What's in the franchise agreement?

If you are about to become involved in franchising, you'll soon come across a franchise agreement. These are often 40-60 pages long, (and sometimes much longer) and deal with a wide range of different legal concepts.

The following is a guide to some of the things you can expect to find covered in a franchise agreement. Its purpose is to help you get a personal understanding of what the agreement you are considering actually means. The more informed you are, the more informed your questions will be when you go to your lawyer, accountant and banker and the better your and their decisions will be at the end of the investigation process. It will help you save some money, too.

Function & form

The franchise agreement sets out the rules under which the franchisor (who owns the franchise network) and the franchisee (you) will have to live by for the period of the franchise. It is by far the most important of the legal documents.

In addition, it must also be read alongside the franchise operations manual which almost every full format franchise will have. The franchise manual usually represents a core part of the value of the franchise package for the franchisee. Most agreements will include a statement that the operating manuals of the franchise form an integral part of the franchise arrangement, and require that the franchisee operates his or her business according to the systems and methods set out in the manual.

Agreements generally follow the same order. They start by identifying the parties, provide a short background to the franchise and the agreement itself, then lay out the main terms. At the end there are usually one or more schedules giving some specific details such as dates, amounts, territory boundaries, renewal rights. Where these are grouped together it makes it easy to look up the highlights, but of course they still need to be interpreted against the other details in the main body of the agreement.

The agreement may also have extra documents attached such as guarantees and/or copies of standard sub-franchise agreements (if it is an area master franchise). There may also be other legal documents to be signed or considered such as non-disclosure agreements or Privacy Act consents. Very importantly there should be a disclosure statement or disclosure document giving details about the franchise in a formal way.

The disclosure document is a document which gives important and helpful information about the franchisor. Having such a document is required by law is a requirement of membership of the Franchise Association of New Zealand (FANZ) although non-members will also frequently have such a document. The absence of a proper disclosure document may be a warning sign.

If you are buying a franchise, in part, the transaction should be looked at in the same way as any other business purchase. However, the difference is that the purchase is not an absolute one because of the residual interest and obligations of the franchisor, and the controls as to how you should run the business.

Contents

The following looks at some of the most important parts of the franchise agreement.

How long do I get?

Near the beginning of the agreement will be a grant of rights. This is usually a short clause that says that the franchise is yours, at least for the franchise term and subject to you complying with all the other terms of the agreement.

It is vital to realise that a franchise is like a lease ­ you are only 'renting' the right to the franchise system for a set number of years. After that, your right to continue in that business stops, unless there is one or more right of renewal in which case, if the renewal conditions are satisfied, it may be extended until it stops at the end of the final renewal term.

Renewal provisions need to be looked at carefully. They will tend to contain some or all of the following provisions:

- Requiring notice to be given within strict time guidelines ­ if the renewal notice is not given in time the right to do so is lost

- Payment of a renewal fee (which may be equivalent to a full new franchise fee, although usually it is not)

- Allowing the franchisor to change the wording of the franchise agreement upon renewal

- Allowing the franchisor to change (and very often to reduce the size of) the franchise territory where the particular agreement provides exclusive rights to the franchisee within a defined territorial area in which other franchisees will not be allowed to operate.

- Obligations on the franchisee to redecorate and/or refit premises on renewal and often to undertake some more training.

These provisions may seem harsh, but there are good reasons for them. As the franchise grows and expands, improvements and alternatives develop in the operation of the franchise business. The law and other outside circumstances also change so changes are needed to keep franchise agreements up to date. Examples of operational changes might be requirements to provide an extra range of products or services, or to install a computerised stock control system if such systems were not required when the franchise was granted originally.

Where Will The Business Be Located?

Most agreements provide for a set location where the franchise is to operate. This may be from a particular place or within a wider area. This is called the territory. Normally, you as franchisee must not operate the business outside the territory.

As population densities change and franchise systems and markets mature there can also be good reason to adjust territories. As an intending franchisee, you may in some cases yourself look for your agreement to contain some special extra feature such as an option or first right of refusal for a time to take additional franchise/s in an adjoining area.

How much will it cost?

There is usually a large amount to be paid out initially for the franchise fee, and for other initial and set-up costs, followed by ongoing payments to the franchisor during the franchise term. Ongoing payments generally include regular royalties and advertising levies both based on gross turnover, and may also include a mark-up or margin on products supplied by the franchisor. The term royalty here simply means a fee charged which is usually calculated as a percentage of the franchisee's turnover (but it is sometimes a flat fee) and is paid weekly or monthly or at some other regular interval.

In addition there may be training fees and other payments to be made during the term of the agreement, and also at such times as the sale of the franchise or renewal. There may also be obligations to attend franchise conferences, usually once every year, and to pay for the costs of fares and accommodation for yourself and possibly staff members. In addition there will probably be other meeting and attendance requirements.

Some agreements also require franchisees to reimburse the franchisor for its legal costs relating to various matters such as entry into the agreement, renewal and assignment of the agreement.

The agreement should set out clearly the details of what has to be paid and when, including conditions relating to any deposits payable before securing the franchise. The actual figures are likely to be set down in the schedule at the end of the document.

Special mention should be made of advertising and promotion costs. Commonly, the agreement will provide for a contribution to marketing funds by way of a levy on gross turnover ­ often 1-3%. The agreement should specify when the payment is to be made and to whom, including details of any special banking arrangements.

There are often guidelines as to what marketing funds can be spent on. Usually the franchisor has full discretion on allocation and timing of expenditure, but will consult with franchisees on major initiatives. In addition, there may be a term in the agreement requiring franchisees to co-operate with major promotions in various ways, including giving recommended price discounts and 'specials'.

Opening

There is often a requirement that the franchisee spend a specified minimum amount on the marketing and promotion of the franchise in the area when starting the business. Some or all of this may be required to be paid to the franchisor and spent by him or her for this purpose.

Many franchises require the premises from which they operate to be refurbished and fitted out in a special way. The agreement may provide for the cost of this or for part of it to be paid to or through the franchisor. In addition, you as franchisee would need to pay all the other costs direct to the other suppliers involved.

Stock

If the business involves the supply of goods or materials, then the agreement will also provide that you start off with and maintain a proper level of stock. Some franchises also require the franchisee to purchase specialised plant and equipment. If so, this should be set out with full details including the amounts involved, either in the agreement itself or in a side agreement.

If all this looks frightening, don't worry. Its purpose is to set out precisely what you are going to be spending and what you will get for it. It may add to the paperwork, but it avoids misunderstandings and misconceptions and your relationship with your franchisor will get off to a better start.

Premises, leases & mobile businesses

Most franchises, particularly retail operations, are required to have premises in carefully chosen positions which are suitably fitted out in the franchise's corporate style. Premises just means the shop or office or other space the franchise outlet will occupy. Because of the importance of the location for many types of franchise businesses, the franchise agreement will normally contain various provisions relating to leases. Often these will allow the franchisor to take over the lease at the end of the term, and also during the term if the franchisee defaults. In this way, the franchisor is protecting the long term ownership of the goodwill relating to the business.

In other franchises the franchisor will itself lease the property and grant a sublease to the franchisee, either for reasons of security, or income or because the landlord demands it. The strength and detail of the terms will vary from franchise to franchise.

For mobile franchise businesses, the agreement will contain terms that set out the signwriting and other décor required by the vehicles from which the business is operated, and possibly to be used on any major items of equipment. If a specialist vehicle or vehicle-mounted equipment is required you may be required to buy the fully set-up vehicle from the franchisor. Otherwise you will have to provide a suitable vehicle yourself.

Usually the franchise, even if it is a mobile one where services are taken to the customer, will be required to have a defined home base from which it operates, where contacts can be made, where items are stored and checked and records kept. That may be the franchisee’s private home in cases where there are no business premises.

The franchise business

At the beginning of the agreement there is usually an introduction (often headed Background) where there is a very brief description of the business of the franchise referring to the goods or services it provides. Both the term Business and the term System (which refers to the methods of operating the business) will usually be formally defined and are then referred to from time to time throughout the agreement.

Although these terms are important, they normally contain very little explanation of the actual nature of the business. Only the manual usually has a detailed description of how the business is carried out. The disclosure document (where there is one) will also give more information.

The manual

This is an essential feature of most franchises: it is the ‘bible’ or blue print which gives you guidance on 'how to do it'. The agreement normally provides that a manual will be supplied on loan only, remains the property of the franchisor and is to be returned to the franchisor at the end of the franchisee's term.

In addition, the agreement will allow for the manual to be added to and changed from time to time, and for existing portions to be deleted or amended ­ for this reason, manuals tend to be loose-leaf if they are in hard copy form or they may be intranet-based or otherwise available on-line. There will be an obligation to ensure that the manual is kept up-to-date.

Obligations

Every agreement should contain clauses setting out the initial and continuing obligations of both franchisor and franchisee. These amount to a list of do's and don'ts. Relevant clauses can often contain a daunting 30 or 40 subclauses – or even more – and may be spread right through the agreement and even into the manual.

Intending franchisees should look closely at them all and be sure that the meaning of each is clear or is adequately explained to them by their lawyer and the franchisor. Breach by a franchisee of any of his or her obligations may entitle the franchisor to terminate the franchise.

Examples of franchisee obligations include minimum opening hours, insurance, engagement of staff, and uniform requirements. Examples of the franchisor's obligations include maintaining the manuals, providing products, and training.

There will invariably be strict obligations on the franchisee to keep accurate and up-to-date accounting records. Other requirements include regular reporting and auditing, and in many businesses there will be a requirement for the electronic linking of point-of-sale systems to the franchisor.

Intellectual property rights

This term is used widely in most franchise agreements. It covers various different types of legal rights which have developed to protect ownership of inventions and creations of various types. Laws relating to intellectual property include Acts of Parliament relating to:

- Copyright (which includes manuals, brochures and computer software)

- Trade Marks (brand names and logos)

- Designs (eg. plans)

- Layout Designs (eg. computer chip designs)

- Patents (inventions)

These are some of the most common types of right, and there is a separate Act of Parliament relating to each. Mostly they follow international conventions designed to give worldwide consistency, so far as can be achieved.

Other laws which protect or create rights include the Fair Trading Act 1986, designed to prohibit misrepresentation and the common law rules (judge made law) prohibiting passing off ­ the copying by one business of the identity of another. These laws and the provisions relating to them in the franchise agreement are an essential part of the glue which holds franchise networks together and keeps competitors at bay.

Can you sell the franchise?

That depends entirely on the terms of the agreement, which will also reflect the nature of the business and the training required to run it. Most agreements will allow the franchise to be sold during its term, but:

- The franchisor will probably have first option to repurchase the franchise;

- The incoming franchisee must be approved by the franchisor to protect standards;

- The incoming franchisee will probably be required to undertake training as a condition of approval;

- There may be a transfer approval fee.

Most importantly, the existing franchise term will not usually be altered and the purchaser will therefore only be buying the unexpired residue of the franchise term – the period left to run before the term runs out – unless the agreement provides for the franchisor to allow or require any purchaser to enter a brand new agreement for a full length new term. If so, this may be either for a full-length new term or for the remainder of the current term.

Termination

As well as providing that the agreement will expire at the end of the term (or, if there is a right of renewal, at the end of the renewal term if renewed), the agreement will also contain a clause listing a number of circumstances in which the agreement may be terminated prematurely. These include such events as bankruptcy (for persons), liquidation (for companies) or criminal conviction of the franchisee, termination of leases to the franchise premises (where premises retention is important), and failure to pay money due to the franchisor.

Breaches of obligations (see above) may also qualify for termination. Most agreements, however, allow some opportunity to rectify most breaches depending on their nature and seriousness.

There will also be clauses setting out what happens once the agreement has been terminated. These will include the immediate loss of the right to use the name and trademarks, a requirement to return the manual and promotional material and also to hand over plant and equipment used in operating the franchise. If the business is premises based, the franchisor may opt to require the premises to be handed over as well.

Non-competition – restraint of trade

Non-competition restrictions will also apply during the franchise and after termination. These mean you will be unable to, or be restricted from:

- Employing any person who has worked for the franchisor or another franchisee;

- Soliciting customers away from the business;

- Owning or operating a competing business.

These are important clauses to be looked at carefully.

Disputes

If any disagreement between the parties cannot be resolved by discussion or direct negotiation, most newer forms of agreement now follow industry best practice and provide for mediation before parties are free to proceed to litigation or arbitration. Mediation offers greater speed, more flexibility and less cost than full legal proceedings, and has the advantage of being potentially less damaging to the franchise relationship.

Cooling-off periods

FANZ requires its members to provide in their agreements (or to allow at an earlier stage) an option for franchisees to withdraw from the agreement within a period of seven days after having signed and an entitlement to receive a refund of the deposit paid if they do cancel (often less some charge for initial costs). Inclusion of such a provision in the agreement is usually a favourable indication of the franchisor’s intentions and approach, and is mandatory for FANZ members.

Other terms

Many of the other clauses to be found in a franchise agreement are either to do with the interpretation of the document or are of a fairly standard nature commonly found in business agreements generally.

In this category one especially important clause is the Entire Agreement provision, which usually states that what is contained in the agreement overrides anything which may previously have been promised unless it is stated in the agreement or in a document which is expressly referred to in the agreement (such as the disclosure statement, if there is one).

As a franchisee, you should be on your guard to make sure that anything on which you have relied in selecting your franchise is carried into the agreement in some way, and as a franchisor, that it is accurate.

To mention just one other type of provision common to most agreements, look for a definitions section usually close to the beginning. In addition to defining such terms as the Franchise System, it also contains many other key definitions. One of the most important is Gross Sales, the figure on which the franchisor's royalty is usually based. Usually the term Gross Sales covers almost every type of transaction carried out by the business and almost every payment received or which should have been received.

Parties

The requirements of different businesses and circumstances can mean that instead of there being a single franchisor and multiple franchisees, there may be others involved such as master franchisors, sub-franchisors or area franchisees. The agreement should define the relationships between each of the parties involved.

In addition, instead of being in business on your own account in your personal name, you may wish to establish your franchised business under the name of a limited liability company. In this case, the franchisor will require that you are still a party to the agreement as a guarantor.

Any decision to use a company to operate your franchise should be taken early as a last minute change of mind can cause delays and extra expense.

Changes

The above information is designed to give a background to the franchise agreement and what to expect from it. Remember that, although many of the terms may look harsh, they are there to protect the franchise system, not just the franchisor, and that as a franchisee you will also be protected by it from the misdemeanours of other franchisees.

With an established franchise, the agreement will probably have been in force for some time and the franchisor is unlikely to change it beyond perhaps a few words here and there just because you ­ or your lawyer - don't like it. However, you should go through it clause by clause and get your lawyer to do the same to make certain that you understand the provisions it contains. After all, you will be the one signing it, not your lawyer.

In the case of a newer franchise it is possible that there are some terms open to misinterpretation, or some detail issue which could usefully be covered and the franchisor may agree for an amendment to be made.

Advice

Finally, remember the basic rule: if you wish to be a franchisor or franchisee you should always take proper legal and other advice. Do this before you prepare the agreement (and other documents) if you are the franchisor, and before you sign anything if you wish to be a franchisee. You should choose a lawyer experienced in franchising. The franchise agreement is the foundation of your business. You must be certain that you have a clear understanding of what it means for you before you start to build on it.

This article was last published in Franchise New Zealand magazine Volume 19 Issue 2

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