Periodically, we see significant trade secrets issues arising in the franchise context. As counsel, we regularly advise clients on these issues. Given the significance of trade secrets in the franchise organization, we thought it might be helpful to get the perspective of the President of Franchise Opportunities Network, W.C. Garth Snider, on the role of trade secrets in the franchise operation. Franchise Opportunities Network, www.franchiseopportunitiesnetwork.com, connects domestic and international franchisors and potential franchisees through Internet-based (online) websites (counting over 20 in number), including www.franchiseopportunities.com and www.smallbusinessopportunity.com. Snider also is a regular author of blog postings related to franchising, such as www.franchisinglaw.com, www.franchiseopportunitiesnetwork.com/category/blog, and http://www.franchiseopportunities.com/blogs/
The first question that I posed to Snider was how important does he think trade secrets are in the franchise arena. In a nutshell, he responded, “Very.” As he pointed out, a franchise is based on the principle of using a specialized system to sell products. A franchise’s “success is derivative of the ability of the franchisor (1) to protect the method and manner by which it distributes its product and (2) the uniqueness of the product itself. So, to the extent that there is a formula, pattern, device, or compilation of information that it can take advantage of that are not readily accessible to its competitors, that is very valuable.” Snider noted that the heart of any good franchise is its goodwill, and in turn, that goodwill is based on the trade secrets behind the products it takes to market.
Typical types of trade secrets found in franchises depend on the type of business, but can vary from Kentucky Fried Chicken’s original recipe or the chemical formula behind a successful carpet cleaning company to business methods and plans for tax preparation companies. And, depending on how well protected the information is, trade secrets in the franchise context can include supplier lists, pricing data, algorithmic formulas for data and software, and customer lists.
Snider opined that protection for these trade secrets begins first and foremost with the franchise agreement. The agreement should define very clearly what is considered a trade secret or other confidential information and how that information should be handled. He recommends that “nothing be left to chance” when it comes to crafting adequate protections in an agreement. For example, he recommends including language in the agreement that makes it plain that the trade secrets are being licensed and not sold. Moreover, he suggests including a ban on reverse-engineering in the agreement itself, requiring the franchisee to ensure that its personnel receive frequent reminders regarding confidentiality, and that the franchisee require its personnel to execute appropriate confidentiality agreements. Finally, he suggests that repeated reminders be included in operation manuals; education of employees regarding the importance of guarding the secrets can be crucial to preventing negligent disclosure.
One recommendation that Snider makes is for the franchisor to have a compliance officer who monitors the use of the trade secrets and the proper implementation of restrictions on the use of the trade secret information. Snider suggests that the compliance officer be charged with conducting audits and monitoring reports from franchisees. Indeed, he suggests that the franchisees self-audit and report to the compliance officer as well. By creating a closed loop on all of the protections in place, the company is more secure and, if something unforeseen happens, also in a good position to protect its trade secrets in litigation.
A tricky question that comes up when we talk about trade secrets and franchises is valuation of the franchise based on the trade secrets. Snider did not have a magic formula (trade secret or otherwise) for how best for a franchisee or franchisor to value the trade secrets, but offered a rule of thumb: the more easily replicated the trade secret, the less valuable it is. According to Snider, it is a sliding scale; if the trade secret can be reverse engineered with relatively minimal expenditure of time and resources (while still qualifying as a trade secret), the less value a franchisee may place on it. As an additional layer, value is added by brand recognition. The Kentucky Fried Chicken brand is more valuable than Joe’s Fried Chicken because it is well-known -- even if the chicken is comparable. Customer lists also are difficult to value, but not impossible. The key there is to make sure that the list is protected as a secret and not widely distributed.
As domestic franchisors expand abroad, Snider had one firm recommendation - know a local lawyer. “Franchising is its own discipline in every country,” Snider said. “Spend the time and money to get it right the first time.” [Note - protections that may work to protect trade secrets in the United States may not work in some foreign countries, particularly Europe, where employee workplace privacy protections are strong; monitoring of employee activities in workplace such as e-mail and physical surveillance are different.] As for international franchisors moving into the U.S., particularly from the Gulf states, India, and Australia, we agreed that franchisors beginning business here should take all the same steps to protect their trade secrets as a domestic franchisor would.
In sum, Snider agreed, franchisors and franchisees have much to be concerned about when it comes to trade secrets and much to protect. Actively monitoring and managing these assets is critical to a successful enterprise.