Written by Garth Snider on October 22nd, 2010
There has been a lot of ink spilled recently about the plight of the small businessman in the recession. In particular, there has been a great deal of discussion as to whether franchising as a business model has done relatively better or relatively worse than non-franchised businesses.
There is no definitive answer. If the answer is that franchises have done relatively worse why might that be the case? There are myriad answers from excess liquidity in the capital markets to the simple fact that franchising did so well over the past two decades that it was only natural that it would experience a temporary set-back.
Another possible reason, and the subject of this essay, may be that by its very nature franchising has a greater inherent risk profile due to the fact that franchising necessarily entails the transmission and transference of trade secrets and confidential. Consequently, the more popular a franchise becomes the more difficult it is to maintain its trade secrets and confidential information.
This, in turn, impacts the long term economic health of the franchise. A franchisor therefore makes a bet that it can parlay its franchise system into a profitable venture without losing the value it already has staked in its trade secrets.
So to the extent that the growth of a franchise system impacts the ability of the franchisor to carefully monitor its trade secrets, the financial health of the franchise will be affected. The growth of franchising has not been driven by thousands of uniquely derived and/or recently invented products. The growth of franchising, and the ensuing fragmentation of many markets within franchising, is a direct result of former trade secrets and confidential information being disseminated in the market place.
Unlike patents, which carry a protectable interest of 20 years, trade secrets are protectable for an indefinite period of time. Realistically speaking, however, trade secrets do not usually provide indefinite value to the franchisor. The more popular the franchise becomes the more likely it is that someone in the future will either receive trade secret information or will reverse engineer the trade secret. Thus the problem obtains in the ability of the franchisor to protect the trade secret long enough such that the franchise itself has enough brand loyalty to compensate for any dissemination of information that may have formerly been classified as trade secrets.
Much, if not all, of the value in a franchise is contained in the unique manner in which the franchise is sold and the unique nature of the product itself i.e., its trade secrets. The ability of the franchisor to sell franchise units is a direct function of a prospective franchisees belief that the franchisor has created a product and a product distribution system that cannot be easily replicable. The value of the franchise is necessarily derivative of how easily a non-franchisee (or ex-franchisee) can replicate the franchisors’ offering. A franchisors “gold” lies in its trade secrets. A franchisor derives value from its franchise system because its unique system is not generally known by the public. Therefore a franchisor must be diligent in preventing the unique means and methods it has of conducting business from being readily known by the public.
What is a trade secret exactly? The Uniform Trade Secrets Act which has been adopted in some form or fashion by more than 40 states– defines trade secrets as
Information, including a formula, pattern, compilation, program, device, method, technique or process that: i) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and ii) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.
The Restatement of Torts identifies six useful factors to consider in determining whether something is a trade secret:
1) The extent to which the information is known outside of the business,
2) The extent to which it is known by the employees and others involved in the business,
3) The extent of measures taken to guard the secrecy of the information,
4) The value of the information to the business and to competitors,
5) The amount of effort or money expended in developing the information, and
6) The ease or difficulty with which the information could be properly acquired or duplicated by others.
The fundamental function of contract law is to deter contracting parties from behaving opportunistically toward one another in order to encourage the optimal timing of economic activity and obviate costly self-protective measures. It is an ineluctable fact of human nature that during times of difficult economic circumstances people are more prone to exhibit behavior that pushes the envelope on what society considers fair business practices. People are more inclined to put to the test exactly what is considered legal and/or acceptable when it comes to business dealings. This is evidenced by the rise of litigation on contractual disputes over the past two years. Some of these disputes are a function of one party simply not being able to adhere to its side of the bargain. But more than a few are likely the function of one party testing the limits of the terms of the contract. Stated differently, one party to the contract behaves in an opportunistic manner.
With fewer real dollars being exchanged in the marketplace, the competition to achieve relative wealth in our society is magnified. Thus a party to a contract who during better economic times might have not been inclined to behave opportunistically might during leaner economic periods test the limits of what is permitted under the contract. Because the licensing of trade secrets is so often the prime repository of the value of the franchise, understanding what a trade secret is and how to protect it is of particular importance in franchising.
By definition, a franchisor allows an erstwhile stranger to license, distribute and sometimes produce the very product that the franchisor created and upon which it relies to generate revenue. Given the nature of the franchisor/franchisee relationship franchisors need to be acutely aware of the opportunities for harm that inhere in the franchisor /franchisee relationship. During the best of times, the franchisor/franchisee relationship is balancing act of mutual self-interest. During times of economic uncertainty, the franchisee may find itself struggling to keep its business afloat. Or maybe worse even, as the franchisee finds itself as Bruce Springsteen put it – with debts that no honest man can pay. Through no particular fault the franchisee may be faced with financial difficulties; difficulties that the franchisee may think could be alleviated extra-contractually or opportunistically. And so an opportunistic franchisee may seize upon the chance to exploit loop holes in a franchise agreement. The opportunities for harm most often manifest themselves in the dissemination of trade secrets and confidential information.
A franchisor must therefore be extremely diligent in its protection of its trade secret information. It starts and ends with the franchisor being certain that it has done all it can do to keep the trade secret information confidential. As an initial matter, only employees who need to know the trade secret information should be allowed to learn of the exact nature of the trade secrets. Second, the franchisors employees and officers should sign confidentiality agreement acknowledging the confidentiality of the trade secrets and expressly prohibiting the dissemination of said information.
The next step is to clearly identify the trade secrets in the franchise agreement. The agreement must make clear that the trade secrets are being licensed and not sold. The franchise agreement should also require the franchisee’s to have its employees sign confidentiality agreements similar to the one’s the franchisor. The franchisee should be required to take reasonable steps to preserve the confidentiality of the trade secret information.
It is also a good idea to have a compliance officer monitor the use of the trade secret information. The compliance officer would be in charge of conducting audits of the franchisees. A concomitant obligation of the franchisees would be to provide compliance reports to the compliance officer which demonstrate that the necessary precautions are being taken to protect the trade secret information. If it is discovered that trade secret information has been misappropriated, a franchisor is going to need to prove inter alia that has taken reasonable steps to protect the secrecy of the information. Adhering to the aforementioned recommendations will ensure the franchisor a better position in the fight.
The popularity of franchising as a method of doing business will inevitably have its peaks and its valleys. Its robust popularity will come back. But the very thing that makes it effective as a means of doing business is the very thing that makes it risky. The higher the risk, however, means the greater the return. And so it is that the more popular the franchise becomes the more chances it has of falling prey to an opportunistic franchisee–the more chances it has of having its trade secret information lost. But every new idea one day will die and that’s a fact. It is therefore important for the franchisor to protect its trade secret long enough to build up its brand such that the death of the trade secret merely gives rise to the birth of a household brand with no need for recourse to the court.