States need to understand how cannabis regulations impact the use of the franchise model

As states decriminalize cannabis, the regulations they establish and enact shape the industry’s market through both intended and unintended consequences. Critically, few state policymakers appear to consider how their regulations – such as regulations on out-of-state investment in cannabis retailers– impact brands’ ability to use the franchise model for growth and uniformity. States should consult franchise experts to understand how their regulations will foster, or impede, the ability of cannabis brands to use the franchise model, so that they can make informed decisions regarding that impact.

The benefits of cannabis franchising: States should want to encourage franchising in cannabis. Under the franchise model, experienced operators train franchisees in how to effectively operate their retail locations. By joining a franchise network, franchisees are committing to follow an established system. These characteristics would be particularly valuable in the cannabis industry – a regulated industry looking to establish legitimacy and demonstrate the ability to offer consumers consistent, quality products and services. Franchising can also be a stabilizing model in developing markets in jurisdictions where decriminalization has recently occurred.

In Canada, where the cannabis industry is ahead of the U.S. market thanks to federal decriminalization in 2018, the franchise model has proven to be advantageous. Some of Canada’s largest cannabis retailers operate using the franchise model. There is also anecdotal evidence to suggest that franchised cannabis retailers are faring better than unaffiliated retailers, as market oversaturation in provinces such as Ontario has caused the number of retailers to decrease.

Over the last 60 years, franchising as developed into a successful growth model for a wide variety of retail industries. So, it seems inevitable that some cannabis retail brands will look to the franchise model to expand their brand presence in markets – and their brand recognition among consumers.

In the U.S., state policy makers seem unaware of how initial cannabis retail regulations impact franchising, and, as a result, have implemented regulations that create challenges for would-be franchisors. The result may be that states inadvertently and artificially limit the cannabis industry’s ability to utilize a proven growth model that is enjoyed by most other retail industries.

Many of the hurdles facing the cannabis industry will impact franchised, and non-franchised, brands in similar ways. These hurdles include the prohibition on retailers using standard business deductions on their federal taxes, a lack of access to standard payment processing services, being shut out from major banking institutions, and, of course, the ever-looming threat of federal enforcement actions. However, some common state regulations, such as the three listed below, can have an outsized impact on a brand’s ability to use the franchise model for its expansion, but do not appear to intend to limit franchising.

Limitations on out-of-state investment: Under the franchise model, franchisees make the financial investment necessary to build an outlet that operates under the franchisor’s brand. In exchange, under most models, the franchisee keeps the majority of the outlet’s revenue, and pays the franchisor an initial franchise fee, and ongoing fees calculated as percentages of gross sales. Even though cannabis franchise systems would be expected to use this same basic model, the breadth of some state regulations prohibiting out-of-state investment in cannabis retailers may prevent agreements with out-of-state franchisors, or franchisors that are owned by residents of other states. Such regulations can be drafted to clarify that they do not seek to prohibit cannabis retailers from entering into franchising relationships that would allow local retailers to benefit from the knowledge, experience, and proven operational systems that a franchised brand would offer.

Residency requirements and restrictions on license transfers: States understandably see value in having local residents operate their cannabis retailers and take advantage of the market opportunities created by decriminalization. In other retail industries, the franchise model enables local entrepreneurs to open and operate a brand’s outlet in their community, delivering the brand’s product to local consumers, and benefiting from the brand’s operating system, advertising and promotional efforts, and purchasing power. Franchising can create similar opportunities for local entrepreneurs in communities that are creating new markets for cannabis.

However, these restrictions can also undermine the terms used in franchise agreements to protect the franchise brand and goodwill enjoyed by franchisees. For example, if the individual owner of a franchised outlet dies, or becomes incapacitated, residency requirements can interfere with the brand’s ability to step and take over ownership of the outlet while a new, local franchisee is identified to purchase the outlet. Residency restrictions can also limit a franchisor’s ability to terminate a noncompliant franchisee. Franchisors must retain the right to terminate a franchise agreement if the franchisee is not following brand standards or, say, complying with local health and safety laws. While terminations can be sources of disputes between the target franchisee and the franchisor, most franchisees want their franchisor to have the ability to exit noncompliant franchisees from the network so that they do not negatively impact the goodwill of the brand.

If residency requirements prohibit the franchisor from taking over the operations of an outlet following a termination, the franchisor may face the Hobson’s choice of either terminating a noncompliant franchisee, and losing the outlet’s presence in the market, or allowing a noncompliant franchisee to place the brand at risk through noncompliance and offering an inconsistent, or negative customer experience.

Regulations prohibiting the transfer of the local or state licenses required to operate a cannabis retail outlet can have similar impacts.

This brand inconsistency can be avoided if policy makers craft residency and licensure requirements that preserve opportunities for local citizens, while allowing franchisors to protect the brand and the outlet if needed. However, policymakers need to understand the basics of the franchise model so that they can create regulations that achieve their policy goals – protecting the local market and retaining control of who is operating within that market – while still giving local operators the opportunity to associate with brands using the franchise model to promote their brand in multiple markets.

Conclusion: Franchise experts should engage policymakers in states that are considering decriminalization to help educate them on the franchise model, and work with them to craft regulations that provide necessary protections while not inadvertently impeding brands that want to use the franchise model. Policymakers in states that have already decriminalized cannabis should work with franchise experts to understand how their regulations can be revised, or interpreted, to not interfere with efforts to utilize the franchise model.

Consumers, and the market, should decide whether brands using the franchise model will succeed. However, states with policymakers who do not account for the franchise model in their regulations may be inadvertently, and unnecessarily, restricting the ability of their local brands and operators to experiment with whether this common retail model – one based on uniformity, consistency and compliance – can help create stability and success in their local cannabis markets.

Paul Woody Franchise Attorney with Greensfelder, is an experienced business attorney and litigator with deep knowledge of the compliance and business concerns that affect franchisors of all types. He works with franchisors in a variety of industries to help ensure their compliance with federal and state laws and proactively avoid disputes.