CUTTING THROUGH THE JARGON
A GUIDE TO COMMON CLAUSES IN FRANCHISE AGREEMENTS
in this article:
Franchise lawyer David Foster explains what to expect in a franchise agreement and what it means for your future.
When you buy a franchise, you enter into a business relationship with the franchisor which is governed by a legal contract. That contract is called a franchise agreement, and for as long as you own the business it will control how you and your franchisor must act.
Franchise agreements that have been properly prepared are generally quite lengthy documents. While some parts may be in plain English and can be readily understood, there will be others that require some explanation. The following is intended to give you a brief introduction to some of the clauses that you will often find in franchise agreements and what they actually mean. If you don’t have a proper understanding of what every clause means, and how it might be interpreted in a Court, that can be dangerous. For this reason, it’s important that you consult a specialist franchise lawyer before signing anything. When it comes to the clauses in any particular agreement, you must get specific advice as to:
- What they mean;
- What risk they might present to you;
- Whether any perceived risk can be reduced or removed through negotiation.
Bear in mind that a franchisor is unlikely to consider any variations to the franchise agreement (especially if there are already other franchisees on the same agreement) unless:
a) It is a new agreement that may be going through its ‘teething’ stages; or
b) The suggested change clarifies a provision that doesn’t otherwise make sense; or
c) You can demonstrate that the provision is completely unreasonable and without commercial justification.
Most franchise agreements will start with a section headed Background which is intended to record the history and purpose of the arrangement the franchisor and franchisee will be entering into. Is this accurate from your point of view?
There will also be a section headed Definitions. This sets down the meanings of words and phrases that are frequently used in the agreement so that it can be clearly understood and correctly interpreted. It is important that these definitions make sense; they are a most important part of the agreement.
There may also be a section on Acknowledgments which requires you to confirm that you have carried out due diligence. If the franchisor is a member of the Franchise Association of New Zealand (FANZ), these will include at least the following statements:
- That you have read and understood the terms of the agreement;
- That you have taken (or declined to take, if you are stupid) independent legal and accounting advice in respect of the agreement;
- That you have received no warranty or inducement or relied on any statement other than those contained in the franchise agreement;
- That there is no guarantee as to rate of return, profit, success of the business and that those things depend upon you.
It’s worth noting that FANZ members’ agreements (and some non-members’ agreements) also provide a compulsory seven-day cooling off period which allows the buyer to withdraw from the agreement – great if you suffer from ‘buyer remorse’ after you have signed up or if new information comes to light.
The franchise agreement should also contain a provision that the franchisor has the right to use the intellectual property (including the franchise’s name, processes and systems) and grant franchises during the term. This is most important: if the franchisor does not own the intellectual property, then the whole franchise – and your own investment – could be endangered.
When you buy a franchise, you don’t buy the business outright – you buy the right to operate it for a specific term, which will be detailed in the franchise agreement. In New Zealand, the term is usually defined in the agreement as a prescribed number of years which may range anywhere from three to ten years. There may be a right of renewal for one or two more terms. Once the agreement expires, you will have no further rights in respect of the business system at all.
It is most important that the conditions upon which any renewal is granted are understood. The financial and timing aspects of the renewal, whilst critical, are only two of the most important factors to be considered. There will also probably be requirements as to franchisee performance, renewal fees and the new agreement to be signed. If the franchise is ‘premises critical’ – for example, if it is a restaurant or retail business which is dependent upon having adequate premises – then there will probably be an obligation to bring the premises up to standard (if they are not already) or to refurbish to the image required by the franchise at the time of renewal. This may include a new fit-out and signage. It will also be a requirement that you have an acceptable lease of those premises for the renewed term.
Many (although not all) franchise agreements will specify a territory within which the franchisee may operate. Some territories apply to the franchisee’s premises only, but most include a ‘marketing territory’ within which the franchisee may promote their own business or call on potential clients. This may be defined by a map included in the schedule (see below). There can be provisions for the territory to be changed if you don’t perform, or on renewal and in some other instances. By the way, if the franchisor talks about an ‘exclusive’ territory, check what ‘exclusive’ means. Does it mean that no other franchisee will be appointed within this area, or no other franchisee may market within this area? Does the restriction extend to the franchisors having company-owned outlets or selling to customers in the territory via the internet?
Another common clause relates to Commencement of Business. Once the franchise has been granted, you will need to start operating by a certain time and do all of the things necessary to enable that to happen. If you fail to meet your obligations, the franchisor will have the ability to terminate the agreement.
Franchise agreements contain obligations on both parties – both franchisors and franchisees. Check the franchisor’s obligations: some franchisors specify in reasonable detail what they will do for you, but more often than not the franchisor’s obligations are recorded in quite broad and non-specific terms tempered by the words ‘at the franchisor’s discretion’ or ‘if the franchisor deems necessary.’
On the other hand, the franchisee’s responsibilities tend to be more detailed. These should be read through thoroughly and understood by you. In particular, look out for obligations preventing you from operating or possibly being involved in any other business. In the list of your obligations you can also expect provisions relating to:
Personal Property Securities Act. This allows the franchisor to register a charge over your business to secure monies due to it;
General conduct. You have to act in such a way as not to damage the reputation of the franchise brand. For example, if you are convicted of a criminal offence or don’t pay your bills on time, your agreement can be terminated;
Financial records. You have to keep appropriate records of accounts and may have to disclose certain information to the franchisor. Check this obligation with your accountant;
Intellectual property. Although you are acquiring the right to operate the franchise, the brand, operating system and so on will remain the property of the franchisor. This may have implications for what you can do after you leave the franchise.
Confidentiality. To protect the intellectual property, you will also be obliged to keep the secrets of the system and the manuals confidential;
Minimum performance. Many franchises set minimum performance requirements for their franchisees to ensure that the business is properly run. You may have obligations to achieve certain sales and other targets.
Approved suppliers. It is highly likely that you will be obliged to purchase some or all product and/or materials through approved suppliers. This requirement is important for a number of franchises as it ensures that:
a) The products are of a quality approved by the franchisor and meeting its standards; and
b) The purchasing power that bulk purchases can obtain means large discounts which should largely be passed on to you with a rebate of some type made available to the franchisor.
You need to read and understand all the obligations in advance of signing a franchise agreement so you are aware of the implications if you let things slip. The agreement will contain a termination mechanism whereby franchisees who do not meet the required standards of performance and conduct may be removed from the system. Such mechanisms are necessary to protect the investment that every franchisee, as well as the franchisor, has made in the system. As with all other parts of the agreement, have an experienced franchise lawyer explain the termination provisions to you. At first glance they may appear harsh but, once considered, you should understand the need for them. By using a specialist, he or she will also know if they are unreasonable and be able to steer you away from a bad investment.
When you buy your franchise, it’s important to understand exactly what you are getting into so that you can enjoy the benefits, challenges and rewards that it brings. However, you also need to be aware of the restrictions that apply when the term comes to an end or the time comes to sell.
Your ability to sell your business is very important to the overall return you will receive on your investment. In order to maintain the standard of franchisees in the system, the franchisor will need to approve your purchaser; this is a standard clause in most agreements. Any proposed purchaser will go through the same process for franchisor approval as you did. It is also not uncommon for the franchisor to have a right of first refusal to purchase your business. Once again, a franchise-experienced lawyer will be able to look at such clauses and tell you whether they (and any formulae for setting the purchase price) are reasonable.
Other issues to be considered on the sale of your business are: Who owns the goodwill? Who owns the customers? What is the relevance of these things? If these items are specified in the agreement as belonging to the franchisor, ask your lawyer what effect that may have on your ability to sell the business and the possible sale price. You should note that the franchisor’s ability to sell his business – including his rights in respect of your franchise agreement – is unrestricted. Your next franchisor could be anyone – a competitor, a corporate or an overseas-based business.
The agreement will also contain a provision entitled something like Action on Termination. This will specify what you will need to do when your term ends or if the franchise agreement is terminated earlier for any other reason. These clauses can be quite lengthy and will include restraints of trade which will prevent you operating a business similar or competitive to the franchise and/or doing anything else that may affect the franchise for a certain time and within a certain area.
Restraints of trade are commonly found in franchise agreements; in fact, if there were not a restraint provision I would be more than a little concerned (although finance broker franchises do not have them as a rule). Whilst restraints of trade are expected and will restrain you from competing there is some debate as to their effectiveness – much depends on the wording, the terms and the intent. Again, it is better to be aware of the implications before buying the franchise, rather than after.
The agreement should, for easy reading, contain a schedule which will specify all of the things that are unique to your agreement – and a few other things, too. The things a schedule will specify will include:
- Commencement Date
- Term Renewals – terms and costs
- Payments – franchise fee, royalties, marketing, initial stock charge, initial equipment charge and others where applicable
- Initial training
- Manager (where not managed by the franchisee)
- Addresses, phone numbers, fax, email addresses
- Trade marks/trade names
- Assignment fee
There will be further schedules too which are likely to detail:
- Initial equipment required
- Initial products/stock required
- Employee confidentiality covenant
- Guarantee (see below)
- Lawyer’s and accountant’s certificates.
It is likely that you will want to create a company to be the franchisee to take advantage of the various benefits such an entity offers. In that case, the franchisor will want you to personally guarantee the company’s obligations to the franchisor. A guarantee may also be required in respect of payment of suppliers and the various taxes involved in the business. It will also require that you personally are subject to the restraint of trade and confidentiality obligations. Such requirements may be expected in any franchise arrangement.
As franchise terms can run for many years, good franchisors will include in their franchise agreements a procedure for resolving any disputes that may arise (this is a requirement for FANZ members). Such a procedure usually involves mediation. Mediation provides a faster and more cost-effective method than litigation of resolving any disputes that may arise during the term of your agreement. However, in certain extreme circumstances – for example, where health and safety or intellectual property ownership is under threat – immediate legal action may be allowed for in the agreement.
Finally, although the above should give you some of the background you need to understand a franchise agreement, it cannot be over-stressed how important it is to take advice from a lawter who specialises in franchising. Those with experience of acting for both franchisors and franchisees will know which provisions are reasonable, which are unreasonable, what should be expected and what is missing! A lawyer who doesn’t have significant franchise experience in franchising cannot do as good a job. A specialist will also be much more cost-effective than a general commercial lawyer. Click here to find a suitable lawyer near you.
If you take only one message from this article, let it be this. Advice from non-specialist lawyers can kill your prospects of entering into a successful, long-term business relationship. If you want to be the owner of your own business and the author of your own destiny, start by getting the right advice from the right people. It could make all the difference to your future.
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