In general, selling and offering a franchise is regulated by state and federal franchise laws. Registering a franchise often impacts the sale and offer of a franchise, so it is important to know when registration is required. In California, franchisors are required to register before offering and selling franchises. Having to register before offering and selling a franchise can be frustrating for a franchisor because registration can take a long time and be expensive. As a result, franchisors are often stuck waiting for a registration to finalize, when they can be offering and selling their franchise.
Luckily, California has several exemptions from registration. These exemptions can be based on the different types of transactions or can be based on the characteristics of franchisors and potential franchisees. If one of these exemptions apply, then franchisors can avoid the registration process and sell their franchise a lot sooner.
The seasoned franchisor exemption is available to franchisors if they meet certain net worth and experience standards. In California, the net worth standard is $5 million or $1 million if the parent company has a net worth of $5 million. Cal. Corp. Code § 31101(a). Additionally, the experience standard requires franchisors to have 5 years in the business or have at least 25 franchisees in the business. Cal. Corp. Code § 31101(b). For example, McDonald’s does not have to register in most states because it meets the net worth and experience standards.
The sophisticated franchisee exemption is available to franchisors if their potential franchisees are sophisticated enough to protect their own interests. Potential franchisees having at least 50% ownership must have 24 months of experience in the business within the last 7 years. Cal. Corp. Code § 31106(a). Franchisors must not control potential franchisees with at least 50% ownership. Cal. Corp. Code § 31106(a). Also, franchisors must reasonably believe that potential franchisees have the capacity to evaluate risks and protect their interests in the franchise investment. Cal. Corp. Code § 31109(b). However, if leveling the playing field between franchisors and franchisees is required, then it is likely that potential franchisees are not experienced or sophisticated enough.
The large franchisee exemption is like the sophisticated franchisee exemption in that the exemption is available to franchisors when potential franchisees have strong bargaining positions. Potential franchisees, as entities, must have $5 million or more in assets and must not be formed for the purpose of purchasing a franchise. Cal. Corp. Code § 31109(a). Potential franchisees, as natural persons, must have a net worth or joint net worth with a spouse of more than $1 million at the time of purchase. Cal. Corp. Code § 31109(a). Further, potential franchisees must intend to purchase a franchise for the purpose of conducting the business as a franchise. Cal. Corp. Code § 31109(c).
The insider exemption is available to franchisors if potential franchisees are already associated with franchisors. The idea is that “insiders” are knowledgeable about the franchise business, so California is less concerned about sophistication or experience issues. “Insiders” are generally partners, executive officers, directors, or managers. Cal. Corp. Code § 31109(a). Potential franchisees of 50% ownership in a franchise must have been (within 60 days and for at least 24 months) an officer, director, manager, or owner of at least a 25% interest in the franchisor. Cal. Corp. Code § 31106(a). Additionally, potential franchisees must not be controlled by franchisors. Cal. Corp. Code § 31106(a).
Like the sophisticated franchisee exemption, franchisors must reasonably believe that potential franchisees have the capacity to evaluate risks and protect their interests in the franchise investment. Cal. Corp. Code § 31109(b). Like the large franchisee exemption, potential franchisees must intend to purchase a franchise for the purpose of conducting the business as a franchise. Cal. Corp. Code § 31109(c).
The fractional franchise exemption is available to franchisors when a franchise is only a small percentage of the potential franchisee’s business. A “fractional franchise” is meant to allow an existing business to add new, but similar products or services. Cal. Corp. Code § 31108(b). Potential franchisees must have at least 24 months of experience before purchasing a franchise in a “substantially similar” business. Cal. Corp. Code § 31108(a). Additionally, the franchise must be operated from the same location as the potential franchisee’s existing business. Cal. Corp. Code § 31108(c). Franchisors and potential franchisees must anticipate that sales from the franchise will not be more than 20% of the total annual sales of the potential franchisee. Cal. Corp. Code § 31108(d). Lastly, franchisors must not control potential franchisees. Cal. Corp. Code § 31108(e).
The out of state franchise exemption is available to franchisors when a state allows them to sell outside the state to non-residents. Franchisors in California must ensure that sales, leases, or other transactions between potential franchisees and customers are made outside of California. Cal. Corp. Code § 31105. Also, goods or services must be distributed outside of California. Cal. Corp. Code § 31105. For example, fee payments must be made outside of California to qualify for this exemption. Thus, if franchisors receive payment in California, franchisors will not qualify for this exemption, regardless of the location and operations of the franchise.
The exemption by order depends on whether the franchise is within the purpose of its franchise rule and whether the franchise is in the public interest. For example, registration may not be “necessary or appropriate” in the public interest or for the protection of investors. Cal. Corp. Code § 31100.
Again, if an exemption applies, franchisors can skip the registration process. Though these exemptions are specific to California, keep in mind that federal and state exemptions can be very different. Additionally, there are some California exemptions that may impact disclosures, but not registration, and vice versa. Thus, it is important to consider how federal and state exemptions interact with each other when registering, selling, and offering a franchise.