Ten Contract Provisions That a Prospective Franchisee Should Consider Before Signing a Franchise Agreement

by Nexsen Pruet, PLLC
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The saying that “love is blind” is as true in picking a franchise as in finding a soul-mate.  Most prospective franchisees tend to shop franchise concepts instead of franchise agreements.  They focus their search on hot concepts, franchise systems that have a good track record, and franchise opportunities that match their lifestyle. The franchise agreement, which forms the backbone of the franchise relationship, is usually not given the same focus.

While due diligence of the nature of the franchise concept and the strength of the brand is important, so too are the terms that will govern the franchise relationship.  Before entering into a franchise agreement the franchisee should understand the intricacies of how the relationship will work.  In other words, how will the language in the franchise agreement affect how the franchisee operates its business from the time that it first signs the franchise agreement until its exit years down the road? Before signing a franchise agreement the prospective franchisee should become thoroughly familiar with the provisions that will govern this long term relationship.

When reviewing a franchise contract the franchisee should understand that a key aspect of the successful operation of a franchise system is the uniformity that a franchisor seeks to achieve to maintain the integrity of that system.    Because of the need for uniformity, the franchisor is likely not to want to negotiate any provisions of its franchise agreement, especially those that apply to the overall operation of the franchise system, like the management of the advertising program and the administration of the advertising fund.  For many prospective franchisees their due diligence of the franchise agreement stops after reviewing the contractual obligations relating to the payment of the initial franchise fee, royalty and advertising contribution.  Beyond these provisions there are a number of others that deserve a prospective franchisee’s attention. Below is a discussion of material terms to a franchise agreement that a prospective franchisee should consider before it signs a franchise agreement. 

1. Term. While a franchisee may not consider the length of the initial term of the franchise agreement to be material because the agreement may provide for multiple renewal options, the initial term should be viewed in the context of the initial investment that a franchisee will make in its business.  At some point the franchisee will want to realize the financial returns on that investment, which usually occurs upon the sale of that franchised unit.  By measuring the length of the term against the size of the investment and the time necessary to obtain the necessary return on that investment, a franchisee can determine whether the initial term is long enough to realize that return.  While most franchise agreements provide renewal options, the terms of those renewal options may cause the franchisee to alter its business strategy.  Historically, franchisors preferred to grant initial terms of ten or more years.  As franchise concepts have become more varied, this is not always the case. Today, shorter contract terms may be more conducive to address the rapidly changing marketplace.  Franchisees should play close attention to both the length of the initial term and the rights and obligations to be granted and  undertaken upon renewal.    

2. Renewal. Upon renewal of a franchise relationship the franchisee will likely be required to: upgrade its facility at its cost; pay a renewal fee; and sign the franchisor’s, then current, franchise agreement.  That agreement may contain material changes, including, among other provisions, a new royalty structure and a change in the franchisees exclusive territory or the franchisor’s reservation of rights, discussed in paragraph 3 below.

With respect to the renewal fee how much will the franchisee be required to pay to continue in the franchise system? In some cases the franchisor’s renewal fee will be little more than the administrative expense for handling the paper work incident to the renewal. In other cases, the renewal fee could be equal to the then current initial franchise fee. 

With respect to the costs of updating the franchisee’s facility, while it is common for a franchisor to require the franchisee to update its facilities as a condition of renewal, for the franchisee it is important to understand whether the costs of those renovations or updates are capped. While there is no bright line as to what constitutes fair renewal requirements, the franchisee should review these requirements against the initial costs of the franchise system and its expected return over the term of the franchise. 

3. Franchisee’s Exclusive Territory and the Franchisor’s Reservation of Rights. Most franchise agreements grant a franchisee some form of protected market area.  This territorial exclusivity is usually based upon geographic or demographic parameters.  What most franchisees neglect to consider in viewing these exclusive territory provisions is the limitations that can be imposed through a franchisor’s reservation of rights. 

Usually a franchisor will reserve for itself the ability to offer the products and services of a franchise system through different channels of distribution. This means that while a franchisor may grant the franchisee the exclusive right to sell its products and services within a specific territory from a designated location, the exclusivity may not extend to the internet or other less conventional modes of distribution. The franchisee must therefore examine how those rights reserved for the franchisor will impact its business.  While it may be difficult for a fast food franchisor to sell hamburgers over the internet it may not be hard to sell those hamburgers out of grocery stores, which may be located in the franchisee’s trade area.  If the franchisor does reserve this right, are there any corresponding provisions in the franchise agreement that will provide for the sharing of revenues derived from this additional channel of distribution?

The reservation of rights may allow a franchisor to offer similar products and services under a different trademark.  This may happen either by the franchisor starting a new chain, or purchasing another franchise system that sells the same products and services. Consolidation of multiple franchise concepts is common in today’s market.  As an example, at one time the owner of Honey baked Ham purchased the franchise system known as Heavenly Ham, and operated parallel systems.  If this occurs are there provisions in the franchise agreement that require the franchisor either to divest itself of that unit, give the franchisee the first right of refusal for that unit, or require the franchisor to purchase the franchisee’s unit?  Many franchise agreements do not contain such clauses, but it is not out of the question for a franchisor to agree to amend its franchise agreement to provide for such solutions.

4. Advertising contributions and the advertising fund. How advertising programs are managed and advertising funds administered has been a source of conflict between franchisors and franchisees. As the administration of an advertising program will likely affect the entire chain, a franchisor is not likely to modify the program for the benefit of one franchisee.  Therefore, it is important that a franchisee thoroughly understand how the advertising program is managed.  Is the program based on national, regional, or local advertising, or a combination of all three? And how are the advertising funds allocated among these marketing initiatives?  For a franchisee in an established market, national advertising will not be seen as critical to the growth of the brand in that market. Conversely, a franchisee located in an undeveloped market may be much more dependent on national advertising to focus attention on the brand. 

The franchisee needs to understand how much of its advertising contributions will go toward the actual development and placement of the advertising, and what portion of the advertising contribution may be devoted to franchise sales advertising, or the defrayal of the administrative costs of the franchisor in administering the program, including actual costs, and the general overhead of the franchisor related to advertising.  While these uses for an advertising fund are not uncommon, the franchisee needs to understand the allocations before it signs its franchise agreement. 

5. Operations Manual. Most every franchise system will provide its franchisees with an operations manual that is intended to cover many aspects of the franchise system including products and services that may be offered by the franchisee at its franchised business.  The operations manual also may cover the days and hours in which the franchisee will be expected to operate its business.  The franchisor will reserve for itself the ability to change the manual in its discretion. The franchise agreement likely will state that the operations manual is incorporated by reference into the franchise agreement, which means it should be treated as being part of the franchise agreement.  Franchisor’s need to be able to update the system from time-to- time, and changing procedures in the franchise operations manual is the best way to do that.  For the franchisee, certain changes to the operations manual may constitute material changes in the way the franchisee conducts its business. For example, if the franchisor changed the days and hours of operation to 24-7, this could materially change the economics of how a franchise does business.  Some franchise agreements may restrict the franchisor from making changes that affect the fundamental rights of the franchisee.  Where this language does exist the franchisee should ascertain the definition of fundamental rights.

6. Obligations of the franchisor. Many prospective franchisees believe that when they buy into a franchise concept, the franchisor will provide them with all the necessary assistance and training to open and operate their franchised business.  While it is generally true that the franchisor will provide the franchisee with initial training and site selection assistance, there are many of the pre-opening obligations that the franchisee will need to undertake on its own. The franchisor is required to list its obligations in both the Franchise Disclosure Document (“FDD”), in Item 11, and the franchise agreement.  A prospective franchisee should review those obligations and ensure that it has the expertise or can obtain the expertise to undertake the obligations that the franchisor has not agreed to undertake.  For example, it is more than likely that the franchisee will need to retain the services of a real estate attorney to assist it in negotiating its lease or purchasing of the franchised premises.

7. Source of Supply. Most franchise systems will dictate the types and quality of products, equipment, and inventory that the franchisee will be required to purchase.  In some cases the franchisor will require that the franchisee purchase certain items directly from the franchisor or its affiliates.   The prospective franchisee should understand those requirements before it signs onto the franchise system. In addition, item 8 of the FDD will disclose if the franchisor will earn income from the sale of such products, and if so, how much.  These provisions are not uncommon in franchise agreements, but they should be understood before the franchisee signs the franchise agreement.

8. Sale of the franchise. Probably one of the least reviewed provisions of the franchise agreement is the provision regarding resale by the franchisee of its franchised business.  At some point, a franchisee will want to realize a monetary return from its investment.  Accordingly, the franchisee will need to understand the resale requirements that a typical franchisor will impose on the franchisee as part of the resale process.  The four most common requirements are: updating or refurbishing the unit as a condition of resale; the resale fee, which can range from a modest ($2,500) administrative fee to a new initial license fee; the requirement for the incoming franchisee to sign the franchisor’s then current franchise agreement, which may include material differences from the agreement that the franchisee originally signed; and the requirement that the franchisee sign a release, which may not be mutual.  While the franchisor has every right to control who enters the franchise system, and on what terms, it is important for the franchisee to pay attention to these provisions, because they may affect how the franchisee can or should price its unit for resale. If the new franchisee must sign a new franchise agreement that contains a higher royalty rate than paid by the selling franchisee, thus impacting its net revenues, this can impact the price that the franchisee may realize from the sale

9. Termination by the Franchisor. The catalogue of defaults that can lead to termination of the franchised unit is not terribly different from franchise system to franchise system.  In most cases, these termination provisions enable the franchisor to maintain the integrity of its franchise system for the benefit of the franchisor and the other franchisees in the system.  In examining this section of the franchise agreement the franchisee should check to see whether it may terminate the franchise agreement before the end of the stated term, or whether the franchisor may terminate the franchise agreement for no cause.  Termination without cause is rare in franchise agreements, and illegal in certain states that are guided by franchise relationship statutes.  It is important for franchisees to understand the consequences of not complying with the obligations stated in the franchise agreement so they do not suffer any rude shocks as a result of missteps in the franchise relationship.

10. Post Termination Obligations. What happens upon termination of a franchise agreement is an aspect of the franchise agreement that, not surprisingly, receives a great deal of attention by dispute resolution panels.  It is critical for the franchisee coming into a franchise system to understand that upon termination of the franchise agreement, usually for any reason, it will be required to undertake a whole host of obligations, including relinquishing its right to use the franchisor’s name and marks.  In addition, the franchisor likely will have an option to take over the lease for the franchised premises upon termination and purchase the assets of the franchisee’s business, usually exclusive of the goodwill in the business.  The post termination obligations also likely will include a “non-compete covenant,” which is intended to prohibit a franchisee from using the franchisor’s business system to compete with the system.  This period usually extends for one to two years and covers the franchisee’s location and some mileage radius around that location.  It also may cover a fixed distance around other franchisees in the system. While a limited number of states will not enforce post-termination covenants against competition as being a violation of the state’s public policy, most courts will enforce these restrictive covenants as long as they are reasonable as to time and distance. 

Conclusion.  No franchisee should go into a franchise relationship blind. It is important to understand the obligations imposed under the franchise relationship.   Most franchisors are loath to negotiate changes to their contract absent certain extenuating circumstances. Franchisors may be most willing to negotiate changes that are least likely to impact the entire franchise system.    For the franchisee, understanding the terms of the franchise agreement will inject a degree of predictability that should make for a smoother relationship with the franchisor.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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