The franchise agreement is the document which underpins your relationship with your franchisor. It is essential that you understand your obligations under your franchise agreement and any pitfalls contained in it. Fortune Manning has experienced franchise lawyers who can help you with this. While every franchise agreement has been drafted with the needs of the particular franchise system in mind there are certain areas which are covered in most franchise agreements. These are explained below:
This is where the franchisor gives you the right to operate your business using the franchisor’s system which includes its manual and intellectual property (i.e. brand name and trade marks). It is this grant which is the cornerstone of your agreement with the franchisor. Usually the grant is only for a limited period (see Term below) and sometimes it is limited to a particular territory (refer Territory below).
Most grants of franchises are only of a limited period of time. Usually this period is between 5 to 7 years but can be both longer and shorter. During this time you are granted the right to operate your business using the franchise system. The term can come to a premature end if the franchisor terminates the agreement due to a default by you. Once the agreement is terminated (whether due to default or just expiration of the term) you will lose the right to conduct the business (refer Termination below). This is why it is extremely important that you ascertain that the term is sufficient to met your investment requirements. It is also important to bear in mind when assessing the length of the term that once you have entered into the franchise agreement that your rights to cancel prior to the end of the term are minimal.
Territory can be a major issue. The franchisee wants an exclusive territory to ensure that they will not be competing with another franchisee within a specified area and the franchisor wants to avoid exclusivity so it can grant other franchises in the territory and/or operate on its own account in the territory. There are variations on the way territories are handled in a franchise agreement including:
- The franchisee is granted an exclusive territory and the franchisor cannot grant other franchises within that area. The franchisor is also restricted from itself conducting the franchise business in the specified territory and the franchisee is restricted from operating the business outside the territory. The territory is usually described by way of a map attached the franchise agreement.
- The franchisee is granted a territory but in a restrictive sense only, meaning that it cannot operate the franchise business outside the territory but the franchisor can grant other franchises in the area or it can itself operate the franchise business in the territory.
- The franchisee is granted an exclusive territory but the franchisor, can, under certain circumstances (e.g. default, failure to meet minimum performance requirements or at its discretion) reduce that territory by adjusting the boundaries and/or, granting a further franchise in the area.
- As for 3 above but the franchisee has a first right of refusal should the franchisor want to grant additional franchise in the territory.
- The franchisee is granted a relatively small exclusive territory as for 1 above but also has a wider territory outside the exclusive territory within which the franchisor can grant other franchises but only if the franchise has not exercised its first right of refusal to purchase the franchise being granted by the franchisor.
Generally speaking there are three types of fees payable by a franchisee under a franchise agreement – initial, ongoing and one off fees.
The initial franchise fee (for the grant of the franchise) (refer cooling off period below) is payable on signing of the agreement or after the cooling off period has expired.
Ongoing fees such as the royalty (or sometime called franchise fee or franchise service fee) are payable on a regular basis (usually monthly) to the franchisor for the continued use of the franchisor’s intellectual property and for the support received from the franchisor. This fee is usually calculated as a percentage of the gross revenue achieved by the franchisee but can also be a fixed monthly amount. Another ongoing fee is the advertising fee (sometimes called the marketing contribution) which is used by the franchisor to pay for the advertising and promotion of the system as a whole. This is also usually calculated as a percentage of gross revenue but can also be a fixed monthly amount.
One off fees can include an assignment or transfer fee which is payable by you to the franchisor if you transfer the business and a renewal fee which is payable by you in consideration of the franchisor agreeing to grant you a franchise for a further term.
It is essential that you become familiar with the requirements of the franchise system before you begin operating your franchise business. The franchisor will usually have an obligation to provide you with some form of initial training and you will be required to attend this and complete it to the franchisor’s satisfaction. You will also be required to undergo ongoing training (usually at your cost) as required by the franchisor and to ensure that your employees are trained in the system.
You will usually be restricted to selling only those products and services which have been approved by the franchisor and which have been purchased from those suppliers which are approved and notified to you by the franchisor. There will probably be a provision in the agreement which deals with the situation if you are unable to obtain the products from an approved supplier and allows you to source the products from a different supplier with the approval of the franchisor.
It is standard that the franchisee pays the franchisor an ongoing amount on a regular basis (usually monthly) for advertising purposes. The franchisor will use this amount together with amounts paid by other franchisees to advertise the system as a whole – for instance national television campaigns etc. It is usual that any decisions made in relation to advertising are at the franchisor’s sole discretion and are not in relation to a particular franchise business. It is comforting to see franchisors which have agreed that any advertising fees are pooled and placed in a separate account only to be used to pay for certain expenses and that the franchisees will receive a statement in relation to the advertising fund at regular intervals. However this is no means standard. In some franchise agreements the franchisor has absolutely no obligations in respect of the advertising fees it receives.
Intellectual Property and Confidential Information
The franchise agreements will contain pretty strict provisions in respect of the franchisor’s intellectual property and confidential information. In a very basic sense intellectual property refers to human creations and innovations which are capable of being protected under law and includes copyright, trade marks, brand names, patents, logos, literary works, written texts, and artistic works. The franchisor in developing the franchise system has probably developed various forms of intellectual property including copyright (in the manual and in other written information), trade marks, logos, brand names etc. There will also be a fair bit of information which the franchisor will want to keep confidential from competitors and members of the public, for instance; details about the system, financial information and the contents of the Manual. It is vital to both the franchisor and all the franchisees in the system that the franchisor’s intellectual property and confidential information is protected as much as possible and there are usually strict obligations on the franchisees in relation to the intellectual property and confidential information and sanctions for breaching those obligations contained in the franchise agreement.
Most franchise agreements require the franchisees to regularly report to the franchisor. Where the franchisor is calculating the franchise royalty based on gross sales then it is usual to see weekly or monthly reporting obligations in respect of your sales. In addition there could also be quarterly, bi annual and annual reporting obligations in respect of the financial information about your business. These reports enable to franchisor to track how their franchisees are performing and ascertain areas for improvement and training. There may also be minimum performance obligations which a franchisee must achieve and reports can help the franchisor ascertain whether or not these obligations have been achieved. It is also common for the franchisor to have the right to audit your financial information and to require you to provide any information about your business that the franchisor requires from time to time.
The franchisor will require you to take out various types of insurance in respect of your business (including insurance in respect of the premises, public liability insurance etc) and most often will require you to provide the franchisor with evidence on a regular basis that you have this insurance in place. In addition the franchisor may require the insurance policy to record the fact that the franchisor is an interested party.
Where you are required to occupy premises in order to operate your franchise business the franchise agreement will probably contain a number of provisions in respect of the premises which may include:
- Approval of the premises by the franchisor
- Approval of the lease or licence which you will be required to enter into
- Fit out to be in accordance with franchisor’s requirements
- Lease to contain provisions required by franchisor
- Consent from franchisor required before relocation
- Franchisor permitted to enter premises to ascertain whether you are complying with your obligations
- Strict compliance with the lease
- Refurbishment required at request of franchisor and at your expense
Sometimes the franchisor will enter into a lease directly with the landlord (“the Head Lease”) and will then sublease the premises to you. In this situation your directors and shareholders may be required to guarantee the Head Lease.
It is usual to see non-competition or restraint of trade provisions in franchise agreements. These are provisions which restrict the franchisee from conducting a similar business during the term and after. Some franchise agreements even restrict the franchisee from conducting any other business whatsoever during the term of the franchise agreement. This is usually where the franchisee needs to devote all of their time and attention of the business to ensure its success. Generally, a restraint of trade is assumed to be invalid but the courts have discretion to decide whether to enforce it or not. The onus is on the franchisor to convince the court that the restraint should be upheld. In deciding whether to enforce the restraint the courts will consider the following factors:
- The respective bargaining powers of the parties
- Whether the restraint is essential to protect the franchisor’s business interests
- Whether it would be against public interest to enforce the restraint
- The scope of the restraint – generally speaking – the wider the restraint the more likely the courts will be not to enforce it
- The term or period of the restraint
More often than not your franchise agreement will provide that you have a right to renew it at the end of the first term provided you meet certain terms and conditions. These terms and conditions can include the following:
- Obligation to pay the franchisor’s legal fees associated with processing the renewal and preparing the new franchise agreement etc.
- Payment of a Renewal Fee for the grant of the use of the franchise system and the franchisor’s intellectual property for the further term.
- Not being in breach of the franchise agreement at the time of the Renewal. Sometimes a condition of the renewal will be that you have not committed any breach of the franchise agreement during the term. Obviously this highlights that strict compliance with the agreement is essential.
- Refurbishment of premises to met the current image of the franchise system. Provision of notice in writing within a certain time frame.
- Execution of the franchisor’s current franchise agreement (which may be on different terms and conditions to your existing franchise agreement). Franchisor’s right to review the territory and reduce/enlarge at its discretion.
If you are thinking about selling your franchise business you will need to look carefully at the provisions in the franchise agreement relating to transfer. The franchisor will want to have control over who purchases your business much in the same way it controls the process of selecting a new franchisee.
A franchise agreement will usually provide that the franchisor has a first right of refusal which means that you will need to offer your franchise business for sale to the franchisor before you agree to sell it to anyone else.
If the franchisor does not exercise its right of refusal the franchise agreement will usually provide that the transfer of your business will only be approved if certain conditions are met, these can include:
- Approval of the new franchisee
- You not being in breach of the franchise agreement at the time of the transfer
- Payment of a transfer/assignment fee by you
- Payment of a training fee by the new franchisee
- Reimbursement of legal costs incurred by the franchisor
- Payment of all amounts owing to the franchisor
- The new franchisee signs the current franchise agreement and other documents – note that the term of the new franchise agreement could be the unexpired term under your franchise agreement
- Updating the premises and/or vehicle to met the franchisor’s current requirements
Cooling Off Period
A cooling off period is a limited period of time which starts immediately after the franchisee has entered into the franchise agreement during which the franchisee can terminate the agreement and receive a refund of any money it has paid (usually less the franchisor’s expenses). If the franchisor is a member of the FANZ then it is required to have a cooling off period of 7 days in its franchise agreement. Even if the franchisor is not a member of FANZ it is becoming standard to see a cooling off period in the franchise agreement.
One of the risks of purchasing a franchise agreement is that it is terminated prior to the end of the term. This is why it is essential that you understand the circumstances in which a franchisor can terminate your agreement.
There are generally two types of termination – immediate and on notice.
The franchise agreement will usually state that the franchisor can issue you with written notice of breach if you breach any provision of the franchise agreement and/or certain other requirements which are set out. The notice of breach will tell you what you have done wrong, what you need to do to remedy the breach and by when. If you do not comply with the terms of the breach notice the franchise agreement will usually provide that the franchisor can terminate the agreement.
Immediate termination is reserved for serious breaches of the franchise agreement and events such as:
- your bankruptcy (if the franchisee is an individual)
- liquidation of the franchisee company
- non-payment of amounts owned under the agreement within a certain period of time
- assignment without the franchisor’s consent as required under the franchise agreement
- conviction of the directors/ managers of the franchisee of certain offences, being issued with a certain number of breach notices within a certain period of time
The very nature of a franchisor and franchisee relationship and the dependencies involved can give rise to disputes from time to time. Usually these disputes can be sorted out between the franchisor and franchisee. Most franchise agreements will contain a clause which sets out what is to happen if the franchisor and the franchisee disagree with each other. If your franchisor is a member of the Franchise Association of New Zealand Inc then the franchise agreement will contain a dispute resolution clause which is similar to that required under the FANZ Code of Practice.
The existence of a dispute resolution clause is of benefit to you. Without it the only way you will have to resolve a dispute (unless the franchisor agrees otherwise) is to go to court – a timely and very expensive process.
There are different types of dispute resolution provisions ranging from negotiation between the parties, mediation (when an independent party tries to assist the franchisor and the franchisee to come to a resolution) or arbitration (where after hearing both sides of the story an independent party (the arbitrator) makes a decision).
If the franchisee is a company then the directors and shareholder of that company will be required to personally guarantee the company’s obligations under the franchise agreement.
Most guarantees will provide that the guarantors will:
- Personally guarantee the franchisee’s performance of its obligations under the franchise agreement.
- Indemnify the franchisor against any claims, losses and expenses which the franchisor may incur as a result of the franchisee’s breach of the franchise agreement.
- The guarantee will continue even if the franchisor has exercised any of its rights under the franchise agreement.
- The guarantor’s obligations under the franchise agreement will continue until all money owed under the agreement is paid in full.
- Agree that the franchisor does not have to make a claim against the franchisee company before claiming against the guarantors.