How To Read Your Franchise Agreement

I have both franchisors and franchisees as clients in my legal practice. Although there is much more work involved in setting up a brand new franchise agreement than in reading one, it can be difficult to give advice to a prospective franchisee.

They may be under pressure to sign up, and may lack experience. Maybe they have never run a business before, or attempted to read a complex contract like a franchise agreement. They have a lot to learn, and have to do it quickly.

Together with the franchise agreement, they will also have to read the franchisor’s disclosure document, and possibly also a lease and a disclosure document for the lease. They show me these and ask: “Can you tell me if there is anything dangerous in these?” Where shall we begin?

The approach I take with my franchisee clients, and which I am passing on here, is this: you can’t afford to be ignorant. You have to come to grips with the franchise agreement and understand how to comply with it. The wrong time to find out what you were supposed to do is when you are having a costly dispute with the franchisor a couple of years later. The same applies to your lease and indeed to every contract you sign.

The disclosure document is a helpful summary, in plain language, of the major provisions of the franchise agreement, packaged together with other important information. But it doesn’t always match up precisely with the franchise agreement. And, the disclosure document is almost always excluded from being part of the franchise agreement. Basically, you can’t avoid learning what the franchise agreement says.

Take It Apart

So you have your franchise agreement sitting in front of you. What’s the best way to study it? Go get a pack of coloured highlighters. Pick four themes to review the agreement for, and give each one a colour. Let’s say;

Pink is for penalties and default clauses.

Yellow is for things the franchisee has to do.

Green is for things the franchisor has to do.

Blue is for things that cost the franchisee money.

Next, go through the document and highlight its parts using this colour scheme. Watch it become less mysterious. Patterns may emerge. Its structure will make more sense. Then, make a list of all the clauses that require you to do, or not do something. For example, you have to get permission to use the franchisor’s trademark. You aren’t allowed to distribute marketing material without prior franchisor approval. You must have a minimum amount of stock on hand. You must keep the operating manual confidential. Once all of these things have been highlighted, you can assemble them into a list.

The list doesn’t have to be complex. All you need is a few words and a reference to the relevant clause. When you need to find out what the agreement says about the topic in question, you can go look it up in the agreement.

Be Proactive

Having a franchise agreement highlighted in fluoro colours and a list of the important clauses is a good start, but not enough. To avoid breaches, you need to be proactive. If you have to keep the operating manual confidential, you need to identify how to make that happen. Maybe it will require you to keep the manual under lock and key, limit the number of employees who have access to it, and make anyone who uses it check it in and out like a library book. You should also ask every employee to sign a written confidentiality undertaking.

Looking at each obligation placed on the franchisee by the franchise agreement, the franchisee needs to identify the measures that can be implemented to avoid breaching the obligation, and set up a smart system to do that.

Ask Questions

Most franchisors want new franchisees to come into their franchise system with a correct understanding of how the franchise business works, and are very happy to provide information and explanations. Once you have reviewed the franchise agreement, ask the franchisor to explain anything you don’t understand.

The other persons you should be speaking to are your advisers, especially your accountant and your lawyer. Unless you have experience reading contracts, much of the franchise agreement’s language will be strange. How do “indemnities” and “warranties” work? Most franchise agreements have indemnity and warranty clauses. What about the guarantee clauses? Are they normal or extra harsh? If you are the director of a company and are becoming a franchisee, you will probably be putting your personal assets on the line by signing a personal guarantee as part of the franchise agreement. How much risk are you taking?

Business involves taking risks. But there is a big difference between taking risks with your eyes open and taking risks without knowing what they are. Think of your legal and accounting advice as an investment. Yes, you will spend some fees at the beginning of the franchise relationship, but if this saves you from a serious problem in future that would have cost you much more, then you have saved money. Like most lawyers, I have seen awful examples of people who have naively signed documents without understanding them, and who have serious problems later. In a lot of cases, this could have been avoided if the right advice was obtained at the beginning.

Knowledge Brings Confidence

A franchise agreement can be a fairly daunting document. But if you approach it in a systematic way, and get assistance with the parts you don’t understand, you can become familiar and comfortable with its contents. Lawyers like to say that good fences make good neighbours. Knowing what is in your franchise agreement, and setting up a plan to make sure you comply with it, is a great step towards making sure you have a good and productive relationship with your franchisor.

James Irving is a commercial and business lawyer in Perth. For more information visit his website:

www.irvinglaw.com.au

This article is not intended as legal advice for any particular person.