Many franchisors are wondering what changes they should make in response to California’s AB-5 that went into effect on January 1, 2020. In a nutshell, we don’t think it makes sense to make any significant changes to a franchise system because the applicability of AB-5 to franchisors isn’t fully determined, and there will likely be changes to this law in 2020.

The purpose of AB-5 is to crack down on companies like Uber and Lyft that treat their employees as independent contractors when they should (according to California) be treated as employees. California wants to be able to collect taxes and unemployment contributions, and they want to be sure employees receive benefits, overtime, and minimum wages.

What does this mean for franchise systems in California? Franchises are not specifically mentioned in the bill, but currently they are also not exempted from it. So, in theory, unless a franchisor can show that its franchisees meet certain conditions, the franchisor would have to treat its California franchisees as employees and pay employment taxes and provide certain benefits. However, the issue is far from settled, and most franchise attorneys agree that making any changes in response to AB-5 now would be premature. Our understanding is California intends to modify the law in 2020, and the author of the law, Lorene Gonzales, recently tweeted, “AB-5 is not intended to interfere with independent businesses.”

The new law assumes anyone compensated for labor or services is an employee. In order to be exempt from this, a hiring entity (potentially a franchisor) must satisfy all three parts of the AB-5 test:

(1) Show that the person is free from the control and direction of the hiring entity, on paper and in practice. This is similar to the joint-employer concerns that have been on the radar for several years already. Most franchisors can overcome this requirement through use of targeted language in the FDD, franchise agreement, operations manual, and standard operating procedures;

(2) Show that the person performs work that is outside the usual course of the hiring entity’s business. This part of the test could be more difficult for a franchisor to overcome, especially if there are company-owned outlets or the franchisor advertises that the “company” (by use of general references to the system name) provides certain services; and

(3) Show that the person customarily operates independently through a business, occupation, or trade that is the same nature as the work performed. Franchisors would need to show that their franchisees are customarily involved in the same industry (for example, a plumber who purchases a plumbing franchise).

Another factor that may help a franchisor steer clear of AB-5 is to avoid using any structure that makes franchisees look like employees. We recommend you:

  • Ensure franchisees use a business entity to operate the franchise;

  • Require franchisees to hire employees to avoid a situation where a franchisee is the sole employee of the franchise; and

  • Avoid any structure that could be interpreted as a system where a payment is made from the franchisor to franchisees for services performed.

Every franchise system is unique, and it would take a case-by-case evaluation to judge whether a system’s franchisees could fall within the scope of the law. For the time being, we expect there to be changes to the law in 2020, and there are ongoing lobbying efforts to revise the bill’s definition of “employer” or include a statutory exemption for franchises.

Update: On November 16, 2020, the International Franchise Association (IFA) and others filed a lawsuit against California to stop the state from enforcing AB-5 against franchises.  They argue the law “fails to take into account the basis of our basic business model.”  This case is currently pending in federal court in the Southern District of California.

Also, several ride-share and food delivery companies, including Uber, Lyft, and DoorDash scored a win on election day when Proposition 22 passed, allowing them to continue treating employees as independent contractors.  Ironically, this means the very companies that were the target of AB-5 are now essentially exempt from the law.  Unfortunately for the franchise industry, franchises are still potentially subject to the law and will have to wait for the litigation to play out to get more clarity.

Our team will keep researching this issue as it unfolds. If you want to talk to a franchise attorney about these issues, please contact us.