September 19, 2016

The Devil is in the Details: what you need to know about your Franchise Agreement

Deciding to purchase a franchise is a complex process. After researching the business side of the investment, prospective franchisees should carefully review the franchise agreement with their legal advisors before signing it. Many franchisors will tell you that their franchise agreement is standard and non-negotiable and that may very well be the case, however, you should fully consider the following four key issues before you purchase any franchise.

Franchise Fee

In addition to the actual amount of the franchise fee, you should determine if the franchise fee is refundable and if so, how much will be refunded and under what circumstances. Typically, franchisors will return at least some portion of the franchise fee if a location for the franchise is not found within a certain time period (e.g. 6 months) or if you do not successfully complete training. If the Franchisor or you are unable to secure any sites that are suitable to you, then you should be entitled to a full refund of the franchise fee. If there is no incentive for the franchisor to actually secure suitable premises, it makes little sense for the franchisor to be entitled to any of the franchisee fee as it really hasn’t done anything to earn that fee. If you don’t successfully complete training, it’s reasonable that the franchisor keep a portion of the franchise fee to cover its actual expenses.

Advertising Fund

The lack of effective general advertising in return for the monetary contributions made by the franchisees to an advertising fund is a frequent source of complaints from franchisees. If the franchise agreement entitles you to obtain annual reports on the advertising activities financed by the marketing fund, you should ask the franchisor for copies of past years reports in order to determine the type of marketing that is being conducted and whether it would provide any benefit to you. You should also check the portion of the advertising fund that is spent on administration (a good rule of thumb is that administrative expenses be no more than 20% of the marketing fund).

Protected Territory/Rights Reserved

Defining a protected territory in which you will operate can be critically important, particularly if you will be operating a franchise in a highly saturated market. Beyond drawing the borders of the territory on a map, you should carefully consider whether and in what circumstances the territory can be changed by the franchisor, and what sort of exclusive rights you have to operate in it vis-à-vis other franchisees and the franchisor itself. For example, being in compliance with the franchise agreement or in “good-standing” may be a criterion for maintaining your territory. Since even the best operator may commit minor operational breaches from time to time, you should have the franchisor agree that you only need to be in “material compliance” with your obligations in order to avoid having minor technicalities result in the loss of your territory.
Despite the apparent protection of the territory given to you, the franchisor will often reserve itself certain rights such as building non-traditional locations (i.e., mobile trucks, airports, etc.) within your territory, distributing its products through alternative channels of distribution (i.e., supermarkets, grocery stores, and other outlets), or operating a business within the protected area under a different brand (even if it competes with you directly). It is important to carefully review these reserved rights since you may well have to compete for sales with your own franchisor and its other franchisees.

Required Purchases

You should be wary of franchise systems where you are required to purchase all of your products, supplies, and services directly from the franchisor or from suppliers designated by the franchisor. Although there are legitimate reasons for franchisors to impose this restriction (e.g., to maintain consistent quality throughout the system), it comes at the cost of your ability to out-source your products and supplies for more competitive prices. Moreover, the retention of rebates by franchisors, and their failure to distribute at least some of the benefits of these rebates in an equitable fashion to their franchisees (whose volume buying makes those rebates available in the first place) is often the source of great frustration on the part of franchisees. Since it is relatively standard for franchisors to reserve the right to retain all rebates it receives, you should try to get the franchisor’s assurance that it will not mark up the price of goods or services it supplies to you. At a minimum, the franchisor should agree that such rebates will not inflate prices to the franchisee above those available in the market from similar suppliers for similar products and services.