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By Nina L. Kaufman, Esq.
What is the difference between Ralph Lauren and Jenny Craig? Yes, one is a clothing and accessories line, and the other centers on nutrition and weight loss. But, more importantly, Ralph Lauren diversified its income stream by using licenses; Jenny Craig did so through franchises. With proper planning, small businesses can use licenses and franchises to increase their income, too.
Let’s look at an entrepreneur we’ll call “Denise.” She owns Denise’s Den, a trendy Dallas steak restaurant. She has neither the time nor the money to open another restaurant or to ramp up a separate product line. But, another entrepreneur, “Diane,” is interested in starting her own food-related business. Her enterprise could involve selling Denise’s private label steak sauce/vegetable dip (“Devil’s Dip”), or opening a Denise’s Den restaurant itself, either of which would provide Denise with a new income stream.
So, how can Denise protect herself and still earn good money from this opportunity?
Licensing Devil’s Dip
One option is for Denise to license Devil’s Dip to Diane. Essentially, a license is the revocable “permission” to do something. Think of a driver’s license: If you pay the fee and follow the “rules of the road” (the traffic laws), you can maintain your license. If you drive unsafely, your license can be revoked.
In a license arrangement, Denise will set out the rules that she wants Diane to follow. If Diane violates the terms, Denise will revoke the license. Their agreement will address a wide range of issues including:
• which names/trademarks (e.g., Denise’s Den and Devil’s Dip, and the Devil’s Dip recipe) the license covers, plus whether Diane may use the name with unrelated items, such as t-shirts;
• quality standards for Devil’s Dip;
• length of time the license is in effect;
• geographic “territory” within which Diane may sell Devil’s Dip;
• minimum fees or royalties that Diane must pay; and
• how Denise and Diane will conclude their relationship when the license ends, whether naturally or because of a default.
Note, however, what Denise does not do. She does not dictate to Diane how to run a Devil’s Dip manufacturing business. Denise does not specify where and how Diane must advertise. She does not tell Diane how to dress or train her employees. Denise does not procure the supply channels for food ingredients. Plus, Devil’s Dip is only a small part of the overall Denise’s Den business model. (This is an important distinction between a license and a franchise.)
Franchising Denise’s Den
Alternatively, Denise could grant Diane a franchise to open a Denise’s Den restaurant.
A franchise is the right that a trademark owner grants to another to engage in business using her trademark. According to federal law — and many state laws — there are three elements to a franchise: 1) paying a fee; 2) using a trademark or trade name; and 3) “substantial” assistance in replicating the original business model. “Substantial” assistance can include marketing plans, systems, operations manuals, business methodologies, and/or actual requirements for running the business. In essence, with a franchise, Denise controls how Diane will run the restaurant, because Diane will be emulating the entire Denise’s Den model, not just the one Devil’s Dip piece of it.
Unlike licenses, franchises are stringently regulated.
Most franchises need to be registered with the Federal Trade Commission and/or state regulatory authorities in the locations in which the franchise is being established. Denise must also provide Diane with franchise documents (referred to as a “franchise offering circular”) that fully disclose the advertising, offering, licensing, contracting, and/or promotion that Denise will expect — even before actually granting the franchise to Diane. Failure to do this carries potentially severe civil and criminal penalties.
As with a license, Denise’s franchise agreement with Diane will clearly set out the minimum fees that Diane needs to pay, as well as the trademarks that are covered. However, because of the controls exerted, a franchise offering circular must disclose a comprehensive description of the franchise. The details would reveal, among other items:
• the business background of the directors and managers of Denise’s Den;
• lawsuits involving Denise’s Den;
• whether Denise’s Den or its owners have filed for bankruptcy protection;
• audited financial statements and estimates of Diane’s total financial investment;
• supply arrangements and restrictions;
• whether Denise’s Den will provide any financing to help Diane with the franchise; and
• other “substantial assistance” or training that Denise’s Den’s will provide to Diane.
When Licenses Cross the Franchise Line
Unfortunately, the distinction between a license and a franchise can be murky, especially in states like New York that have very broad definitions of what constitutes a franchise and what is included in its reach.
In both the license and franchise situations, Diane would use a trademark or trade name within certain prescribed circumstances. In both cases, Diane pays a fee (or royalty).
The slippery slope from license to franchise seems to turn on what the trademark owner (Denise) really has in mind. The more Denise wants to replicate each and every aspect of Denise’s Den, the closer she comes to establishing a franchise. Therefore, Denise would need to carefully determine how much of the Denise’s Den methodology she really wants to provide.
Licensing the right to manufacture and sell Devil’s Dip to Diane alone may lack the “substantial assistance” component of franchises. But if, over time, Denise licenses her preparation style, then décor items, and then, employee uniforms, Denise may unwittingly create a Denise’s Den franchise.
Because small business owners can cross “the franchise line” without realizing it, they should not establish these kinds of relationships without the help of an attorney well versed in this area.
Conclusion
Denise has other options, such as growing her business with investors or establishing other Denise’s Den locations herself, rather than providing her methods and model to others. Nonetheless, licensing and franchising could provide Denise with a new income stream for relatively little ongoing work on her part. The route she takes will depend upon her financial goals.
NINA L. KAUFMAN, Esq., is a founding partner of the award-winning Paltrowitz & Kaufman LLP (www.palkauf.com), a New York City law firm providing wise counsel for growing businesses® on many of their transaction and litigation needs. Kaufman also is president of Wise Counsel Press LLC (www.WiseCounselPress.com), which sells booklet guides on legal issues for small businesses. She can be contacted at 212-808-7210 (e-mail: nkauf@palkauf.com). This column is for your general information only and is not meant to substitute for legal or accounting advice regarding your specific situation.
(This article is reprinted from the Winter 2005 edition of Enterprising Women magazine. Copyright 2005 Enterprising Women Inc. Reproduction in whole or part is prohibited, except by express permission of the publisher.)
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