WHAT HAPPENS AT
THE END OF THE TERM?
in this article:
Franchises don’t last forever: Stewart Germann looks at some of the issues franchisees need to understand
A popular bumper sticker reminds us that ‘A dog is for life, not just for Christmas.’ But, unlike a dog, a franchise isn’t for life – it’s for a fixed term of a certain number of years. That’s something that confuses a lot of people new to franchising. When you buy a house or an independent business, it’s yours till you choose to sell it. So why is a franchise different?
Well, as a franchisee your business is part of a larger system involving the system’s originator – the franchisor who owns the brand, the intellectual property and the ‘know-how’ of running the business – and other franchisees, too. One of the franchisor’s duties is to maintain standards throughout the whole franchise and ensure that it is regularly updated to maintain its competitive position and address any market, financial or statutory issues that may require changes. Therefore, just as with other arrangements whereby individual businesses operate under a common brand (such as agencies or distributorships), there needs to be a regular review and renewal process. Granting franchises with a fixed term allows for this.
Accordingly, when a franchisor issues a franchise agreement to a franchisee it is usually for a fixed period of time (usually years) with one or two rights of renewal for the same period of years. For example, in New Zealand a common term for a franchise is 5 years with a right of renewal of 5 years, making 10 years in total.
If a franchisee pays an upfront franchise fee of $40,000 for a 5 year term, with one right of renewal of 5 years upon payment of a renewal fee of $10,000, then that equates to a 10 year term for $50,000 or $5,000 per year for each term of the franchise.
What many franchisees don’t understand is that when all the terms have elapsed, unless a new agreement is signed (which is not unusual) then the relationship is over. For example, say a franchisor of a business format franchise grants a franchisee a 5 year term with one right of renewal of 5 years. A normal clause might state the following:
This Agreement shall commence on the commencement date and shall be for a term of 5 years.
Most franchise agreements will contain a right of renewal clause which might look like this:
The franchisee shall have the option to renew the franchise for one term of 5 years commencing on the day immediately following the date of expiration of the term provided that:
(a) The said option is exercisable only by the franchisee giving to the franchisor written notice of its exercise of such option and that such notice is given not less than three (3) months and not more than six (6) months prior to the end of the term (or then current renewal term as the case may be) and time shall be of the essence in relation to the time limits as set out in this sub-clause.
(b) The franchisee must not have breached the agreement during the term.
(c) The franchisee pays on demand to the franchisor the full costs of the franchisor renewing the franchise including but not limited to legal fees incurred in the preparation of all necessary documents and consultation and/or training fees.
(d) The franchisee has undertaken, paid for and completed to the satisfaction of the franchisor any further training required by the franchisor.
(e) The franchisee is able to continue to conduct the business from suitable premises for the renewal term.
(f) The franchisee executes the franchisor’s then current franchise agreement and such other documents then customarily used by the franchisor for its franchises. The then current franchise agreement may contain terms which differ from those contained in this agreement provided such agreement shall not oblige the franchisee to pay any further initial franchise fee and provided further that it shall not require the franchisee to materially alter the manner in which the franchisee conducts the business. The franchisee must also pay to the franchisor the renewal fee which is additional to all costs in relation to the preparation of documents, consultation by the franchisor and any further training fees.
You will see that the renewal provision above provides that the franchisee must give written notice to the franchisor exercising its right of renewal for a further term of 5 years, usually upon payment of a renewal fee, and upon the franchisee executing the franchisor’s then current form of franchise agreement upon terms which may differ from the (current) terms of the initial franchise agreement. At the end of the second 5 year term the franchise will expire. If there is no further right of renewal what will happen?
Most franchise agreements contain a clause with the heading ‘Action upon Termination of Franchise’ or ‘Effect of Termination’ which states what is to happen to a particular franchise and what the franchisee must do when the term has expired. The franchisee will no longer be able to carry on business, will no longer be able to use the brand and the franchisee has nothing to sell. Conversely, the franchisor will be able to sell a new 5 + 5 agreement to a new franchisee and obtain an upfront franchise fee which may have increased from $50,000 to $60,000.
It is important to realise that when the franchise agreement comes to an end the franchisee normally has to hand everything related to the franchise back to the franchisor. This will include the manuals, stationery and business cards showing the brand, client lists and all other proprietary information which would be included in the intellectual property of the franchisor. If a franchisee has a sublease of the premises, or a licence to occupy the premises, then the franchisee will have to vacate the premises because termination of a franchise agreement would normally trigger a termination of a sublease. If a franchisee holds the head lease of the premises then the franchise agreement may (but not always) contain a clause allowing the franchisor to have the option of taking over the head lease. This would require the prior consent of the landlord.
The franchise agreement will often provide for the franchisor to have an option to purchase the assets of the business (equipment, fittings, vehicles and other assets) at a fair value. This will often equate to book value. There will be no requirement for the franchisor to pay anything for the goodwill of the business so the franchisee is in a very weak position once the term has expired.
The basic principle to be adopted is that the franchise relationship should be capable of subsisting on a long-term basis. There may be reasons for a relatively short period, such as the legal position in the tied supply of products, but most franchise agreements allow for the franchisee to be able to exercise a right of renewal. If the agreement does not grant a right of renewal then a prospective franchisee should proceed with caution. It may mean that the franchisor will not even be prepared to agree to any renewals, or will try to make renewal unreasonably expensive. Beware of agreements which grant a relatively short initial period with rights of renewal for which additional fees must be paid.
In addition, most agreements state that it is a precondition to a renewal of term that the franchisor is still carrying on franchising at the time of renewal. If the franchisor has the right not to renew on this basis, then check the agreement to see if, in such circumstances, it allows the franchisee an ongoing licence to use the franchisor’s intellectual property and expressly excludes the operation of the restraint, termination and confidentiality provisions after the expiry of the current term of the franchise agreement.
Ensure that the term of the agreement and the periods of renewal will be sufficient to enable a franchisee to obtain a reasonable return on their investment. Normally, the greater the financial investment, the longer the term required to recoup that capital investment. Consequently, an agreement for a retail operation which includes a very significant fit-out of premises may require a term of 10 years with several rights of renewal of 10 years each.
The fact that at the end of the term the franchisee has nothing to sell is completely normal in franchising as nothing lasts forever. A franchisee is purchasing the right to use the brand name and system for a period of time, and when that time has elapsed the franchisee must stop using them.
In Australia, an amendment to the Franchising Code of Conduct earlier this year requires Australian franchisors to notify their franchisees at least six months before the end of the term of a franchise agreement of their intention to renew or not renew the agreement. Franchisors also have to include a section in their disclosure documents describing the process that will apply in determining end-of-term arrangements. No such requirement exists in New Zealand even under the FANZ Code of Practice and it is often up to the franchisee to give notice of their intentions.
Last year I acted for a franchisee who was most distressed that the franchise term had expired and he had received a letter from the franchisor advising that the term had expired and the franchise agreement was terminated. The term of the franchise was 5 years and there was one right of renewal for 5 years. When I looked at the right of renewal clause in the franchise agreement, I noted that there was a time period for the franchisee to give notice to the franchisor of its intention to renew the franchise and such notice was to be given not more than 6 months and not less than 3 months before the end of the term. However, the clause contained the phrase ‘time shall be of the essence’, which means that the time periods are very important and will be strictly enforced. Because the franchisee had forgotten to exercise his right of renewal and because the franchisor did not like the franchisee and was wanting to terminate the franchisee, then I advised the franchisee that there was nothing which could be done because the franchisee had missed the time limit.
The moral of the story is that franchisees must be very careful not to miss time limits when they have to do something and in every case the expiry of the term or the renewed term is a crucial event. The period of notice to be given must be highlighted so that it is not missed, otherwise the consequences could be catastrophic. This is yet another reason why those buying a franchise should take independent legal advice from a specialist franchise lawyer. Unlike that bumper sticker, a franchise does not last forever, and you want to be certain that you’re buying a viable business with real prospects – not a dog!
This material is copyright © Franchise NZ Marketing Limited, Franchise New Zealand ™ magazine and Franchise New Zealand On Line . While it may be downloaded for personal use, no part may be reproduced in any form whatsoever without the specific written permission of the publisher.