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Franchising is a much abused word and means many different things to different people. In simple terms it is the granting of certain rights by one party (the Franchisor) to another (the Franchisee) in return for a sum of money. The franchisee then exercises those rights under the guidance of the franchisor. Franchising is a business arrangement where a franchisor sells a business idea and methodology or a "franchise business" to a franchisee, who operates the business under the franchisor's name. The franchisee is authorized to use and market goods or services under the franchisor's trademarks, service marks, and trade names for a specific length of time. In exchange for the advantage of not having to start the business from the ground up, the franchisee usually pays the franchisor an up-front fee and a percentage of sales. Each state has its own franchise information regarding the franchise law and regulations governing franchises.
Business format franchising can be defined as a contractual licence granted by one person to another which:
Permits or requires the franchisee to carry on a particular business using the franchisor’s know-how under the franchisor’s brand as an independent business;
Allows the franchisor to exercise continuing control over the manner in which the franchisee carries on the franchised business; and
Obliges the franchisor to provide the franchisee with ongoing support in carrying on the franchised business.
As a commercial matter, the agreement inevitably requires the franchisee periodically during the period of the franchise to pay to the franchisor sums of money in consideration for the franchise and / or goods and / or services provided by the franchisor to the franchisee.
A franchise is an agreement by which the franchise business (the franchisor) licenses the business operator (the franchisee) to operate a business under the name of the franchisor. The franchisee is authorized to use and market goods or services under the franchisor’s trademarks, service marks and trade names, for a specific length of time.
The logic in buying a franchise is usually that there is significant value in the goodwill and other rights associated with the franchised business model that has previously been developed and operated successfully by the franchisor. This may or may not be the case in a given situation.
Generally, the franchisee will pay an up-front fee as well as continuing fees based on the dollar amount of goods or services sold. The franchisor offers services such as training the franchisee and providing market research to determine a favorable location for the business. The franchisor typically has strict rules and standards as to how business is conducted, the goods and services to be sold and the design and construction of the business location.
Lenders may be more willing to finance the franchisee of a reputable and established franchisor than the entrepreneur desiring to open an unproven business. Although by no means free from risk, a franchise from a franchisor with well-known and well-accepted products or services can significantly reduce business risks and enable you to own and operate a business on your own with no previous training.
If you’re considering franchising, you’ll have to carefully investigate:
The specific costs;
Whether financing is available;
What your expected earnings might be; and
How long the franchise agreement runs?
The franchise agreement is the cornerstone document of the franchisee--franchiser relationship. It is this document that is legally binding on both parties, laying out the rights and obligations of each. A sample agreement may either be attached to the disclosure statement or presented separately. Either way, you are entitled to receive it as a prospective franchisee five business days before signature. You should have it reviewed by a lawyer familiar with franchise matters--especially since most agreements are extremely one-sided in favor of the franchiser. No one should enter into a franchise and expect to have an evenly drawn contract.
The agreement will contain provisions covering, in considerable detail, the obligations of the franchiser and franchisee regarding operating the business; the training and operational support the franchiser will provide (and at what cost); territory and any exclusivity; the initial duration of the franchise and any renewal rights; how much Franchisee must invest; how must deal with things such as trademarks, patents and signs; what royalties and service fees will pay; tax issues; what happens if Franchisee should want to sell or transfer the franchise; advertising policies; franchisee termination issues; settlement of disputes; by the company, operating practices, cancellation, and attorney fees.
The key items of the disclosure statement include
Background information on the franchiser and any predecessor;
The identity and business background of key personnel affiliated with the franchiser or franchise brokers;
Any prior litigation actions;
Any bankruptcy history;
Franchisee's initial franchise fee or other initial payment to begin the operation;
Other fees, such as service fees, training fees, advertising fees, royalties;
Any commitment of a franchisee to purchase or lease from designated sources;
Franchisee's principal obligations;
Obligations of the franchiser; supervision; assistance; services; Exclusive area or territory;
Trademarks, service marks, trade names, logos, and commercial symbols; Patents and copyrights;
Any commitment of the franchisee to personally participate in the actual operation of the franchise business;
Renewal, termination, transfer and dispute resolution;
Statistical information and listing of other existing franchisees; and
Audited financial statements.
There is no standard form of franchise agreement because the terms, conditions, and the methods of operations of various franchises vary widely depending on the type of business involved. For example, franchises for printing, employment agencies, and automotive products will differ from the franchises for fast food service, convenience stores, or clothing.
A franchise agreement should achieve three fundamental objectives:
Given the absence of specific franchise legislation, it should contractually bind the franchisor and the franchisee and accurately reflect the terms agreed upon.
It should seek to protect for the benefit both of the franchisor and the franchisee, the franchisor's intellectual property.
It should clearly set out the rules to be observed by the parties.
As there is no specific legislation or regulation for franchising, the franchise agreement becomes all-important in determining the rights and obligations of the franchisor and the franchisee and the relationship between them. In this respect the franchise agreement can be said to form the 'engine room' of the whole transaction. If difficulties should arise between the franchisor and the franchisee they will need to turn to the contract to see what, if any, rights and obligations have been provided in the franchise agreement.
What, then, should one look for in a franchise agreement?
A franchisee will look for promises:
To train the franchisee and his staff;
To supply goods and / or services;
To be responsible for advertising, marketing and promotions;
To assist the franchisee to locate and acquire property and have it fitted out and converted into a franchised outlet. (Similar considerations apply with regard to the acquisition of vehicles, fitting them out, equipping the franchisee etc.)
To assist the franchisee to set up in business;
To improve, enhance and develop the business system; and
To provide certain support management and possibly accounting services.
Franchisors will be anxious to ensure that the franchise agreement clearly sets out the obligations of the franchisee. A franchisor will therefore wish to:
Monitor the performance of the franchisee;
Protect himself from unfair competition;
Protect his intellectual property; and
Impose obligations and restrictions on the franchisee with regard to the exercise of the rights granted by him to the franchisee.
Figure: Strategic Franchising
THE INTELLECTUAL PROPERTY
These are in the nature of:
Unless the franchise agreement contains sufficient safeguards to protect the franchisors intellectual property rights, the franchisor may find that he is unable to prevent infringement of his rights by a third party or an ex-franchisee.
Franchisors should be aware that it is not only in the interests of the franchisor that these rights be protected. Franchisees are equally concerned to ensure that the franchisor had done everything that is reasonably possible for him to protect the intellectual property rights in question. Many franchisees purchase a particular franchise because of the high profile a franchise enjoys in the market place. In many cases, a franchisee has the choice of which franchise to purchase in the same market sector and one of the reasons why a franchisee will have chosen a particular franchise is because of its strong brand image. It follows therefore that the franchisee will be anxious to ensure that in the event of infringement, the franchisor has taken sufficient steps to safeguard his ownership in his intellectual property rights so that he can stop infringement and thereby protect the reputation of that brand name both for himself and for his franchise network. If the contract is weak on this point, franchisees will not consider that particular franchise to be a sound investment proposition because the franchisor will be limited in what he can do to prevent a 'copy cat' operation from being set up in direct unfair competition with a franchisee.
Brand names and trademarks are becoming increasingly important to business; they can increase the asset value of a company and therefore need to be adequately protected. The franchise agreement should therefore not only grant relevant rights to the franchisee and reserve rights for the franchisor, but should also contain mechanisms necessary for protecting the franchisors intellectual rights from infringement.
All franchisees should be treated as a family and, as such, there should be no room for favourites. This means that the franchise agreement should be in a standard form with all prospective franchisees being offered the same terms with no special deals being done. If a franchise agreement is to be non-negotiable then it is important, from the franchisees point of view, that is well balanced in terms of rights and obligations of the parties and takes into consideration the franchisees concerns also. Again, in the absence of legislation or regulation, which tells the franchisor and franchisee what to do and how to behave, and given that franchisors and franchisees perceive the franchise relationship to be a long term one, it is important that the contract spells out very clearly what is expected and of each party to the contract.
The franchise agreement should therefore clearly:
Specify in detail the duties and obligations both of the franchisor and of the franchisee;
State the grounds upon which the franchisor will seek to terminate the franchise agreement;
Deal with the payment of franchise fees and the timing of those payments; and
Set out the consequences of such termination.
Some thought has to be given to the franchisees and their objectives and provision should therefore be made in the franchise agreement to deal with what is to happen should the franchisee die or become permanently incapacitated.
It is also advisable to deal with the question of what is to happen if a franchisee wishes to sell his business during the term of his franchise agreement. Here, as in other matters, a balance has to be struck between the need of the franchisee to realise his investment as and when he wants to and the requirement of the franchisor to approve those coming into the franchise network and to prevent those leaving the network (for whatever reason) from continuing to use the franchisors trade secrets and competing unfairly.
The franchise transaction is complex and the franchise agreement must respect that complexity. Experience has shown that those franchisors who take the matter of the franchise contract lightly pay dearly for their mistake. To the franchisee, the franchise contract represents an investment. His business depends upon it to the extent that his business may disappear should it terminate. For the franchisor, the franchise agreement is an income producing asset which will ultimately have a place on his balance sheet. If for any reason the franchise contract turns out to be defective, the cost to the franchisor can be the loss of his whole network (given that the franchise agreement is in a standard form). Although it may be tempting for both franchisor and franchisee to rely on goodwill, ultimately it is only the contract that matters.
Whatever the size or reputation of the franchisor, prospective franchisees will always look to the quality of the franchise agreement because they know that there may be a change of policy within the franchisor company or that the people running the franchise operation may change. They know that at the end of the day, all they can rely upon will be whatever rights are written into that contract.
Once a franchise agreement has been signed, both parties will be bound by it. It can be a double-edged sword and if the franchisor has got it wrong he will have to pay the price. A final word of caution - remember that generally speaking, there is still no law against making a bad bargain!
ZA-LLP is a full-services law firm with a national practice dedicated almost exclusively to franchise business law, distribution and business licensing matters. The law firm litigates on behalf of franchise companies throughout the country and provides legal advice on franchise development, franchise sales compliance, distribution and trademark, trade secret and copyright law and protection matters. Our lawyers have extensive experience in pre-litigation legal counseling, litigation, arbitration and mediation in trademark infringement, non-compete, antitrust, collections, underreporting and encroachment claims. In business transactions, our clients look to us to overcome obstacles and close deals. In litigation, our clients count on tactical and strategic legal advice, calculated to accomplish the desired business result, from the earliest stage of the case.