Franchise Territories: Do they really help?
This article appeared in Issue 3#3 (March/April 2009) of Business Franchise Australia & New Zealand
A search through many franchisor websites and magazines such as this magazine will find franchisor advertisements highlighting that their systems offer franchisees "designated territories" from which they may conduct business.
An unsuspecting prospective franchisee who has already had their eyes glazed by professional marketing techniques, which may have been utilised by a franchisor or franchise consultant, may neglect to realise that the existence of a territory does not necessarily provide the degree of competitive protection that they were hoping for.
In this article, I outline the different types of territory provisions that I have seen in the numerous franchise agreements I have reviewed and drafted, details of which franchisees should consider very carefully.
Mandatory Franchisor Disclosure
Under the Franchising Code of Conduct a franchisor is obliged to give a prospective franchisee a "disclosure document" at least 14 days before a franchisee enters into a franchise agreement or pays any nonrefundable money. This disclosure document must have attached to it the franchise agreement in the form in which it is to be executed.
Although the legal position in respect of a territory is ultimately governed by the terms of the franchise agreement a franchisor must, in its disclosure document, disclose:
- Whether the franchise being offered for sale is for an "exclusive" or "non-exclusive" territory, or whether the franchise being offered for sale is limited to a particular site.
- Whether, within the territory the subject of the proposed franchise agreement:
- Other franchisees may operate a business that is substantially the same as the franchised business;
- The franchisor or an associate of the franchisor may operate a business that is substantially the same as the franchised business;
- The franchisor or an associate of the franchisor may establish other franchises that are substantially the same as the franchised business;
- The franchisee may operate a business that is substantially the same as the franchised business outside the territory of the franchise;
- The franchisor may change the territory of the franchise.
- 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.
- Details of whether the territory (or site) to be franchised has 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.
It is evident from the above disclosure obligations that franchise sector regulators see prior disclosure of matters pertaining to territories as being very important.
Types of Territorial Provisions
1. Exclusive Territory for Franchisee
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.
But that does not mean that the franchisee will have no competition! I know of no franchise system that has no competitors and, whilst a franchisor may promise not to compete with you within your territory or allow another franchisee to do so, the franchisor cannot prevent a competitive brand opening business nearby, even next door! That is a normal risk that every business purchaser must take.
A franchisor 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 examples of where this has occurred are rare. A prospective franchisee of leased premises in a shopping centre should raise this issue with their franchisor.
Whilst it is common to see agreements containing exclusive territories, it is equally common to see territory size quite small. For example, in a retailing context, the territory might be limited to a strip retail shopping precinct or a particular level of a regional shopping centre.
In granting an exclusive or protected territory, the franchisor is effectively relying on the appointed franchisee to achieve the required market penetration in the territory granted.
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 dissect the territory if the franchisee is not meeting pre-determined performance criteria.
Hence the franchisor is more likely to heavily scrutinise the franchisee's market penetration within the territory and, if this is not satisfactory, the franchisor may be entitled to take remedial action.
Franchisees faced with these types of agreements 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).
Exclusive territory agreements 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 local newspaper 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 agreed to be part of the campaign.
These types of restrictions are also generally supported by prohibitions on franchisees maintaining their own website.
2. Territories limited to the Site
Sometimes I have seen franchise agreements flooded with wonderful territorial protection for a franchisee, only to find in the Schedule that the territory is limited to the site at which the franchised business is located.
There is nothing legally wrong with these types of agreements, but they can easily mislead the unwary franchisee.
3. Non-Exclusive Territory
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 right of first refusal. If the franchisee is too busy or is unable to perform the work within his 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 brand garden maintenance franchise, form a good relationship with a particular franchisee, and then move their residence to outside that franchisee's territory. The customer may insist that the same franchisee maintain their garden. Rather than losing the customer, the franchise agreement may allow the original franchisee to clean the customer's house 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. 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 neighboring franchisee working or conducting business within the territory of the first-mentioned franchisee.
This causes anger and discontent within the system and usually a huge headache for the franchisor. Sometimes if the franchise agreement is poorly drafted, franchise disputes between the franchisor and the franchisee and between neighbouring franchisees arise and they are often hard to resolve.
I recall seeing one franchise agreement defining territories by reference to municipal boundaries. When the municipal boundaries changed, it meant that one franchisee was technically no longer able to service its biggest customer. This became complicated when the franchisee who gained the benefit of the municipal boundary change refused to allow the original franchisee to encroach into his territory to service the original client.
I could hear the franchisor say "if only the territorial boundaries had been better defined - by references to roads". After much angst, that dispute was settled with the franchisor having to put his hand in his pocket.
Then there was the franchise agreement whereby work was directed to a franchisee through a Telstra 13 number. The location of the incoming call determined which franchisee the call was directed to. Imagine the problems that arise if the 13 system moves out of alignment with the territorial boundaries.
Agreements of this type also do not cater for the situation where a customer telephones the 13 number from his or her place of work, with the call being automatically directed to the franchisee nearest the place of work, when the work to be actually performed could be on the other side of town in another franchisee's territory. Even though the franchise agreement may prohibit the franchisee who took the call from doing the job, that franchisee may nevertheless be enticed to do so.
The internet also does not sit well with territorial provisions. The "world wide web" is truly world wide, 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 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 try and incorporate into their franchise agreement some form of benefit to them arising from such internet sales by the franchisor in their exclusive territory. Franchisees should also bear in mind that unless the franchisee agreement reserves this right to the franchisor, it will be breaching the exclusive territorial rights of franchisees by selling goods or services into the exclusive territories of those franchisees.
When assessing a franchise system (in particular the price that is being paid for by the franchisee), there are many factors that a prospective franchisee must consider when weighing up whether they will be getting value for money.
One is the territorial provisions, if any. Even if an exclusive territory is granted, do 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 8 & 11, but do not stop there. The Disclosure Document does not define your relationship with the franchisor - the Franchise Agreement does this. Franchisees must:
- Read the Franchise Agreement carefully;
- Determine whether territorial protection is essential for the business venture and be prepared to walk away if you believe it is not essential and the franchise system does not offer adequate protection;
- Look at the territorial boundaries and be satisfied that they are accurately defined, so there can be no argument;
- 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)
Again, I stress that territorial protection is the ultimate protection from competition. Clearly if the concept is a successful concept, others will copy and very often this cannot be legally prevented. There is always the risk that a more cashed up competitor will open business across the road.
Head of Dispute Resolution & Litigation Division
Accredited Specialist in Commercial Litigation
MASON SIER TURNBULL LAWYERS
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Mount Waverley Vic 3149
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