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Franchise Agreement law: the ultimate guide


Franchise Agreement law: the ultimate guide

No document is as important to your success as the Franchise Agreement itself. This guide breaks the Franchise Agreement down from the differences between different franchise agreements to ways to exit your franchise agreement

No document is as important to your success as the Franchise Agreement itself. So let’s boil it down and look at the fundamental components of this crucial piece of legal paperwork, starting with the Franchise Agreement definition.

What is a Franchise Agreement?

In its broadest sense, the ‘franchise’ element describes any third-party relationship in which one business is licensing its key intellectual property, such as the trademark, copyright in materials, any proprietary software, and its know-how, to enable another business to replicate how it operates and sells its products and services.

Typically, this is characterized as a ‘business format’ franchise, but the franchise relationship can have varying degrees of control and different monikers, such as ‘JV partners’, ‘franchise partners’, and ‘licensees’.

The Franchise Agreement will also cover the franchisor’s provision of initial and ongoing support and training, and also some centralized services. There will be a long list of the franchisee’s obligations to follow the system and comply with guidelines. The Franchise Agreement will also set out the key financial obligations and what happens when the relationship comes to an end.

The Franchise Agreement sits alongside the operations manual and the business plan: all three documents together form the foundation of a franchisee’s business, so it is essential that both parties fully understand the terms of the Franchise Agreement, otherwise they will not have a strong foundation on which to build a successful business relationship.

How does a Franchise Agreement work?

Franchise agreements differ from many other forms of commercial contracts due to their one-sided nature, so it’s best to think of them as their own franchise contract. But there is a good reason for this: by joining a franchise network and growing a business using the franchisor’s brand, know-how, products, and support, a franchisee is entering into a legal relationship which is very different from bi-lateral commercial agreements.

The franchisor has to be able to monitor, audit, and effectively police its network of franchisees in order to ensure uniformity of brand experience and brand standards. Equally, the franchisor is placing its core business asset, its IP, in the hands of a third party, so there has to be a firm commitment to adhere to standards and develop the business in accordance with certain standards.

The Franchise Agreement must be biased in favor of the franchisor, otherwise, the built network is a house of cards. The litmus test for any compromise on a franchisor’s standard terms is: “What would happen if this compromise was given to all franchisees?”

If the answer is that it would lead to an erosion of the franchisor’s ability to protect its IP, change and update its system and consumer offering, and police and enforce brand standards, then the compromise must be rejected. Crucially, this unilateral approach will benefit compliant franchisees, as it means that quality standards will be high, it shows that the franchisor cares and that poor-performing franchisees should not be able to undermine the network.

What’s the difference between a Franchise Disclosure Document and a Franchise Agreement?

Put simply, the Franchise Disclosure Document (FDD) is a piece of paperwork that outlines the franchisor-franchisee relationship, providing the potential franchisee with everything they need to know about the franchisor, the franchise concept, franchise fee, operating manual, and the franchise offering. It’s a document that allows a prospective franchisee to undertake due diligence about the franchise business.

The Franchise Agreement is a binding contract signed between the franchisor and franchisee that legally governs the relationship between both parties.

What’s involved in a Franchise Agreement for franchisors?

1. Clarity over the grant of rights, and what is reserved to the franchisor

If a franchisor is offering a territory-based franchise, it should only grant the minimum required territory and impose performance targets, to ensure that the territory is fully exploited and that the franchisee has the capability of utilizing it fully. Understanding your target territory and the capability of the franchisee is crucial. Franchisors should resist the temptation to grant blanket exclusivity and, if necessary, use rights of first refusal.

It is easier to increase the territory later than reduce it. Franchisors of certain systems – particularly in the retail and leisure and hospitality sectors – should think increasingly about exclusivity both in terms of geography and “channels”.

2. The ability to evolve the franchise system

Typical Franchise Agreements are often long-term commercial contracts that are set in stone on the day they are signed. The operational manual is a living and breathing document that will evolve over time as the system changes, and it is therefore vitally important to ensure that the Franchise Agreement and operational manual work in tandem. It’s important to strike the right balance between legal and financial certainty for the franchisee and the franchisor’s need to innovate and drive changes through the system to ensure that the franchise remains competitive.

If the right balance is not achieved, a franchisor may find itself unable to develop the system or forced into developing a two or multi-tiered system in which a consumer’s experience of the brand may vary from market to market, or from franchisee to franchisee.

3. Protecting the know-how for franchisors

Restrictive covenants (RCs) are very common in Franchise Agreements. They seek to protect goodwill and customer relationships by limiting the licensee’s right to operate a competing business both during the term and after the termination or expiry of the agreement. RCs will typically comprise undertakings of non-solicitation, non-dealing, confidentiality, and non-competition and have a specific duration and/or geographical reach. RCs can be vital in protecting the integrity of a brand’s network.

RCs must comply with applicable competition law and common law principles on restraint of trade. To be enforceable, RCs in Franchise Agreements must therefore strike a delicate balance between protecting the franchisor’s legitimate business interests and at the same time not being overzealous in their scope and duration.

Poorly worded RCs could render the entire clause, or possibly the franchise agreement, unenforceable. RCs that fall foul of competition law also risk exposing the parties to the agreement to an investigation by the UK or EU competition authorities and fines for infringement of the competition rules. A franchisee that suffers loss as a result of an anti-competitive RC may also have a damages claim against the franchisor.

4. Managing risk in a franchise agreement

From a financial perspective, it is important that the franchise agreement clearly sets out all of the relevant fees and payment obligations. A common blind spot is who is responsible for the franchisor’s costs in providing initial and ongoing support and assistance and conducting inspections and audits in the franchisee’s territory. Equally, where a franchisor supplies goods on credit to the franchisee, or facilitates a direct relationship between each franchisee and its nominated supplier, it is important that the franchisor can monitor the credit risk and take action, as the risk of systemic financial exposure and damage to the brand is significant.

Other areas of increasing importance are those sections in the Franchise Agreement which relate to online promotional activities, e-commerce and data protection. All three are key touchpoints with customers, so it is important that the Franchise Agreement sets the framework for how these interactions should operate.

5. Exit and investment planning for the franchisor

Franchisors should plan for an exit that is smooth, causes the least disruption to the network, and maximizes the value. It is important that your Franchise Agreements facilitate this and do not act as a blocker on any potential investment into or sale of the franchisor. Change of control and assignment provisions must enable a franchisor to dispose of its business without having to seek individual consents from franchisees.

5 things franchisees need to look for before signing a Franchise Agreement

1. Check for trademark protection

One of the key pieces of due diligence on a franchisor is to check what trademark protection they have in place and whether they own those registrations, or are simply licensed to grant franchises.

In relation to know-how, the European Code of Ethics for Franchising – which is designed to promote ethical franchising in Europe and provides the franchise industry’s foundation for voluntary self-regulation – was recently updated. One of the new obligations on franchisors is to guarantee the right to use the know-how transferred and/or made available to the franchisee, and it is the franchisor’s responsibility to maintain and develop this know-how.

2. The franchisor should evolve the system and police the franchise network

For franchisees, franchisors should be duty-bound to develop and innovate the system and keep it competitive against other similar systems. Furthermore, the franchisor’s desire to have the broad rights to monitor the network and enforce contractual terms should arguably extend into an obligation to police the network and sanction franchisees that do not play by the rules.

3. How to run the business online

Franchisees need to understand how they promote their business and even sell their services and products online. Therefore, it should be incumbent on a franchisor to inform prospective and individual franchisees of their internet communication and/or sales policy. It should not be acceptable for some franchisors to hide behind the opaque pretense of “prior written consent” before a franchisee is allowed to participate in online activities.

4. Maintain good faith and fair dealing

There is clear recognition in the Code of Ethics that the franchisor-franchisee relationship should be underpinned by the principles of good faith and fair dealings. Both are expressly included in the preamble to the Code of Ethics, which emphasizes the importance of franchisor-franchisee relations based on fairness, transparency, and loyalty, each of which contributes to confidence in the relationship.

Franchisees should check dispute resolution clauses to see if they contain an escalation process for resolving complaints, grievances and disputes through fair and reasonable direct communication and negotiation.

If this fails, the agreement should be clear about how disputes are finally resolved, for example through the courts, mediation or arbitration. Arbitration can be a very expensive blunt tool for resolving domestic disputes in the U.K. specifically, although it has advantages in an international context.

5. Exit planning

Franchisees should have the right in most cases to sell or transfer their business as a going concern during the term of business. For larger franchisees, it is also important to ensure that they have the ability to transfer shares between existing owners, assign rights as part of a corporate restructuring exercise, or take third party investment, provided that such activities do not materially change the ultimate management of the franchisee or compromise the franchisee’s contractual obligations around issues such as on-compete restrictions and secured interests.

5 Pitfalls in international and master Franchise Agreements

1. Plan for change within the market

In an era of rapid change, even the best strategy, planning and due diligence by a franchisor cannot perfectly predict the market reaction to a brand or its products and services. A robust international strategy includes risk assessment and early-stage monitoring mechanisms, together with a thorough ‘Plan B’.

A prosperous international strategy that is not supported by a clear and comprehensively drafted Franchise Agreement that leaves room for tweaking or modifying will inevitably lead the brand or system to flounder.

An international Franchise Agreement must be designed in a way that makes it most resilient in the face of the unexpected. This involves considering a range of potential outcomes and alternative approaches that the franchisor might take in expanding to the foreign territory such as changes to the system service offering to meet unexpected market reactions.

Most importantly, such tailored drafting goes far beyond the use of a pro forma system modification clause found in many Franchise Agreements.

2. Note the nuances of international franchising

Some foreign territories have entirely different legal systems. Ironically, those territories can be less dangerous than territories that are closer in proximity and similar in franchise regulation. This is because franchisors fail to take notice of the subtle differences in closer and more similar territories which often results in significant challenges down the road.

This problem often rears its head when U.S. franchisors expand into Canada. With the ever-expanding body of case law in Canada, an international Franchise Agreement covering the region must be reviewed carefully to ensure that it reflects the laws in Canada at the time.

Generally speaking, the customization process need not be protracted, and in many cases is not arduous, but it needs to be done competently, and as close to signing as possible. By way of a more specific example, in Canada, it has been held that selecting Ontario, which has franchise legislation, as the governing law for franchises operated outside of Ontario invokes the Ontario franchise legislation and makes disclosure mandatory, although it would not have otherwise been required.

Another example is that general releases required under a Canadian Franchise Agreement, at time of sale or renewal, may not be enforceable if the rights of franchisees under the relevant franchise statute are not carved out.

3. Create a clear online strategy

Online presence and social media have become a major aspect of documenting the rights and responsibilities of franchising parties. They become even more important when drafting master Franchise Agreements.

There are many questions you need to consider when devising an international Franchise Agreement – and there is not a set master Franchise Agreement template to follow – such as: How will the use of the internet and hosting of websites be divided between the franchisor and the franchisee in the foreign territory? Can the franchisee market and sell online, or will the franchisor host a specific webpage for the new territory and refer leads to the franchisee? You also need to recognize the importance and responsibility of social media. Will the franchisor prepare the social media policy for the foreign territory, or will this be controlled by the franchisee?

In determining who will host and manage the foreign territory’s specific website, the franchisor has to balance the need to maintain control of the brand with the fact that the franchisee is better placed to understand its market. Whatever your strategy, it needs to be well-planned and understood before the agreement is signed.

4. Scrutinize the agreement structure

Tax planning and corporate structuring in international franchise arrangements are often undervalued, overlooked, and poorly implemented. It is a critical step in expanding to foreign territories that should be undertaken by an international franchise lawyer before any agreement is prepared.

It is equally important that the parties understand the planning and structuring under which the Franchise Arrangement will operate, and ensure that the agreements reflect that planning and structure.

Try to answer all of the following questions before drafting an agreement. Do one or more individuals comprise the franchisee? Is it a corporate franchisee? Are the individual shareholders providing personal guarantees? Has the franchisor incorporated one or more entities for the international expansion? Will one such entity have the rights to grant the trademark license to the franchisee? What is the intended process for repatriation of profits? Are there withholding taxes and how will they be dealt with?

5. Understand termination and enforceability

Understandably, franchisors typically hope for the best, however they need to plan for the worst. The reality is that considering the ‘end game’ at the beginning of the relationship is absolutely critical. This requires a tailored approach in carefully analyzing the range of likely potential outcomes and the alternative approaches in circumstances where there is a breakdown of the relationship and a breach of the agreement by the franchisee.

Once the franchisor has determined what rights it should have to revise, terminate or grant to the franchisee, those mechanisms should be tested against the regulatory backdrop of the foreign jurisdiction. In an age of increased regulation and litigation, franchisors should not rely simply on standard default and termination provisions. Attention must be paid to all franchise laws, relationship laws, breach and termination principles, and non-competition laws.

These are but a few of the often-overlooked considerations that should be specifically addressed in drafting and negotiating international and master franchise agreements.

How to exit the Franchise Agreement

It happens all too often: As a franchisor, you have spent time, effort, and good money on getting your template Franchise Agreement drawn up by an experienced franchise lawyer. When it came to filling in and sending out versions of the agreement to franchisees who are about to come on board, you entrust the task to someone in your admin team. Some months/years later, a franchisee is in default, and action needs to be taken. You hand the relevant documents over to your franchise attorney, confident that you have a water-tight case.

Then comes the unwelcome news: your franchisee’s lawyers have found a loophole. Your case is now looking not so water-tight, and your lawyers are warning you about the substantial costs and risks of litigation. The quick, cost-effective route to justice that you thought you would have is nowhere in sight.

The truth is that it can happen frighteningly easily. There are a growing number of lawyers who regularly act for franchisees who are dissatisfied with their franchise, and no shortage of franchisees who visit those lawyers, saying that they wished they hadn’t signed up to the franchise in the first place, and who are seeking a way out. The smartest lawyers know all the escape routes. So if you want to know how to reduce your risks, read on.

Escape Route 1: Keep copies of the franchise agreement

Who has got the legal agreement? It is surprising just how often franchisors can’t actually find a properly signed copy of the relevant Franchise Agreement. After the agreement was originally signed, years can go by before a dispute arises, in which time you may well have had changes in staff or office moves. Documents go astray. If you don’t have the signatures of all the parties on an agreement, you have given yourself an uphill battle.

Solution: Pay your franchise lawyer to take responsibility for issuing Franchise Agreements and keeping scanned copies of the signed copies.

Escape Route 2: Keep an eye for detail of franchising info

You can find the signed agreement, but the details were not filled in properly. It is incredibly easy to slip up here. You need a keen eye for detail to ensure that the right people signed in each of the right places, and that all the details regarding franchise territory, advertising commitment, advertising fees, and royalty fees were correctly added.

Where a franchisee provides a personal guarantee, for example, this should be signed as a deed, which means that their signatures must be witnessed by someone independent. If witness signatures or details are missing, or if you witnessed the signature yourself, you could be in difficulty.

Solution: Same as for Escape Route 1. It should only cost a modest amount to pass the responsibility of this to your franchise lawyers.

Escape Route 3: Expired franchise agreement

The Franchise Agreement had expired. The franchisee continued operating beyond the expiry date of the agreement. You may have mentioned to them a few times the need for a new agreement, and you may even have sent them a renewal document. Nevertheless, it was not signed.

This does not make your legal case against the franchisee hopeless. But it does present difficulties, particularly if you want to enforce the non-compete clauses that were to apply after franchise agreement termination.

There is an open position in the English courts whether the restrictive covenants – for example, prohibiting the franchisee from being involved in a competing business for 12 months after the end of the term – should run from 12 months from the point that you terminate the agreement, or for 12 months from the original expiry date of the agreement.

The franchisee’s lawyers may well argue for the latter, and tell you that the 12 months has already expired. Because the law is not clear-cut, your case will be more difficult.

Solution: Keep rigorous records so that you can flag well in advance that an agreement is up for renewal. Check that your standard agreement has a specific provision providing for a short notice period for termination if the agreement continues beyond its original expiry date.

Escape Route 4: Specify warning in your franchise agreement

The franchisee signed their Franchise Agreement without being advised to take independent legal advice. This, unfortunately, leaves a potential door open for the franchisee to argue that they did not understand what they were signing. In particular that they did not realize they were providing a personal guarantee.

As the Franchise Agreement was in all probability provided to the franchisee on a “non-negotiable” basis, and in the same form that you have provided to every other franchisee, there may well be a runnable argument that some provisions cannot be enforced.

Solution: Certainly you need a specific warning in your Franchise Agreement, on the same page as the franchisees’ signatures, that they must not sign before taking independent advice. Consider even making this mandatory before onboarding a new franchisee.

Escape Route 5: Review the franchise agreement

The restrictive covenants relating to not competing against the franchisor are too wide or have left unintended loopholes. Restrictive covenants will not generally be enforceable if they are drafted wider than they strictly needed to be in order to protect the franchisor’s legitimate goodwill. A smart lawyer will pick at the wording, and will sometimes succeed in finding a hole that is sufficient to unravel the whole clause.

Solution: Get your Franchise Agreement reviewed regularly. Your restrictive covenants might have been appropriate for your business as it was at the time of drafting. But what was once exactly on point might not be so as your business evolves.

Escape Route 6: Don’t forecast future earnings

Misrepresentation. The most commonly-used escape route that lawyers acting for franchisees will use is a claim that the franchisor gave a prospective franchisee unrealistic forecasts of turnover, profits, or customer numbers. They then argue that because of this the franchisee should be able to “rescind” the agreement as it doesn’t correlate with the agreement term, which means treating the agreement as never having existed in the first place, making post-termination obligations completely null and void.

Solution: Never make forecasts of future earnings to prospective franchisees unless these are backed up with real-world evidence. Putting a disclaimer in your franchise brochure or Franchise Disclosure Document to the effect that the forecasts are illustrative only and that the franchisee’s performance is not guaranteed will not suffice. As to what counts as “real-world” evidence, seek advice from your franchise lawyer.

Escape Route 7: Adhere to the Acts

Your agreement falls foul of the Trading Schemes Act 1996. This act was designed to stop pyramid selling. But the law of unintended consequences saw to it that it ended up putting a restriction on the enforceability of Franchise Agreements as well. You may be able to draft your agreement in such a way that you avoid the impact of this act. But depending on your industry sector, this may not be achievable.

Solution: If you don’t remember having taken careful advice from your franchise lawyer at the time, check this point with them again. Are you doing anything that might cause the act to apply? If yes, you might need to make changes to your business methods.

Escape Route 8: Assess the damages

Your franchisee has been involved in another competing business, and you want to sue for damages. But how do you calculate your actual losses? This is less of an “escape route”, but rather a hurdle that you will need to climb over if you want a payment by way of compensation.

Solution: Do not be deterred. You will need to think long and hard about what damage the franchisee is actually doing to you, and how they are damaging your income stream. Are they making it harder for you to recruit other franchisees? If yes, you are losing out on initial franchise fees and management service fees.

Escape Route 9: Listen to your lawyer

If you are taking action against your franchisee, you may well want to have “step-in rights”, which enable you to take over and run your franchisee’s business in order to protect your customers’ interests and the reputation of your brand. But these are notoriously tricky to draft. Particularly if you want the right to enter your franchisee’s premises and take over their lease.

Solution: Take advice from your franchise lawyer about whether you need a specific Deed of Option in relation to your franchisee’s lease.

Escape Route 10: Don’t meddle with the agreement

If all else fails, a lawyer acting for a franchisee will have a look at whether the agreement or any part of it is unenforceable because it is contrary to EU competition law, if you’re based in Europe. Most franchise lawyers will be very mindful of this when drafting Franchise Agreements. But problems can arise where business systems change over time, or when franchisors are tempted to make what seem like trivial changes to their Franchise Agreements.

Solution: Make sure that your franchise lawyers explain to you what “hardcore” restrictions and “grey list” restrictions are so that you can be sure that nothing in your business is falling foul, and do not fiddle with your agreement without legal advice, no matter how tempting it is.

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