Franchise agreements - where are the hooks?

Understanding Franchise Agreements

When buying a franchise you will be expected to sign a Franchise Agreement - but what will you be agreeing to? Vanessa Cathie a franchise specialist and consultant at Asco Legal, Auckland, explains...

Franchising can seem like the safe option for budding entrepreneurs. Unlike an independent business, a good franchise offers tried and tested methods, systems for operating and managing the business, ongoing support and training, and a strong existing brand to leverage off.

However, while franchising does offer considerable advantages, it can also contain some pitfalls – traps for the unwary or the careless. The best way to avoid those traps is to identify and deal with any potential pitfalls at the outset. And the best way to do that is to ensure you get the right professional advice before entering into any franchise agreement.

Unfortunately, while this message has got through to many potential franchisees, others are still cavalier in their attitude. Perhaps excitement at the idea of owning their own business is causing them to overlook certain aspects. Perhaps they think they have already spent enough money, and that additional expenditure on a lawyer or an accountant will be wasted. Whatever the reason, those who buy a franchise and sign an agreement without taking formal advice are running a major risk – and risk avoidance is one of the best reasons for entering into a franchise agreement in the first place.

Understanding Franchise Agreements

What Is The Franchise Agreement?

The franchise agreement is the legal contract which sets out the arrangement between the person buying the franchise (the franchisee) and the person selling it (the franchisor). Among other things, it sets out the rights and obligations of both parties, defines the length of time the arrangement will last, stipulates the territory (if any) granted to the franchisee, and details the costs involved and how they are to be calculated. It is the foundation stone of the whole business arrangement, and can be up to 50-60 pages long.

Franchisees need to be aware that while it is relatively simple to enter into a franchise agreement, it is far more difficult to extract yourself from such an agreement. A standard franchise agreement is a long-term obligation to a third party (often of six to ten years in length). The agreement will include strict obligations on a franchisee which have to be complied with for the full length of the term. Failure to comply with these obligations may (in many situations) allow the franchisor to cancel the agreement.

By contrast, most agreements provide the franchisee with minimal, if any, rights to cancel. This point alone is an example of the perceived imbalance of power in many franchisor/franchisee relationships.

Who Does It Protect?
It is generally recognised that any franchise agreement is going to appear one-sided in favour of the franchisor. When looked at on face value, certain provisions may seem entirely unreasonable and outrageous, especially to a franchisee who is investing his or her own funds in the franchise system and therefore has a 'stake' in the business.

For example:
a) the ability for the franchisor to make changes to the operations manuals at any time and require the franchisee to comply at all times with those changes (even though the franchisee will not know what they may be when signing the agreement);

b) on any renewal of the franchise term, the franchisor may insist that the franchisee signs the then current form of franchise agreement (the terms of which obviously will not have been detailed at the time of signing the agreement);

c) the inclusion of very widely drafted cancellation clauses in favour of the franchisor;

d) the ability for the franchisor to determine the application of advertising money invested in the franchise system by the franchisees; and

e) the ability for the franchisor to take over the day to day running of the franchise in the event of poor performance by the franchisee.

The inclusion of these sorts of clauses is perhaps the biggest psychological barrier that any potential franchisee needs to overcome, for it requires them to accept that, although they may have 'bought' a franchise, they do not have total control over that business.

However, strongly-worded franchise agreements are also the saviour of many franchise systems. What is of utmost importance is the strength and consistency of the franchise brand. For example, when you visit McDonalds anywhere in the world you expect the food and the service always to be of the same quality. Customers rely on that. This is one of the major advantages of a franchised business, and applies whether the franchise relates to the sale of hamburgers or gardening services.

Whatever the franchise you purchase, you want to know that your hard work to maintain the brand is not being undermined by the shoddy practices of a fellow franchisee. When each of the above examples is looked at again in some detail, any franchisee should be able to recognise the benefit to them in these type of clauses. It is vital to any franchisee's business that every other franchisee is required to comply with the franchise procedures currently in place as well as those procedures which are being developed and improved over a period of time.

This is the foundation of all well-run franchise systems. New franchisees should not lose sight of the fact that the franchise agreement needs to be strong in order to control not only their practices but the practices of their co-franchisees.

Franchise Agreements Must Be Strong – But Are They Always Fair?
However, this being so, from time to time, franchise agreements can include clauses which are not strictly necessary to protect the system or which may go a little too far in attempting to protect the franchise business. Sometimes an agreement simply does not support the franchisee in the way they might expect.

Examples may include:
a) A Provision that any costs involved in defending the use of the trade mark should be met by the franchisee;

b) Immediate rights for the franchisor to cancel without notice if the franchisee happens to miss or delays payment of royalties;

c) Lack of clauses regarding ongoing support, training and development of the business by the franchisor;

d) Limitation of the franchisor's liability to the franchisee even if the franchisor breaches its obligations to the franchisee;

e) Widely-drafted clauses undermining a franchisee's 'exclusive' territory in unwarranted circumstances.

The frequency of these sorts of clauses will often depend on the drafting skills of the franchisor's lawyer, but any experienced franchise lawyer commissioned by the franchisee will be able to highlight them.

Once identified, where to from here? Many franchisors adopt the stance that they will not entertain any changes whatsoever to the agreement. Often the franchisor will want to have one form of agreement to ensure consistency amongst all its franchisees. There is a commonly held idea that once some amendments are agreed to, the franchisor is opening the floodgates to future franchisees' requests which could quickly become an admin istrative nightmare. In some cases, the franchisor in New Zealand may in fact be a master franchisor, tied in to an overseas form of agreement and unable to make changes to the New Zealand agreements without extensive discussions with the international franchisor. This is often an undesirable and unsuccessful approach.

It is vital, however, that resistance to change the franchise agreement does not cause the franchisee to ignore the need to understand the agreement. Too many franchisees have become disgruntled because they have not taken steps to read and appreciate each provision in their franchise agreement, only to be dealt a nasty shock some months later when they face a franchisor legitimately taking steps to terminate the agreement.

From the franchisee's perspective he or she must enter into any franchise agreement with their eyes wide open and fully aware of the risks that the agreement provides, whether or not they or their lawyer is able to negotiate any changes. For this reason, potential franchisees should see a visit to a franchising lawyer as an investment in the nature of insurance, and as part of the risk management process of setting out in their new business venture.

Buried In Paperwork?
The franchise agreement is the basis of the contractual arrangement entered into by the franchisee and franchisor. However it usually is not as simple as one document. In fact there can be many peripheral documents of which the franchisee should be aware, including disclosure documents, operations manuals and leases.

Many of these documents are not even available to the franchisee's lawyer before the franchisee is required to sign. The franchisee may therefore be under a responsibility to check these provisions out for him or herself. It is vital to be familiar with these ancillary documents as it is standard for franchise agreements to contain a provision that if any one of them is breached, it constitutes a breach of the franchise agreement itself.

What Should The Term Be?
A franchise is generally granted for a finite period of time - in other words, it is a licence for the franchisee to use the trade mark, logo and other 'get-up' for a defined period. The term of the franchise varies greatly between companies and depends on the nature of the system.

The term should be assessed against the capital input that the franchisee is being required to invest. For instance, the bigger the investment, generally the longer the term as this gives the franchisee a greater opportunity to cash in on his or her initial input. It is likely that the costs of setting out on a lawn mowing franchise would be significantly less than, say, a franchised retail outlet which may include substantial fit-out costs. Accordingly, the term of the retail franchise might be longer.

Many franchise agreements include a number of shorter terms rather than one long term. It is important that the franchisee appreciates that more often than not, the 'right of renewal' may in fact be a right in favour of the franchisor. Most people understand that a right of renewal in a lease sense is a right that can be exercised by the tenant at his or her discretion. However, in franchise situations, usually the franchisor has the ultimate ability to veto the renewal if the franchisee has not been performing to a standard which is often not even defined at the outset.

For this reason, franchisors tend to prefer shorter franchise terms with several 'rights of renewal'. This has other advantages for the franchisor - on a renewal, the form of franchise agreement may be updated and in some contracts, the franchisor can request a renewal fee.

Leases & Sub-Leases
Obviously not all franchise systems require the franchisee to lease premises - many franchisees are mobile or work from home. Where third party premises are an issue, franchisors can deal with leases in different ways. The overriding principle for the franchisor is one of control. Some franchisors exercise this control by taking a lease directly from the landlord which they will then sublease to the franchisee. Other franchisors may require the franchisee to take the lease directly from the landlord but ensure a provision is included that if the franchisee breaches its lease obligations, the franchisor can step in and remedy the problem. In either case, the franchisor is ensuring that the premises will operate according to the strict guidelines of the system - again, so as not to bring the franchise into disrepute.

One issue that is often overlooked, however, is the need to ensure the length of the franchise term coincides with the length of the lease term. Many franchisees have found themselves stuck in a 10 year lease only to find that the franchise term only runs for six years. If the franchise term is not renewed, the franchisee then has the responsibility of subleasing or otherwise dealing with its lease obligations for the remainder of the lease term without the right to operate the franchise!

What happens when the franchisee and franchisor part company, either prematurely or at the expiry of the term? Termination provisions should be looked at very carefully as they are often points of contention. There are frequent misunderstandings by franchisees as to what happens at the end of a term. This does, in fact, vary from one franchise system to another - in some cases the franchisee will simply walk away in the same way that a tenant walks away at the end of a lease term. Other franchise systems include mechanisms for paying the franchisee a figure calculated in reference to certain factors.

However, it should also be borne in mind that if the franchise is operating well and the franchise relationship is a good one, then it is likely that both franchisee and franchisor will want to renew the agreement.

Selling The Franchise
As a franchisee, your rights to sell the franchise are limited. The franchisee will probably have to give the franchisor the first right to buy the business, which in itself can undermine the value of that business and the goodwill for a selling franchisee.

If the franchisor chooses not to purchase, the franchisor will strictly control the sale process. The franchisor has invested time and money in choosing the right franchisee and therefore will be insisting that any sale process is subject to stringent checks by the franchisor. Most franchise agreements will include a provision that the incoming purchaser must be approved by the franchisor at the franchisor's sole discretion.

This supports the underlying concept that good franchise systems are based on good relationships. Since the franchisor will be the party having the relationship with the buyer, it is reasonable to allow the franchisor the right to approve that buyer (on this point, most franchisors would agree that when faced with two potential franchisees, one of whom has much experience in the particular trade while the other has no experience but a compatible personality, the franchisor would choose the personality every time).

Most agreements will include a 'transfer fee' which the franchisee will need to pay to the franchisor when a sale takes place. This is intended to cover the franchisor's costs involved in training the incoming franchisee, and should not be an opportunity for the franchisor to make a quick profit on the way through!

What Other Things Should My Lawyer Insist Upon?
So what sort of things should the franchise agreement contain to protect the franchisee?

There are some important considerations that are often overlooked and this list is by no means exhaustive:

a) Back-up assistance and guidance are essential to the operation of a successful franchise. Details of the support and training to be provided by the franchisor need to be recorded in the agreement. This includes both initial and ongoing assistance. As well as having your lawyer peruse the agreement for these provisions, talk to existing franchisees about the level of support they have received.

b) Check out the financial projections very carefully in the agreement and the minimum performance standards. Many franchise agreements include the provision that if a franchisee does not meet the minimum performance standards, the franchisor has the automatic right of termination without notice. It is important the franchisee realises that despite these minimum performance standards, the franchisor is probably not providing any guarantees that those sorts of projections can in fact even be met. The same applies to financial projections which should be treated with a grain of salt. Franchise projections ought to state the assumptions upon which they are based so that a franchisee can distinguish his or her proposed franchise territory from that represented by the projections.

c) Many franchisees are induced into entering into a franchise on the basis of a number of pre-contractual representations as to turnover or otherwise. It is important that franchisees incorporate these provisions into the franchise agreement itself or in some written form.

d) Is the trademark registered? Registration gives exclusive rights to the use of the trademark and will deter unauthorised people from using or abusing the franchise's image. Don't forget that a franchise premium goes some way towards paying for the goodwill of the brand. The last thing that a franchisee needs is to find out, some months after signing, that there is insufficient intellectual property protection - that is, protection of the trade mark, logo, domain name or trade name.

Having outlined some of the issues to watch out for when considering a franchise agreement, hopefully you're still reading and haven't been put off. It is well-recognised that the chance of a franchise business still being up and running after 2 years is far greater than if an operator were to enter into a new business as a sole-trader or single-person company. The statistics show that franchising can and does work very well.

It should be every franchisor and franchisee's aim that any agreement, once signed, will be filed away in the bottom drawer and never formally referred to again. Whatever the black and white contract says can, of course, be tempered as long as the franchisor and franchisee are working well together, supporting the other franchisees and developing the system as a whole.

However, it is well worth investing in having a franchise-savvy lawyer review and comment on the agreement. Unfortunately, too many people mistakenly still see lawyers as deal breakers rather than deal makers and, combined with the threat of legal fees, a franchisee may choose either not to have the agreement reviewed at all, or to take the agreement to a general legal practitioner who in many cases has little practical franchising experience.

The sort of money involved in funding legal costs is minimal compared with the outlay that a franchisee could face if he or she finds themselves on the receiving end of a disenchanted franchisor who could be acting perfectly legally (albeit, in the franchisee's eyes, unreasonably) under the provisions of the franchise agreement.

No one likes nasty surprises six months down the track. However, if your lawyer adequately explains the requirements of the agreement to you at the outset, both parties can then get on with the business of doing whatever it is you want to do! 

Vanessa Cathie - Asco Legal, Auckland

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