FRANCHISE AGREEMENT ADVICE

A good franchise offers tried and tested methods, systems for operating and managing the business, ongoing support and training, and a strong existing brand to leverage off. However, while franchising offers considerable advantages, it can also contain some pitfalls – traps for the unwary or the careless which you should identify and deal with from the beginning.

Anyone who buys a franchise and signs a franchise agreement without taking formal advice is running a major risk – and risk avoidance is one of the best reasons for entering into a franchise in the first place (see page 20). Make sure you get the right professional advice before entering into any franchise agreement. The Directory at the back of this magazine provides a list of experienced franchise lawyers to help you mitigate the risks of not fully understanding the agreement.

What is a franchise agreement?

The franchise agreement is the legal contract which sets out the arrangement between the person buying the franchise (the franchisee) and the person selling it (the franchisor). It sets out the rights and obligations of both parties, defines the length of time the arrangement will last, stipulates the territory (if any) granted to the franchisee, and details the costs involved and how they are to be calculated.

Although it is relatively simple to enter into a franchise agreement, it is far more difficult to extract yourself from such an agreement. A standard franchise agreement is a long-term obligation and will include strict obligations on a franchisee which have to be complied with for the full length of the term. Failure to comply with these obligations may (in many situations) allow the franchisor to cancel the agreement.

The document is likely to be dozens of pages long and although you may follow 90% of the legalese, without trained legal assistance you may not understand all the terms or the practical implications of all the many clauses.

Who or what does it protect?

Most franchise agreements appear one-sided in favour of the franchisor. At face value, certain provisions may even seem entirely unreasonable, especially to a franchisee who is investing their own funds in the franchise system and therefore has a 'stake' in the business. For example:

• The franchisor can make changes to the operations manuals at any time and require the franchisee to comply;
• On any renewal of the franchise term, the franchisor may insist that the franchisee signs the then current form of franchise agreement;
• There may be widely drafted cancellation clauses in favour of the franchisor;
• The franchisor usually determines how marketing funds invested in the franchise system by the franchisees are spent; and
• The franchisor may have the right to take over the day-to-day running of the franchise in the event of poor performance by the franchisee.

The inclusion of these sorts of clauses is perhaps the biggest psychological barrier that any potential franchisee needs to overcome. It requires them to accept that, although they may have 'bought' a franchise, they do not have total control over that business. In fact, the franchisee buys only the right to operate the business for a period of time – and the agreement dictates the terms of that operation very clearly.

This is because the franchise agreement is also what protects the whole franchise system. The strength and consistency of a franchise brand is paramount. For example, when you visit McDonald’s anywhere in the world you expect the food and the service always to be of the same quality. Customers rely on that. This is one of the major advantages of a franchised business and applies whether the franchise relates to the sale of hamburgers or cleaning services.

As a franchisee, you want to know that your hard work to maintain the brand is not being weakened by the poor habits of a fellow franchisee. It is vital to any franchisee's business that every other franchisee is required to comply with the franchise procedures currently in place – as well as any future procedures developed and improved over a period of time.

Is it always fair?

Sometimes franchise agreements can include clauses which are not strictly necessary to protect the system, or which may go a little too far in attempting to protect the franchise business. Sometimes an agreement simply does not support the franchisee in the way they might expect, for example:

• Immediate rights for the franchisor to cancel without notice if the franchisee is late paying royalties;
• Lack of clauses regarding ongoing support, training and development of the business by the franchisor;
• Limited liability of the franchisor, even if the franchisor breaches its obligations to the franchisee; and
• Clauses undermining a franchisee's 'exclusive' territory in unwarranted circumstances.

An experienced franchise lawyer will be able to identify these clauses and provide guidance about what to do next.

Most established franchisors will not allow any changes to their agreement. Often the franchisor will want to have one form of agreement to ensure consistency amongst all its franchisees. In some cases, the franchisor in New Zealand may hold a master license, and be unable to make changes to the New Zealand agreements without extensive discussions with the international franchisor.

If you and your franchise lawyer identify something that you cannot agree to, your best choice may be to walk away from signing the agreement, no matter how keen you are on the business.

A franchisee must enter into the franchise agreement with their eyes wide open and fully aware of the risks that the agreement provides, whether or not their lawyer is able to negotiate any changes. For this reason, potential franchisees should see investment in a franchise lawyer as insurance, part of the risk management process of setting out in their new business venture.

Too many franchisees have not taken proper steps to read and understand each clause in their franchise agreement, only to be dealt a nasty shock some months later when they face a franchisor legitimately taking steps to terminate the agreement.

How long is the term?

A franchise is generally granted for a finite period of time. The franchisee is licensed to use the trade mark, logo and other specified parts of the business for a set period. The term of the franchise varies greatly, but the bigger the investment, generally the longer the term as this gives the franchisee a greater opportunity to cash in on his or her initial input.

Many franchise agreements include a number of shorter terms rather than one long term. Franchisors often favour shorter franchise terms with several 'rights of renewal'. At the time of renewal, the franchise agreement may be updated, and, in some contracts, the franchisor can request a renewal fee.  

'Right of renewal' in a franchise agreement differs from right of renewal in a property lease situation, where that right can be exercised by the tenant at his or her discretion. In franchising, the franchisor often has the ultimate ability to veto the renewal if the franchisee has not been performing up to standard.

It is also important to coordinate the length of the franchise term with the length of the lease term, if a premises lease is required. Don’t sign up for a 10-year head lease if the franchise term only runs for six years, otherwise you could potentially be dealing with lease obligations for four more years without the right to operate the franchise! 

What happens when the franchisee and franchisor part company, either prematurely or at the expiry of the term? There are frequent misunderstandings by franchisees as to what happens at the end of a term. In some cases, the franchisee will simply walk away in the same way that a tenant walks away at the end of a lease term. Other franchise systems include mechanisms for paying the franchisee a figure calculated in reference to certain factors.

However, if the franchise is operating well and the franchise relationship is a good one, then it is likely that both franchisee and franchisor will want to renew the agreement. 

Selling the franchise

As a franchisee, your rights to sell the business are limited. The franchisee will probably have to give the franchisor the first right to buy the business, and even if they choose not to purchase, the franchisor may still have the right to strictly control the sale process. Most franchise agreements will include at least a provision that the incoming purchaser must be approved by the franchisor at the franchisor's sole discretion.

This supports the underlying concept that good franchise systems are based on good relationships. Since the franchisor will be the party having the relationship with the buyer, it is reasonable to allow the franchisor the right to approve that buyer.

Most agreements will also include a 'transfer fee' which the franchisee will need to pay to the franchisor when a sale takes place. This is intended to cover the franchisor's costs involved in training the incoming franchisee and should not be an opportunity for the franchisor to make a quick profit on the way through! 

What to look out for

Here are a few examples of the sort of things lawyers will check the franchise agreement contains to ensure it protects the franchisee.

Details of both initial and ongoing support and training to be provided by the franchisor need to be recorded in the agreement. It also pays to talk to existing franchisees about the level of support they have received – see 50 Questions to Ask Franchisees at https://franchise.co.nz/articles/935.

Be careful to ensure that minimum performance standards are detailed clearly in the agreement. Many franchise agreements include the provision that if a franchisee does not meet the minimum performance standards, the franchisor has the automatic right of termination without notice.

If the franchisor makes any pre-contractual representations or financial projections to the franchisee it is important that these provisions are written into the franchise agreement itself or provided in some written form.

Check that all intellectual property (IP) is registered. You don’t want to find out, some months after signing, that there is insufficient protection of the franchise IP and that someone else can copy your business’s trade mark, logo, domain name or trade name.

It should be every franchisor and franchisee's aim that the franchise agreement, once signed, will be filed away in the bottom drawer and never formally referred to again. But before you sign, having an experienced franchise lawyer review and comment on the agreement is a good investment. The sort of money involved in funding legal costs is minimal compared with the outlay that a franchisee could face if they unintentionally breach the provisions of the franchise agreement.