Subfranchising is one of three multi-unit franchise structures that the North American Securities Administrators Association, Inc. (NASAA) addressed in their Multi-Unit Commentary, which was the subject of an earlier post. The other two types of multi-unit franchise offerings discussed in that post are area development and area representative.
Of the three multi-unit approaches, the subfranchise is by far the least commonly used in the U.S. And with good reason.
In subfranchising, the franchisor appoints a master franchisee who has the right and obligation to sell subfranchises within a defined territory. The agreement between the franchisor and the master franchisee is called a master franchise agreement.
Subfranchising is common in international franchising, as when a U.S. franchisor expands its franchise system abroad. The U.S. franchisor grants master franchise rights to a company in the destination country, and that company grants subfranchises to unit franchisees in the destination country. The master franchisee in the destination country is typically a native speaker of the language who knows the local culture and market. The transaction is tailored to meet the legal requirements of the destination county. The master franchise agreement is usually a highly negotiated agreement between sophisticated businesses. The subfranchise agreements are in the local language and payments are made in the local currency.
One reason subfranchising is rare in the U.S. is that both the franchisor and the subfranchisor (or master franchisee) are responsible for each other’s compliance with the franchise disclosure requirements. As stated in the Compliance Guide to the Federal Trade Commission’s trade regulation rule on franchising, “The franchisor and subfranchisor bear a joint responsibility under the Rule to ensure that required disclosures are made and are accurate.”
Because the subfranchise is a joint offering, the franchise disclosure document (“FDD”) that the subfranchisor uses when it sells unit franchises in the U.S. must contain disclosures regarding both the franchisor and the subfranchisor, including audited financial statements of both companies. Subfranchising can also lead to quality control problems with subfranchisees because the franchisor may not have a direct contractual relationship with the subfranchisees and is typically far less involved with subfranchisees.
These factors pose risks and obstacles that most franchise companies want to avoid. Of course, there are exceptions. The business coaching franchise system from Australia called ActionCoach, for example, subfranchises in the U.S. Other foreign franchise companies entering the U.S. commonly avoid subfranchising by forming a single wholly-owned U.S. subsidiary to be the sole franchisor throughout the U.S.
The NASAA Multi-Unit Commentary requires the subfranchise FDD to be separate from the unit franchise FDD. But any company that might employ this approach would surely want to use separate FDDs for the master franchise offering and the subfranchise or unit franchise offering and is likely doing so already. The mandate to have separate disclosure documents will probably not require any franchisor to modify its FDD format.