Large Franchise Investment Exemption

The amended Rule exempts franchise offers and sales where the initial investment is atleast $1 million, excluding the cost of unimproved land and any franchisor (or affiliate)financing. In addition, the prospective franchisee must sign an acknowledgment that thefranchise sale is exempt from the Franchise Rule because the prospective franchisee will bemaking an initial investment of at least $1 million.

What Is an “Initial Investment”?

A franchisee’s “initial investment” is limited to the type of expenses that would ordinarilyappear in an Item 7 disclosure – expenses paid through the opening of the outlet and anyadditional expenses paid through the three-month initial period thereafter. It does not reach allpossible payments to the franchisor made over the life of the franchise agreement. Accordingly,future obligations to pay rent, royalties, or advertising fund contributions to be made over the lifeof the franchise agreement do not count toward the “initial investment.” The “initial investment”also does not reach costs associated with unimproved land, nor any funds obtained throughfranchisor (or affiliate) financing.

Further, the exemption focuses on the level of the “initial investment,” not on the numberof outlets or the type of outlets being sold. Accordingly, the exemption will apply where the totalprojected initial investment is reached, whether for a single unit or multiple units. At the sametime, it is possible that the large investment exemption may apply to some, but not all, of afranchisor’s franchise sales. For example, a fast-food restaurant franchisor may sell stand-alone,full facility restaurant franchises for an initial cost of $1 million, while at the same time sellingkiosks for a much reduced price, such as $100,000. Under the circumstances, only the sale of thestand-alone restaurants would qualify for the exemption.

Do Conversion Franchises and Transfers Qualify for the Exemption?

Conversion franchises and transfers of franchised outlets may qualify for the largeinvestment exemption. In a conversion franchise, a business owner has already invested in his orher existing business and now seeks to associate with a particular franchisor’s mark by enteringinto a franchise agreement with that franchisor. When considering a conversion franchisee’s“initial investment” in a franchise, the conversion franchisee’s previous investment in the outlet(as opposed to the current value of the outlet) may be considered. This is true even though theconversion franchisee’s initial investment was not paid to the franchisor making the current offer.In a transfer, a prospective franchisee buys an existing franchise directly from an existingfranchisee, but then may enter into a new franchise agreement with the franchisor. The fact that atransferee will assume an existing contract or may renegotiate an existing contract with thefranchisor ordinarily has no bearing on his or her level of sophistication as an investor. As longas he or she satisfies the monetary threshold, the large investment exemption is available. As inthe case of the conversion franchisee, the prior investment to a party other than the franchisor –here, the transferring franchisee – does not preclude application of the large investmentexemption.

Who must Make the Initial Investment?

Where an investor group seeks to purchase a franchise, at least one individual must investat the $1 million level for the exemption to apply. The large investment exemption is premisedon the assumption that a franchisee’s ability to pay a large sum equates with sophistication. Thatassumption fails when no one investor standing alone is investing at the requisite threshold level.For purposes of this provision, a husband and wife can be considered a single individual sincetheir assets are typically commingled.

What Is the “Acknowledgment” Requirement?

To take advantage of the large investment exemption, franchisors must obtain from theprospective franchisee a signed acknowledgment that the investment satisfies the $1 millionthreshold. The acknowledgment must contain the following prescribed statement:

The franchise sale is for more than $1 million – excluding the cost ofunimproved land and any financing received from the franchisor or anaffiliate – and thus is exempt from the Federal Trade Commission’sFranchise Rule disclosure requirements, pursuant to 16 C.F.R.§ 436.8(a)(5)(i)

While the amended Rule does not specify the exact format of the acknowledgment theacknowledgment must be clear and conspicuous and in plain English, consistent with the Rule’sgeneral directions, and the franchisor has the burden to prove that the acknowledgment wasfurnished to, and signed by, the prospective franchisee.

This post is part of a series of posts discussing the legal aspects of franchising.

CREDIT: The content of this post has been copied or adopted from the Federal Trade Commission’s Franchise Rule Compliance Guide.