Understanding The Franchise Agreement

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This article appeared in Issue 1#1 (Nov/Dec 2006)

of Business Franchise Australia & New Zealand

By Philip Colman, Partner, Mason Sier Turnbull

When you buy a franchise, you will no doubt have to sign a franchise agreement. Franchise agreements vary in size, some as short as 10 pages, others exceeding 100 pages. Either way, it is critical that a prospective franchisee fully understands all of the terms of the franchise agreement and the workings of the franchise system.

The franchise agreement is the fundamental document governing the relationship between franchisor and franchisee. It sets out the rights and obligations of both parties. Often it will incorporate by reference other documents such as procedures manuals and it is important that the prospective franchisee understands those documents as well.

Review of Franchise Agreement

It is prudent for all prospective franchisees to have the franchise agreement and any other related documents reviewed by a lawyer who has experience in advising prospective franchisees. The Franchising Code of Conduct requires franchisors to, at the very least, recommend this course of action to franchisees. Some franchisors will not approve franchisees unless they obtain such advice. The cost will vary from lawyer to lawyer but a “ball park” cost for reviewing and advising on a franchise agreement is about $2,000.00.

What is a Franchise?

Many clients who I have seen do not initially understand what a franchise is.

It is not a business - rather it is merely the right to conduct a business using someone else’s trademarks, brands, systems and other intellectual property for a limited term (not indefinitely) and, in some cases, within a territory.

The franchisor does not own the franchised business and its tangible assets - the franchisee does.

What happens when the Franchise ends?

When the term of the agreement comes to an end, the right to conduct the business under the franchisor’s trademarks, brands, systems and other intellectual property is lost without any right to compensation. Often, all that a franchisee is left with is a bundle of second hand plant and equipment.

Further, in most franchise systems, the franchisee cannot even continue to operated a “de-branded” business whether from the same premises or nearby premises. This is because most franchise agreements:

1.   Are structured in a way whereby the franchisor “controls” the site, by either being the franchisee’s landlord or by securing a commitment from a third party landlord the right to have any lease transferred to the franchisor, once the franchise agreement comes to an end; and

2.   Contain restraints prohibiting an ex franchisee from conducting a similar business for a period of time within a certain territory.

Worse still, some franchise agreements give the franchisor the right to buy the franchisee’s plant and equipment at written down value on expiration of the term - this value may be less than the true value.

Therefore, the first thing I want my clients to understand is that their capital investment in the franchised business will, on the whole, evaporate at the end of the term and that it is unrealistic to expect that any capital gains will be earned from operating a franchised business, unless it can be sold at a gain well before the end of the term.

One Sided Agreement

Prospective franchisees also need to understand and, ultimately accept, that the franchise agreement will substantially favour the franchisor. This is because the franchisor needs controls and flexibilities to protect its brands and systems. The need for this, in theory, is to benefit the whole of the franchise system, including the franchisees in the network.

Hence there are often many terms in franchise agreements which may ultimately allow the franchisor to alter the franchise system to something quite different to that initially represented. Franchisees must be aware of the risk associated with these types of flexibilities before they make their decision to proceed.

Franchisee Obligations

Most franchise agreements spell out the franchisee’s obligations in great detail (often over many pages).

Financial obligations may include:

•   The obligation to pay the initial franchise fee;

•   The obligation to pay a periodic royalty (which may be fixed or a percentage of sales or profit);

•   The obligation to pay contributions into an advertising fund;

•   The obligation to pay a fee to the franchisor when the franchisee sells the franchised business;

•   The obligation to pay the franchisor’s legal costs and any assessable stamp duty; and

•   The obligation to pay for stock and other purchases.

Operational obligations may include:

•   The obligation to wear appropriate uniforms;

•   The obligation to fit-out business premises or a motor vehicle in a particular way.

•   The obligation to have properly trained staff;

•   The obligation to properly maintain and keep clean business premises or a motor vehicle; and

•   The obligation to provide excellent customer service.

Franchisor Obligations

Most franchise agreements, when spelling out the franchisor’s obligations, leave a great deal of discretion to the franchisor. Clauses such as “the franchisor will, if it thinks it appropriate” do such and such, are not uncommon.

The primary obligation of the franchisor must be to provide the intellectual property and the components of the franchise system - the latter is often done via an Operations or Procedures Manual (“the Manual”).

The Manual is a moving document, which franchisors will often amend from time to time to suit their operational needs. As franchisees promise to operate the business in accordance with the Manual, they too, need to recognise that they may need to be flexible to the franchisor’s needs and desires as reflected in amendments to the Manual.

Sale of Franchised Business

Franchisees must also be aware that when they sign a franchise agreement they are promising to operate the franchised business for the term of the agreement and that, if they want to dispose of the business mid-term, via a sale, the franchisor may impose conditions. The Franchising Code of Conduct prohibits franchisors unreasonably refusing to accept a prospective purchaser, but makes it clear that a franchisor may reject a purchaser where:

•   the franchisor believes the prospective purchaser may not be able to meet the financial obligations under the franchise agreement (this could be caused by the purchaser borrowing too much to buy the business);

•   the franchisor believes the prospective purchaser does not meet its selection criteria;

•   the selling franchisee is in breach of the franchise agreement; or

•   the purchaser is unwilling to sign the franchisor’s then current franchise agreement.

As to this last point, franchisees must be aware that, as a franchisor develops its own business, it will often amend its standard franchise agreement, sometimes by imposing more onerous terms. Therefore, when the time comes to sell the franchised business, the franchisee must make it clear to a prospective purchaser that a new and possibly different form of agreement might have to be signed.

Termination

It is rare that franchise agreements spell out a right for a franchisee to bring the franchise agreement to an end (except for the 7 day cooling off period required under the Franchising Code of Conduct).

On the other hand, the right of the franchisor to terminate the agreement is most often spelt out in detail. Apart from certain prescribed matters, a franchisor cannot terminate a franchise agreement unless a franchisee has failed to remedy a breach after having been given reasonable notice to do so.

Conclusion

Despite the warnings above, prospective franchisees should not approach a possible franchised business with a degree of negativity. However they must remember that the franchise agreement is a complex legal contract and full understanding of its terms is critical before signing and parting with money.