Franchise arrangements present both business buyers, and business founders, with certain advantages and opportunities generally not available to other business models. For founders, creating a franchise-able brand can lead to exciting opportunities for growth and a steady stream of revenue. For business buyers, purchasing a business under an established franchise can help relieve some of the burden and guesswork that generally accompanies purchasing and then running a business as the franchise will generally already have a proven (and likely mandated) system under which to operate. However, regardless of which side a party is on, parties contemplating a franchise arrangement should take care to ensure the Franchise Agreement—the legal document that outlines the relationship between the franchisor and the franchisee—is carefully prepared, negotiated, and reviewed in order to help avoid issued down the line.
Although each Franchise Agreement should be individually tailored to meet the specific circumstances of each deal, in general, parties to a Franchise Agreement should pay special attention to the following provisions and considerations in order to help ensure each party understands their bargained-for rights, obligations, and potential risks:
Before diving into the specifics of a Franchise Agreement, it's important for parties contemplating a franchise relationship to understand the nature of a franchise. In short, a franchise is a type of license that grants a franchisee the right to access and use a franchisor's proprietary business knowledge, processes, and trademarks, in order to sell a product or service under the franchisor's business name. An example of a franchise are most fast food chain locations which, although operated under a common name and brand, are generally owned and managed by individual owners.
The Franchise Agreement is the legal document that outlines the terms under which a franchisee is granted the right to use the franchisor’s brand, system, and intellectual property. Accordingly, it is important that the Franchise Agreement, among other things, clearly defines and describes the following:
- Franchise Rights: The Franchise Agreement should clearly define the rights the franchisor is granting to the franchisee, and any limitations on those rights, such as excluded territories.
- Franchisor’s Obligations: The Franchise Agreement should clearly define what support and resources the franchisor will provide to the franchisee. Some common examples include initial training, ongoing support, marketing resources, and advertising assistance.
- Brand Use: The Franchise Agreement should include clear guidelines governing use of the franchisor’s trademarks, tradename, trade dress, and other marketing materials to help ensure consistency in branding and customer experience across separate franchise locations.
Although franchises can be thought of as a type of license, Franchises Agreements are generally more expansive than license agreements, place more restrictions on a franchisee, and grant more control to a franchisor, than a normal license agreement places on licensors and licensees. Although similar, it is important to distinguish license agreements from Franchise Agreements, however, as different legal rules may apply to each. For a more detailed discussion on the differences between a license agreement and a Franchise Agreement, click here.
Franchises aren’t granted for free. Instead, most Franchise Agreements call for some combination of a franchise fee, additional fees, and royalties. Such fees are typically described in separate provisions in the Franchise Agreement, all of which should be carefully prepared and reviewed. Some common fees and royalties may include:
- Initial Franchise Fee: This is the upfront cost a franchisee will need to pay before being granted a franchise. It may cover the cost of things like initial training, site selection, initial inventory, and other startup fees.
- Ongoing Royalties: In addition to the franchise fee, most Franchise Agreements also call for ongoing royalties, which are sometimes based off a percentage of the franchise location’s gross sales, and paid monthly, quarterly, or annually.
- Marketing and Advertising Fees: In addition to royalties, a franchisee may be required to contribute to a national or regional franchise advertising fund. Where included, the methodology for calculating this fee can be complicated, and should be carefully reviewed.
- Additional Fees: Franchise Agreements may also include other fees, such as technology fees, software licensing fees, renewal fees, or franchise transfer fees.
Geographic growth is often one of the primary goals of any franchise. Accordingly, Franchise Agreements often contain detailed information on where a specific franchisee may or may not operate. Understanding what territory awards or restrictions a Franchise Agreement contains is imperative to both franchisors and franchisees. For franchisors, ensuring that Franchise Agreements contain clear territory restrictions helps to ensure franchisees are operating in territories that meet the franchisor's growth strategy, while also helping to avoid disputes between competing franchisees. For franchisees, ensuring that a franchise can operate in a franchisee’s desired territory—and ensuring that no other franchisees will encroach on that territory—can be the make or break factor for a location’s success. Accordingly, parties to a Franchise Agreement should pay special attention to provisions governing rights related to territorial exclusivity (or non-exclusivity), as well as things like future development rights.
Being able to use a recognizable brand to help drive business is one of the main motivations for franchisees entering into a Franchise Agreement. However, for franchisors, ensuring that the brand remains protected is critical to maintaining the franchise’s overall value and reputation. Accordingly, Franchise Agreements should, and often do, contain detailed provisions and rules regarding how a franchisee may use the franchisor’s intellectual property, including trademarks, logos, and proprietary business systems. Such rights and restrictions are often presented both in the form of intellectual property licenses, and through the use of written Branding and Marketing Guidelines. Franchise Agreements also often grant franchisors with broad approval and veto rights with respect to franchisees’ uses of the franchisor’s branding materials. In any event, it's crucial that both parties to a Franchise Agreement understand what intellectual property rights are being granted, as well as the use expectations and restrictions that accompany those rights, before entering into a binding Franchise Agreement.
Because Franchise Agreements often require franchisees to comply with detailed and demanding operating guidelines (often detailed in an Operations Manual), and because the level of training and ongoing support provided by a franchisor can significantly affect a franchisee’s chances of success, provisions governing both initial and ongoing franchisor-provided training and support are often heavily negotiated when entering into a Franchise Agreement. Among other things to consider, parties to a Franchise Agreement should be sure to review the details regarding any training programs and ongoing support that may be included in the arrangement, such as:
- Initial Training: The Franchise Agreement should describe whether any initial training is to be provided by the franchisor and whether such training is permissive or mandatory; whether all employees and owners, or only key personnel, are required to attend the training; and which party will cover the cost of the training. Such initial training, where offered, often covers the basics of operating the franchise, including management practices, marketing strategies, customer service guidelines, and software and systems instruction.
- Ongoing Support: The Franchise Agreement should describe whether any ongoing support is offered following the opening of the franchise, which party is responsible for expenses related to the ongoing support, and whether there are any limits on how often a franchisee may contact a franchisor for support.
- Performance Monitoring: Some Franchise Agreements may also include provisions governing a franchisor’s right to monitor the performance of its franchisees to ensure adherence to brand standards. This can include things like regular inspections or audits. The Franchise Agreement should carefully detail what monitoring or audit rights are provided to the parties, and how to resolve disputes in the event a franchisee is found to be non-compliant with franchise standards.
Although the above are just a few of the key considerations that should be taken into account when negotiating or reviewing a Franchise Agreement, by being aware of such considerations, parties to a Franchise Agreement can help avoid costly mistakes before signing the dotted line. A well-negotiated and thought-out Franchise Agreement can also set the foundation for a long and successful business relationship and a thriving franchise operation. However, entering into a Franchise Agreement is just one step of many when entering into a franchise arrangement, and parties looking to grant or purchase a franchise should also take care to ensure that they comply with applicable federal and state laws governing franchises, including, where applicable, preparing, furnishing, and reviewing detailed franchise disclosure documents (“FDD”). Franchisors and franchisees should also make sure they are aware of local laws that may affect a franchise location, such as zoning laws, labor laws, and health and safety regulations, before entering into a Franchise Agreement.
By engaging a knowledgeable lawyer before entering into a Franchise Agreement or franchise arrangement, parties seeking to grant or purchase a franchise can help save themselves both costs and headaches, while also taking sure to protect their rights, and avoid larger problems down the line.
