The legal details of franchise agreements

There are a number of legal aspects to consider prior to entering into a franchise agreement, says Vicky Wilkes, senior associate at law firm Squire Sanders (UK)

Entering into a franchise agreement usually means a franchisee will make a substantial investment and assume a number of legal obligations.

While no substitute for taking legal advice on the particular franchise agreement a franchisee may be considering signing, this article highlights some of the issues a franchisee should consider before signing a franchise agreement.

Who is going to enter into the franchise?
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The first thing to consider is what form of legal structure you, as a franchisee, are going to adopt when entering into the franchise agreement. There are a number of ways of doing this and each have their own pros and cons.

You could enter into the franchise agreement in your personal capacity, trading as a sole trader or through a partnership formed with other individuals. Other options include setting up a limited company or a limited liability partnership.

If you trade as a sole trader or partnership, your liability is unlimited.

This means the liabilities of your franchise business will have to be met out of your personal assets if the business does not have sufficient assets. Also, if you are a partner in a partnership you could face liability for the actions of your partners.

In contrast, limited companies and LLPs benefit from limited liability for their owners, although in exceptional circumstances - usually involving some wrongdoing - company and LLP owners can face personal liability. The trade off that comes with limited liability is that companies and LLPs are more heavily regulated and have to submit information to Companies House, which is then made publicly available.

However, you should be aware that many franchisors ask their franchisees to personally guarantee the performance of the company or LLP which, in practice, puts you in no better position than if you had entered into the franchise agreement in your personal capacity or through a partnership.

As well as having different positions in terms of personal liability, there are differing tax implications, which you should take expert advice on from your accountant.

Premises
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Depending on the nature of the franchise, you may need premises from which to run the business. Most franchisors will want to inspect and approve the premises before you start trading from them. Depending on the particular franchise concept, either you or your franchisor may have to take a lease from the landlord.

In many cases you, as the franchisee, will take the lease and have to negotiate the terms directly with the landlord. If you take out the lease, you will be responsible for paying all rents and other costs arising under it. You should remember that if your franchise agreement ends before the end of the lease, you will remain responsible for meeting all lease costs until the lease expires or terminates early. Again, it is advisable to take specialist advice before signing a lease.

Franchise agreement
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The franchise agreement is the key document that will govern the relationship between you and your franchisor.

As a franchisee, you will almost certainly have no room to negotiate the terms of the franchise agreement, as most franchise agreements are offered on a ‘take it or leave it’ basis. The commercial rationale for this being that the franchisor requires uniformity across its franchise network to ensure brand consistency.

However, that does not mean you should sign it without taking legal advice. A specialist franchise lawyer should be able to identify the key areas of risk for you in the franchise agreement and advise on steps to take to minimise them.

Common key areas detailed in the franchise agreement on which you may require advice include:

* Term of the agreement and rights to renew. It can take a while for a new business to generate profit and recoup any initial investment and the same is true of a franchise business, even though most franchises are usually businesses based on a proven concept. The term of the franchise agreement and the rights to renew should therefore allow the franchisee sufficient time to recoup any investment and generate a profit. Rights to renew the franchise agreement should not be too restrictive and, ideally, the franchisee should not be required to pay a further fee in order to renew.

* Rights to transfer the franchise. The rights of the franchisee to transfer the franchise to someone else - or to transfer ownership of the company or LLP that’s been formed to enter into the franchise - will be relatively limited, as the franchisor will want complete control over who the franchise business is sold to and who becomes its franchisee.

Usually the franchise agreement prohibits the franchisee from transferring the franchise business without the franchisor’s prior consent. The franchisor will invariably require the potential purchaser to satisfy the same criteria it uses to evaluate prospective franchisees as a condition of giving its consent. A franchisor often has first option to purchase the franchise business from the franchisee, which is usually on equivalent terms to those offered by a third party purchaser or at market value.

If a franchisee wishes to transfer the franchise business, it will usually have to pay some of the franchisor’s administration costs in relation to the transfer. The franchise agreement may give the franchisor the right to charge a commission for brokering any sale of the franchise business, though the amount should not be so high that a sale is no longer worthwhile for the franchisee.

Termination
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While the franchisor will have the right to terminate the franchise agreement for a number of reasons, it is unlikely a franchisee will have the same or indeed any right to terminate it. However, the franchisor should not have the right to terminate for trivial reasons and the franchisee should have the opportunity to put right any breaches, unless they are material ones. This is reiterated in the British Franchise Association’s code of ethics, which says that franchisees should be given notice of any breaches, as well as a reasonable time to remedy the breach where appropriate, before the franchise agreement is terminated.

Usually the events that will give rise to the franchisor terminating the franchise agreement will include insolvency of the franchisee and a number of specific breaches of the franchise agreement, such as if the franchisee fails to pay amounts due to the franchisor on time, doesn’t provide accounting information on time or fails to operate the franchise in accordance with the franchisor’s systems and manuals. The franchisor may also have general rights to terminate for material breaches of the agreement by the franchisee and where the franchisee does anything that may bring the name and goodwill of the franchise concept and trade marks into disrepute.

In conclusion, a franchisee should consider seeking specialist legal advice in relation to the proposed franchise agreement, so that he or she can fully assess the risks involved before signing on the dotted line.