Many franchise networks promote that their networks offer franchisees “designated or exclusive territories”.
An unsuspecting prospective franchisee who has their heart and mind set on being their own boss and buying a franchise may neglect to fully appreciate the difference between an exclusive and non-exclusive territory and that the existence of a territory does not necessarily provide the degree of competitive protection that they were hoping for.
In this article we explore the different types of franchise territory provisions contained in franchise agreements.
It is quite common to see franchise agreements where the franchisor agrees not to establish a competing business or allow another franchisee to establish a competing business within a defined territory.
This is often a good selling point for a franchisor because a franchisee will be attracted by the fact that he or she will have the franchise brand to themselves within their territory.
It is important to note that this does not necessarily mean that the franchisee will have no competition! I do not know of any franchise network that has no competitors and, whilst a franchisor may promise not to compete with a franchisee within its territory or allow another franchisee to do so, the franchisor cannot prevent a competitive brand opening business nearby, even next door! This is a normal risk that every business owner must assume.
National franchisors with some clout with shopping centre landlords may be able to negotiate a restraint that prevents a landlord from granting leases of nearby premises to competitive brands, but this is rare.
Whilst it is common to see franchise agreements containing exclusive territories, it is equally common to see these territories narrowly defined. For example, in a retailing context, the territory might be limited to a strip retail shopping precinct or a particular section or level of a shopping centre.
Some franchise agreements limit the territory to the site at which the franchised business is located. Whilst there is nothing legally wrong with these types of agreements, they can easily mislead an unwary franchisee.
Generally, a franchisor will not want to limit its opportunity to sell franchises by making territories too large. Despite this, some franchisors are happy to do so, but protect themselves with provisions allowing them to split or reduce the territory if the franchisee is not meeting pre-determined performance criteria.
Franchisees faced with these types of territorial provisions must consider the location of their likely customer base and factor into their assessment of the franchise the impact on sales of another franchise opening just outside the territorial boundary (just as they should consider other competitive factors such as a rival brand opening within the territory).
Exclusive territory provisions also often restrict the ability of a franchisee to market outside the territory. This sometimes causes problems where a franchisee might want to place an advertisement in a publication that circulates in many franchised territories. Usually, in such a case, a franchisor would not permit such advertising, unless the other franchisees within the territory agree to be part of the campaign.
Marketing restrictions usually also prohibit franchisees from maintaining their own website and social media sites.
A non-exclusive territory is one where other franchisees or the franchisor may conduct business within the franchised territory.
Some of the service-based franchise systems will allocate a territory to a franchisee and when allocating work (usually coming through a call centre) will give the franchisee in the territory where the work is to be performed a first right to the work. If the franchisee is too busy or is unable to perform the work within the territory, the franchisor is permitted to allocate the work to another franchisee.
Service-based franchise systems also often contain provisions whereby the customer’s wishes are honoured. For example, a customer may use a particular franchisee for its garden maintenance and form a good relationship with a particular franchisee. The customer may move to outside the territory but insist that the same franchisee maintain their garden. Rather than losing the customer, the franchise agreement may allow the franchisee to continue to service the customer even though that customer is in another franchisee’s territory.
Where a franchisee is granted a non-exclusive territory he or she will usually be permitted to work outside the territory, within the rules and guidelines contained in the franchise agreement and/or the Operations Manual. In addition, such franchisees will usually not be restricted in performing work in areas which are not the subject of existing franchises.
Territorial encroachment arises where the territorial rights of a particular franchisee are infringed by a neighbouring franchisee working or conducting business within the territory of the first mentioned franchisee. This causes anger and discontent within the network and usually a huge headache for the franchisor.
Some franchise agreements define territories by reference to municipal boundaries or postcodes. When the municipal boundaries or postcodes change the territory will change and this may mean a franchisee can no longer service some customers.
The internet also does not sit well with territorial provisions. The ‘world wide web’ is truly worldwide, meaning that a franchisor or any franchisee could theoretically market to the whole world through the internet. How would a franchisee with an exclusive territory feel if another franchisee or even the franchisor was effectively competing through internet sales?
Many franchise agreements now reserve the right of the franchisor to sell via the internet. Prospective franchisees should consider these clauses carefully and try and incorporate into their franchise agreement some form of benefit to them arising from internet sales by the franchisor or other franchisees in their exclusive territory. Franchisees should also bear in mind that unless the franchise agreement reserves this right to the franchisor, it will be breaching the exclusive territorial rights of franchisees by selling goods or services online or allowing other franchisees to do so in the exclusive territories of those franchisees.
Franchise agreements may contain other provisions that water down a franchisee’s exclusive territory. For example, a franchisor may be allowed to sell the products available in the franchised business from non-branded retail outlets in a franchisee’s exclusive territory (e.g. supermarkets). A franchisor may also be permitted under the franchise agreement to operate or allow other franchisees to operate mobile or temporary franchises inside a franchisee’s exclusive territory (e.g. at sporting events).
It is critical that franchisees obtain legal advice in relation to the territory provisions so that they understand what rights are provided to them and what exceptions there are to any exclusivity offered.
The Franchising Code of Conduct (‘the Code’) requires franchisors to give a prospective franchisee a ‘Disclosure Document’ in a prescribed form and the franchise agreement in the form in which it is to be executed by a franchisee at least 14 days before the franchisee enters into a franchise agreement or pays any non-refundable money. Although the legal position in respect of a territory is ultimately governed by the terms of the franchise agreement, the Code requires franchisors to disclose in their Disclosure Document certain information about territories in order to assist franchisees to better understand their rights.
The information required to be disclosed is as follows:
1. Whether the franchise is for an ‘exclusive’ or ‘non-exclusive’ territory or whether the franchise is limited to a particular site.
2. Whether, within the territory the subject of the proposed franchise agreement:
(a) other franchisees may own or operate a business that is substantially the same as the franchised business;
(b) the franchisor or an associate of the franchisor may own or operate a business that is substantially the same as the franchised business;
(c) the franchisor or an associate of the franchisor may establish other franchises that are substantially the same as the franchised business;
(d) the franchisee may operate a business that is substantially the same as the franchised business outside the territory of the franchise;
(e) the franchisor may change the territory or site of the franchise.
3. The policy of the franchisor or an associate of the franchisor, for the selection of the territory in which the franchised business is to operate.
4. Details of whether the territory (or site) to be franchised has, in the previous 10 years, been subject to a franchised business operated by a previous franchise granted by the franchisor and, if so, details of the franchised business, including circumstances in which the previous franchisee ceased to operate.
5. Details of whether the franchisee, the franchisor or an associate of the franchisor or other franchisees may make goods or services available online.
It is evident from the above disclosure obligations that regulators of the franchise sector see prior disclosure of matters pertaining to territories as critical.
When assessing a franchise network (in particular the price the franchisee is paying), there are many factors that a prospective franchisee must consider to determine whether they will be getting value for money. One key factor is the territorial protections, if any. Even if an exclusive territory is granted, franchisees should not place much value on this, because this does not prevent all competition.
Franchisees must initially carefully read the franchisor’s Disclosure Document, particularly Items 9 and 13, however, the Disclosure Document does not define the relationship with the franchisor – the franchise agreement does. Franchisees must therefore:
- read the franchise agreement carefully;
- determine whether territorial protection is essential for the business venture and be prepared to walk away if it is essential and the franchise network does not offer adequate protection;
- look at the territorial boundaries and be satisfied that they are accurately defined, so there can be no argument in the future;
- understand what territorial restrictions are imposed on the franchisee (for example, marketing outside the territory);
- understand what forms of encroachment might be reserved to the franchisor (for example, internet sales or an ability to split the territory or re-define boundaries).
Territorial protection is the ultimate protection from competition. Clearly if a business concept is a successful concept, others will copy and this cannot be legally prevented, however, in a franchise network it is important to understand what competition will come from within the network itself.
MST Lawyers has over 25 years’ experience in franchising, representing clients throughout Australia and internationally in a variety of industries. Written by Raynia Theodore, Principal, in the Corporate Advisory and Franchising Team at MST Lawyers, please contact the Corporate Advisory and Franchising Team for assistance or further information.
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