Mama Fu’s Noodle House started as a single Pan-Asian restaurant in downtown Atlanta. Founded by entrepreneur Martin Sprock, who expanded the outlet through his franchising company Raving Brands, the restaurant quickly grew from a single eatery to a fast-casual food chain with locations in Arkansas, Florida, Georgia, North Carolina and Texas. However, the rapid growth of the chain led to discontent among the franchisees, who believed that the company had grown too quickly without providing the support, marketing and training promised under franchise agreements.

Franchising and Licensing: How a Small Business Can Go Big

In December 2006, when it was estimated that Mama Fu’s had reached or exceeded approximately 40 restaurants within 24 months, a group of 29 franchisees and investors sued Martin Sprock, Raving Brands and Mama Fu’s, alleging a variety of claims including violations of state contract and franchise law. Although the United States District Court in Georgia recently ruled in favor of the defendants, the Mama Fu’s three-year lawsuit made as many headlines in the branding world as did the restaurant’s rapid rise to success.

Statistics show that despite or perhaps because of the recent economic downturn, new businesses are continuing to launch. As new ventures have gained traction in the marketplace, new franchises have continued to launch as well. In the United States alone, more than 300,000 franchised small businesses employ eight million people, earning an estimated $1 trillion of income each year.

While franchises are commonly associated with food mega-chains such as Burger King or McDonalds, many small businesses, from coffeehouses to beauty parlors to web design shops, have also turned to franchising as a means of expanding a successful venture. Likewise, an ever-increasing number of small companies are finding ways to use their corporate trademarks and brand assets to build market visibility. As franchising and licensing opportunities continue to grow, it is important for businesses to distinguish between them and find ways to grow without losing control of the business.

What Is A Franchise?

Simply put, franchising is a way for a company (the franchisor) to give an independent third party (the franchisee) the right to operate an extension of the franchisor’s business in specified territories under the franchisor’s logo and trademarks. It is a way for businesses to expand while retaining control of operations, in return for royalties or sales profits. A typical franchise agreement may address the following points:

• Trade names and marks to be used by the franchisee
• Equipment or supplies to be purchased by the franchisee
• Initial consideration (value) to be paid by franchisee
• Profit the franchisee will earn or is likely to earn
• Permissible franchise locations
• Methods of operation
• Territorial exclusions or carve-outs
• Marketing, sales or training programs to be provided by the franchisor
• Buyback of products, supplies or equipment by the franchisor

Franchises are regulated by both federal and state law. The Federal Trade Commission outlines regulations for franchising ventures in the Franchise Rule, which prohibits franchisors and franchise brokers from engaging in unfair or deceptive acts or practices. Under the Franchise Rule, a person seeking to launch a franchise must make certain disclosures of information prior to meeting with a potential franchisee. Required disclosures include trademarks, company history and the related business experience of each director and executive officer over the past five years.

Individual states vary as to how they regulate the creation and operation of franchises. Some state have franchise investment laws that require pre-sale disclosures similar to the federal Franchise Rule, while other states like California and New York treat the sale of a franchise like the sale of a security. In these states, it is necessary for a franchisor to file and register a public disclosure document with the Secretary of State. These state laws give franchisees the right to bring private lawsuits against the franchisor.

What Is A License?

Unlike franchising, which is based on securities law, licensing is a contractual arrangement between two parties for the right to use property in exchange for a fee or other consideration. Licenses may be used to grant usage of a variety of intellectual property rights, including copyrights, patents, and image/likeness rights, but in the context of brands, licenses most often deal with trademark, trade name or trade dress rights.

A trademark or trade name, according to the United States Patent and Trademark Office, is “a word, phrase, symbol or design, or a combination of words, phrases, symbols or designs, that identifies and distinguishes the source of the goods of one party from those of others.” Trade dress is the visual appearance of a product or its packaging that identifies the source of the product to consumers, such as the festive, bright-colored Tex-Mex restaurant décor held by the Supreme Court to be protected in the 1992 trade dress case Two Pesos v. Taco Cabana.

A company that holds the rights to a trademark, trade name, or trade dress (property) may capitalize on these rights by licensing them to others who find value in the brand’s cache. In the context of corporate trademarks, licensing is a way to bring a brand to a broader market without undertaking the groundwork of launching a full franchise. A brand licensing agreement may address the following points:

• Right to use the property exclusively or nonexclusively
• Product category
• Duration: period of time over which licensee may use the property
• Geographic territory where the products or services may be distributed
• Co-op dollars (cooperative dollars): money supplied by licensors to spend on promotion and advertising as licensees deem appropriate
• Financial terms: royalty rate, minimum royalty guarantee (money at the end of the term), royalty advance (money upfront), markup prices and audits

The Fine Line Between Franchising and Licensing

Small businesses are frequently drawn to licensing over franchising because of the lower barriers of entry associated with licensing. However, while a well-executed licensing strategy can be a source of revenue and marketing vehicle, a company can easily run afoul of state franchising or business opportunity laws with the intention of merely licensing its brand. This makes it particularly important for growing companies planning to expand to pay close attention to the definition of a franchise under relevant state law.

A licensing arrangement that qualifies as a franchise under federal law or under the maze of state franchise laws must comply with all relevant disclosure laws and regulations. Thus, for example, a coffeehouse may in fact be operating a franchise when it licenses for its name and logos, as well as the distinctive red-and-green art-deco theme that distinguishes the store, to a coffee stand operator who brews the same specialty coffee under the terms of the agreement.

If the coffeehouse operates in California, the California Corporations Code states that a franchise is formed when the franchisor (1) grants the right to engage in sale or distribution according to a specified marketing plan or system, (2) allows the franchisee to operate a business under the franchisor’s trademarks or trade names and (3) receives a franchise fee. Potentially, the coffeehouse could be liable under California franchise laws for failure to make required disclosures and filings, even if the agreement with the coffee stand operate states explicitly that it is merely a license.

Losing Control, Facing Liability

Trademark licensing arrangements cross over into the realm of franchising when a licensor receives compensation and continues to exert control over the licensee’s day-to-day business. Yet many businesses wish to retain control over the way that licensees use their properties, since the impact of a third-party’s rogue use of a mark could have lasting repercussions on the brand, as well as potential legal ramifications. What begins as a simple deal exposes the company to liability.

For example, in December 2008, the Walt Disney Company faced a highly-publicized products liability lawsuit brought by the family of a child who died as the result of a Winnie the Pooh bassinet with a flawed design. Six month-old Kennedy Brotherton Jones was strangled in the bassinett when she slid through a gap in the crib. Though Disney merely licensed the Winnie the Pooh character to Simplicity, the company that manufactured the cribs, the plaintiff brought suit against Disney for failing to control and ensure the safety of the licensed product.

The Disney suit, which is still pending, highlights the paradox sometimes faced by companies that wish to license their brands. As licensors, they can exert only limited control over the licensee’s day-to-day business operations, and yet in some cases may face liability or a tarnished brand as the consequence of not exerting sufficient control. It is advisable for companies, especially small companies, to consult an attorney when deciding whether to open a franchise, franchise a business or license a brand. These relationships which begin as complex agreements can ultimately lead to partnerships that are profitable for all parties involved.

- By Dava Casoni, Annie Lin