What Is A Franchise Agreement?

Gurmeet S Jakhu, partner at Knights Professional Services, outlines what a franchise agreement is and explains the terms you’re likely to come across within it

Starting a new relationship is daunting, exciting and nerve racking. It takes a while to build trust and a working relationship is no different.

Arguably, the relationship between a franchisee and franchisor is based on a considerable amount of trust. So how can you safeguard yourself from heartbreak?

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Franchising remains a popular means for companies to expand into other territories without overstretching themselves financially and diluting their brand and business values. It’s an ideal option for growing businesses and those looking for flexible employment opportunities with additional business support, but there are assurances in place to protect both parties.

The franchise agreement is central to this working relationship and something anyone considering a franchise opportunity needs to be familiar with before proceeding. The agreement outlines the terms by which a franchisee will purchase the right to operate a franchise, reducing the financial and commercial risk to both parties.

It also assures the franchisee that the business they have acquired is viable and generating income, with the added comfort of knowing that the franchisor will be providing initial and ongoing assistance. It’s for this reason that franchising is sometimes described as ‘being in business for yourself, but not by yourself’.

A franchisor has to regulate the way a franchisee runs the business to protect its brand. Most franchise agreements will contain many obligations that apply to a franchisee and very few clauses setting out what a franchisor will do. The terms found within a franchise agreement can be a little confusing for people who aren’t aware of them, so here’s some guidance on the key terms you’re likely to come across and what they mean:

Grant

This clause will set out precisely what rights are being acquired by a franchisee. Most franchisees are keen to ensure they are provided with an exclusive territory. However, it’s important to understand precisely what this means, because ‘exclusive’ may not appear to be as exclusive as one would first think.

For instance, because of competition law constraints, franchisee A cannot prevent franchisee B, a neighbouring franchisee, from responding to an unsolicited enquiry made by a customer located in franchisee A’s territory.

In addition, a franchisor will often reserve the right to service national accounts when the franchisee is unable to provide the necessary level of service. A franchisor will also want the ability to reduce the size of the territory granted when a franchisee fails to develop the business or meet stated performance criteria.

Therefore, it’s important to fully appreciate what is being granted. What exclusivity has been granted is likely to be limited to the brand at the time of entering into the agreement and not any further brands developed by the franchisor during the term.

Term/duration

In practice, most franchise agreements will last for five years, with at least one right to renew. The commonly held view and one promoted by the British Franchise Association via its code of ethics is that the term should be long enough to enable a franchisee to obtain a return on their investment. Most banks will be keen to ensure the term is long enough to enable a franchisee to repay any loans they may have.

Renewal

Unless the agreement contains a right to renew, the franchise agreement will automatically come to an end on the expiry of the initial term. The agreement will set out criteria that will have to be met before the franchisee is entitled to renew, which includes providing prior and timely written notice of an intention to renew and not having been in material breach at the time of renewal or during the term.

A franchisee may be required to refurbish the premises and or renew the vehicles at the time of renewal, for example. While this benefits the business because it refreshes the look and feel of the trading premises, this should not be used as a means of requiring a franchisee to pay another initial fee to the franchisor or incur a large expense in carrying out the refurbishment. In most cases, a franchisee will be required to pay the legal costs incurred in renewing the agreement, which should be a nominal sum.

Sale

Unlike most other commercial agreements, a franchisee is not free to transfer their business. The franchisor should be notified of the intention to sell and the agreement will include a procedure to be followed by the franchisee.

A franchisor will be involved in the transfer process to vet and approve the prospective new franchisee to ensure that they meet the franchisor’s criteria relating to business, financial and management experience. It will also ensure that the prospective new franchisee successfully undertakes initial training.

It’s not uncommon for a franchisor to have the right to step in and purchase the franchisee’s business at the sale price. A fee is normally payable upon sale in connection with legal costs incurred. A franchisor may also require payment of additional fees, including an assignment and locator’s fee, where the prospect was sourced by the franchisor.

Termination

The agreement will contain tough termination provisions that provide a franchisor with the ability to act swiftly to prevent serious damage to its brand. Modern agreements will provide for different remedies, depending on the severity of the franchisee’s breach.

For instance, a franchisee not providing relevant documents should be treated differently to a franchisee that’s failing to declare their entire turnover or is found to be working for a competitor business.

A franchisor should follow the procedure it has stipulated, otherwise it may be found to have incorrectly and wrongfully terminated the franchise agreement and be exposed to a claim in damages.

Post termination

Most franchisees will think that once an agreement has been terminated or expires, they are free to do as they wish. However, a franchisor will want to ensure a franchisee is not able to carry on in a similar or competing business or deal with former customers.

Such restrictive covenants need to be drafted carefully to ensure they are enforceable and go no further than what is necessary to protect the franchisor’s legitimate business interests.

Guarantees

Where a franchisee has entered into the franchise agreement through a limited company, it’s common to require the individual directors to provide a guarantee and indemnity in respect of the franchisee company.

The directors will be required to provide undertakings to comply with restrictive covenants on termination. These need to be carefully considered, as they will severely affect the former director’s ability to trade following termination of the franchise agreement.

By contrast, franchisors’ obligations can be quite vague and obscure. It’s important to ensure these obligations are clear and concise and capable of being enforced. Most agreements will seek to exclude liability for statements made by a franchisor prior to signing the agreement, whether in sales literature or during discussions.

If a franchisee considers these pre-contractual representations to be important in their decision to become a franchisee, such statements should be appended to the agreement, as most agreements will contain provisions excluding liability for misrepresentation claims.

A franchisee should be aware of any unusual, unreasonable and unworkable terms contained in a franchise agreement before signing it. This is why Knights recommends that a prospective franchisee should have the agreement reviewed by a lawyer who specialises in franchising as part of the due diligence process.