The franchise agreement
The franchise contract is the document in which the whole transaction is drawn together. It must accurately reflect the promises made and it must be fair, while at the same time ensuring that there are sufficient controls to protect the integrity of the system. The contract is, of course, important, although it does seem to attract a disproportionate amount of emphasis. It must:-
- Deal correctly, in legal terms, with the various property rights owned by the franchisor.
- Contain the operational structure and controls.
- Provide the franchisee with security in his operations and in his ability to develop and sell an asset.
In the final analysis, it is an insurance policy for both parties if things go wrong. If the contract has to be read after signature by either party, it will usually be because there is a problem, and not because one of the parties has insomnia for which dull legalese may be a cure.
The personal relationship between the franchisor and the franchisee, together with their common desire to succeed in their respective roles as the business relationship develops, are far more important than the formal contract. In most franchise schemes, the franchisor will own:-
- A trade mark, or trade name, and the goodwill with which it is associated.
- A business format – a system recorded in an operational manual, or manuals which will contain elements, some of which are possibly secret and confidential.
- In some cases, formulae, secret recipes, specifications, design drawings and operational documents.
- Copyright in some of the above items which are in written form and capable of copyright protection.
The recruitment literature of the franchisor will certainly have indicated the nature and extent of the initial services he will provide; the range of continuing services upon which the franchisee will be able to call; and the cost of joining and belonging to his franchise system. We shall look at each of these factors in turn. Whether or not you are considering taking up a franchise with a British Franchise Association (BFA) member you should obtain the BFA guide The Ethics of Franchising since it describes provisions in contracts which the BFA considers to be in conflict with its code of ethics. A franchisor, who is not a BFA member and whose contract does not meet the BFA’s ethical requirements, may not be the right choice.
The initial cost should include all the items necessary to open for business. The franchisor will very likely charge a franchise fee to cover the cost to him of providing the initial range of services to the franchisee, as well as a charge for entry into the system. There can be no hard and fast rule as each system differs. Ignoring the lower end of the cost range, the average amount of the initial franchise fee can in practice range from five to twenty per cent of the total setting-up costs.
Continuing fees enable the franchisor to finance the provision of his on-going services and back-up. The average continuing fee charged by BFA members, which includes funds specifically allocated to advertising and promotional expenditure, is in the region of 10 per cent of turnover. It is vital that the franchisor should not have undisclosed sources of income at his franchisees’ expense, nor should he be able arbitrarily to increase the cost of the products which he supplies to his franchisees. Franchise fees, however they are described, are essentially a payment by the franchisee to the franchisor in return for the services provided by the franchisor. They are the gross income which the franchisor receives for the provision of his franchise services and upon which his business depends to cover its operating costs and profit.
Most franchise systems provide for the advertising and promotion to be handled by the franchisor, who will receive from his franchisees a contribution for that purpose. The most common method of calculating this contribution is the same as for franchise fees, namely as a percentage of the gross sales by the franchisee. In some cases, a franchisor may include the advertising expense in the franchise fee and undertake to spend a percentage of the fee on advertising and promotion. There are also cases where local advertising, rather than national, is more important and a franchises may find that the franchisor does not seek a contribution, but imposes on the franchisee the obligation to spend a certain sum on approved local advertising.
The nature of the initial services will vary, bearing in mind the type of business. Obviously, a van-based franchisee does not need site selection assistance, and conversely, a shop-based franchisee does not need to be taught how to contact his customers in the same way as the mobile operator.
The general principle is that the franchisor’s initial services (including training) should be sufficiently comprehensive to set-up a previously inexperienced person in business so that he can trade effectively, in accordance with his chosen franchise system, as soon as he opens.
Having established the franchisee in business, the franchisor now has the responsibility to sustain a continuing range of services to support him. These include:-
- Performance monitoring to help maintain standards and profitability.
- Continuing update of methods and new innovations.
- Market research and development.
- Promotion and advertising.
- Benefit of bulk purchasing power.
- The provision at head office of a specialist range of management services.
Features of the contract
The normal features of a contract will be as follows.
a) The establishment and identification of the franchisor’s proprietary interests.
This will clearly deal with such things as trade marks, trade names, copyright materials and the franchisor’s business system and know-how.
b) The nature and extent of the rights granted to the franchisee.
This will deal with areas of operation and the formal granting of rights to use trade marks, copyright material, etc.
It is relevant at this point to mention territorial rights, since these create practical difficulties. There are two aspects to the problem which arises when exclusive territorial rights are a feature.
Firstly, there are the commercial considerations and these have caused many problems for franchisors over the years. It is very difficult to determine a territorial arrangement, which is fair to both parties, especially when the extent of the likely penetration of the market cannot be judged. Indeed, quite often even the total size of the potential market cannot be estimated.
In the past, many franchisors, who have chosen the exclusive territorial route, have found that there was no effective way of ensuring that the potential of the area was fully exploited. The effect of this is to harm the whole network. Quite apart from the fact that within the area a market and demand is being created by advertising and promotion which is not met by resources, the way is prepared for competition to move in and do better. Also, disgruntled customers, or potential customers, are not likely to look elsewhere within the same network for their requirements. The franchise thus gets a bad name.
The obvious response is to suggest that performance targets should be established. Since the assessment of fair performance targets is dependent upon the same factors as have to be considered in defining a territory, the problem remains basically the same. Additionally, if performance targets are set they should take into account the potential expansion of the business as well as inflationary factors. These are also difficult matters to deal with in a fair and equitable way.
Secondly, there are the legal considerations. The introduction of exclusive territorial rights is likely to make the agreement subject to the competition laws of the UK and the EU. These competition laws are likely to be applicable to other provisions in the contract. Examples include product ties (in certain circumstances) and restraints on competition. Under both systems (i.e. the UK and the EU) there are what are called Block Exemption Regulations. These give exemption from the impact of the competition laws if the terms of the regulation are complied with. It is anticipated that most franchisors will benefit from the exemptions. This area of EU and UK law is very complex and advice on its impact may be desirable.
c) The period of agreement.
The basic principle in which many believe is that the franchise relationship should be capable of subsisting on a long-term basis. There may be various reasons, such as the legal position in relation to the tied supply of products, for a relatively short initial period (say five years), but most franchise schemes allow for the franchisee to be able to exercise a right of renewal. If the agreement does not grant a right of renewal a prospective franchisee should proceed with caution. It may mean that the franchisor will not even be prepared to agree any renewals or will try to make renewal unreasonably expensive. There may be legal reasons why a contractual right to endless rights to renew will not be possible. Beware of agreements which grant a relatively short initial period with rights of renewal for which large additional fees must be paid.
d) The nature and extent of the services provided by the franchisor, both initially and on a continuing basis.
This will deal with the initial services, which enable the franchisee to be initiated, trained and equipped to open for trading. On a continuing basis, the franchisor will be providing services which should be detailed in the agreement (see Continuing services above), and he may possibly introduce and develop new ideas.
e) The initial and continuing obligations of the franchisees.
These will range from accepting the financial burden of setting-up in compliance with the franchisor’s requirements to undertaking to comply with operating, accounting and other administrative systems to ensure that essential information is available to both parties. These systems will be described in an operations manual which will be introduced to the franchisee during training and which he will continue to have available as a reference guide after he has opened for business. The manual will be constantly updated as the system develops.
f) The operational controls imposed upon the franchisee.
The controls are to ensure that operational standards are properly controlled – failure to maintain standards in one unit can harm the whole network. Franchisees will rightly be alarmed if any of their counterparts fail to maintain standards and the franchisor allows them to continue to do so. Often operational controls are very detailed with a cross reference to the operational manual. The contract will contain the obligations and the manual will explain how these obligations are to be discharged and will contain details of how the franchisor’s system is to be operated. Beware of relocation clauses which may appear innocent enough but which could entitle a franchisor to require a franchisee to close down and move to other premises. In effect, this could result in a franchisee being required to open a new business in a new location or lose his franchise! (The BFA Ethical Guide has guidance on this issue).
g) Sale of the business.
One of the reasons for the success of franchising is the motivation it provides to the franchisee, which comes with self-employment and the incentive by selling the business of making a capital gain. For this reason, the franchised business should be capable of being sold. However, there will always be controls. If there are none, it should be a matter of suspicion. After all, if a franchisor is highly selective when considering applications by franchisees, there is every reason for him to be equally selective about those who want to join the network by buying a business from an established franchisee. It should be borne in mind that when a franchisee seeks a purchaser for his business it is the only time that the franchisor does not recruit his franchisee. The criteria by which prospective purchaser will be judged by the franchisor should be set out in the contract. The procedure to be followed should also be described in the contract. Some franchisors insert into the contract an option to buy the business if the franchisee wishes to sell. If such a provision is inserted in the contract, it should provide for the payment of at least the same price as is offered to the franchisee by a bona fide arm’s length purchaser. Any artificial formula which might enable the franchisor to buy at less than market value should be resisted.
h) Demise of the franchisee.
In order to give the franchisee peace of mind, provision should be made to demonstrate that the franchisor will provide assistance to enable the business to be preserved as an asset to be realised, or alternatively taken over, by the franchisee’s dependants if they can qualify as a franchisee.
Arbitration is in reality private litigation with a judge (arbitrator) chosen by the parties. It has advantages in that the proceedings are private; the arbitrator chosen can be selected because of his special knowledge of the business, which is the subject of arbitration; the timing of the proceedings can be fixed to suit the parties’ convenience; the parties may establish the rules for the arbitration and save time and expense in so doing. There are also disadvantages. Not every dispute under a franchise contract will be resolved by the decision of an arbitrator (e.g. the franchisor will not want an arbitrator to judge whether his quality standards and system are being maintained; the franchisor’s right to an injunction may be impaired if the arbitration agreement does not reserve those rights to him; the wrong choice of arbitrator may result in a compromise decision which will not satisfy either party). Bearing in mind the long-term relationship involved in a franchise, those areas where genuine misunderstandings can arise may be considered suitable for arbitration (e.g. fee calculations, rights of renewal).
The BFA has had an arbitration scheme for many years. Full details can be obtained from the association.
j) Termination and its consequences.
Invariably, there will be express provision for the termination of the agreement in the event of a default by the franchisee. The franchisee should be given the opportunity to put right minor remediable breaches so as to avoid termination, providing that he does not persist in making such breaches. The consequences of termination will usually involve the franchisee in taking steps to ensure that he ceases to display any association with the franchisor. The franchisee will no longer enjoy the use of the trade mark/trade name, and other property rights, owned by the franchisor. In addition, the franchisee will be under an obligation for a period of time not to compete with the franchisor, or other franchisees, nor will he be allowed to make use of the franchisor’s system or other methods.
In a brief chapter, it is not possible to cover every aspect in detail. However, the points highlighted above will have explained some of the basic features of the franchise contract and should enable the reader to approach it in a reasonably enlightened way.
This article is not a substitute for proper legal advice.