. The initial investment does not include future or ongoing expenses like royalties or brand development fund contributions.
In circumstances where the franchisee is converting an existing business to the franchise or is transferring the business from another franchisee, the previous investment can qualify.
For example, if an automotive service provider (1) operate an independent business providing oil change services, (2) had invested amounts in the original business over the threshold, and (3) wanted to convert the business to the franchisor’s brand, the franchise exemption would still apply.
B. Unimproved Real Estate Excluded. The cost of unimproved land is not counted as part of the initial investment.
C. Franchisor Financing Excluded. The initial investment excludes any financing received from franchisor or its affiliate. This would not prevent the franchisor or an affiliate from financing part of the price of the franchise, but the difference between the total price and the financed amount must exceed $1,233,000.
D. Single vs. Multiple Units. The total initial investment must exceed $1,233,000 but the deal can encompass a single unit or multiple units. If the sale of a single unit will not trigger the exemption, the sale of multiple units in the same transaction may push the deal above the threshold.
For example, a prospective franchisee wanted to open kiosk units of the business and the initial investment per unit is $250,000. Opening a single unit would not qualify for the exemption but opening five units, for an initial investment of $1,250,000, would satisfy the threshold.
E. Individual Contribution. At least one individual must contribute more than $1,233,000. This means that a group of investors cannot aggregate small investments to exceed the threshold. Note that a husband and wife are considered an individual because their assets are usually commingled. The rationale for this requirement is that a group of investors that exceed the minimum only through aggregation are probably not experienced investors.
The greatest challenge to qualifying for this exemption is finding an individual purchaser who can personally contribute $1,233,000 without needing to rely on other investors or the franchisor’s financing to reach the total threshold. Nevertheless, this type of prospective franchisee may be the target market for your franchise sales or may emerge as an unexpected, unique opportunity for your brand.
Manning Fulton attorneys are available to help you determine if you can craft a franchise system or a franchise deal that can utilize the large investment exemption.