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What to Look for in a Franchise Agreement
A franchise agreement is a legally binding contract between a franchisee and a franchisor. A franchise agreement lays out the terms and conditions of the franchisee’s and franchisor’s relationship. Franchising remains a popular way for business owners to seek new opportunities in different locations without the financial outlay that is necessary for traditional stand-alone businesses. Statista estimates that there were about 745,290 franchise establishments in the U.S in 2017.
Although franchises may appear to be an easier option than stand-alone businesses, you still need to conduct due diligence before entering into a franchise relationship. One of the main documents you should familiarize yourself with is the franchise agreement. This document needs to be studied carefully with the assistance of qualified professionals, such as lawyers and accountants, to ensure that your risks are minimized.
The franchise agreement will provide you with details about the feasibility and income-generating potential of the franchise. Your duties and responsibilities, as well as the obligations of the franchisor, will also be contained in the franchise agreement. Given that the franchise agreement is a legal document that covers many eventualities, these contracts are normally very lengthy, but generally contain some common clauses.
The following are summaries of general clauses found in most franchise agreements:
Fees – Payment of upfront fees as well as ongoing contributions towards marketing and royalties, for example.
Territory – Describes the region that you will be operating in, including whether you will have exclusive or shared rights to the territory.
Supplies – Details who will provide supplies to the franchise.
Fit-Out – Explains the costs involved in fitting-out the franchise.
Insurance – Gives details of the type of insurance required to operate the franchise.
Termination – Provides an explanation of the process that should be followed if you decide not to renew the franchise after the end of the agreement.
Here is a more detailed explanation of what you should look for in a franchise agreement to ensure that you are able to stick to the terms:
The grant
This franchise agreement clause will specify exactly what your rights are under the contract. It is important to inspect every aspect of the grant to ensure that you understand exactly what is on offer. The following sample of a franchise agreement grant clause is provided by Law Insider:
“The Franchisor grants to the Franchisee, and the Franchisee accepts from the Franchisor, the right to use the Marks and Licensed Methods in connection with the establishment and operation of a ROCKY MOUNTAIN CHOCOLATE FACTORY Store, at the location described in Article 3 of this Agreement. The Franchisee agrees to use the Marks and Licensed Methods, as they may be changed, improved, and further developed by the Franchisor from time to time, only in accordance with the terms and conditions of this Agreement.”
Duration and renewal
When you become a franchisee, you will have the right to operate your business with a brand for a defined period of time. The minimum term of the duration of a franchise agreement is normally five years. It is rare for franchise agreements to last more than 20 years. The duration of the franchise agreement should be stated clearly and you must make enquiries about what happens at the end of the period.
The following are some questions that will help you discover what happens when the franchise agreement comes to an end:
- Is the franchise agreement renewable after the contract expires?
- If you are able to renew the agreement, what is the cost?
- Is the renewal cost the full franchise fee or is there a discount for renewing the agreement?
The renewal clause in the franchise agreement should include the amount of written notice you will be given before the expiration of your agreement. There may be additional requirements before you are allowed to renew the franchise agreement, for example, store renovation.
Costs and fees
You will need to pay an initial purchase fee, which is also known as a franchise fee. Additionally, this section of the franchise agreement details the other costs that you are liable for as part of owning the franchise. The costs and fees section also stipulates how much money you should have available before buying the franchise. This allows the franchisor to be confident that you can meet the costs of expenses, like payroll,equipment repair and property maintenance.
You should spend a significant amount of time reviewing the fees and costs section of the franchise agreement. In general, franchisors need to be paid royalties, which can be a flat fee or a specific percentage of your gross or net revenue. Having a solid understanding of your costs and fees will help you to create a realistic picture of how much> profit you will generate.
Territory
You will be given the right to operate a franchise in a defined territory. This territory will normally be a specific geographic area with a defined radius. This means that other franchisees may not be permitted to open a franchise within a certain number of miles from your store. The territories are allocated to give each franchisee a fair chance at profitability by controlling the amount of competition in an area.
You need to find out whether your territory is exclusive or if your franchise will be in a non-exclusive territory. A non-exclusive area means that other franchisees will be allowed within the same region.
Ask the following questions to find out more about how your franchise’s territory is allocated and managed:
- How does the franchisor determine the territory?
- Is population by numbers used when allocating territories?
- Is a geographical map used to assign territories? If so, how detailed is the map?
Training and support
Franchises are built using specific systems and processes, therefore, it is important for the franchisor to provide adequate training and ongoing support. Training will provide you with the understanding of how to operate your franchise in accordance with the franchisors rules and regulations. Different franchisors offer unique types of ongoing support, which could include advertising discounts and reduction on the costs of equipment.
Ask the following questions to clarify the details of your training and support:
- How long will the training last?
- Where will the training take place?
- If the training takes place over a long period away from home, am I entitled to claim living expenses
- What costs are involved with the training?
Advertising and marketing
The franchise agreement will contain provisions about how much you are required to contribute towards marketing the franchise. These contributions are used to advertise and promote the franchise. This section of the franchise agreement will detail the amount and the regularity of your marketing contributions.
Examine this section of the franchise agreement carefully as it will also impact on your profits.
The following questions should help you to understand how your marketing dollars will be spent:
- What will the franchisor provide for your contribution to marketing? Ask to see past campaigns along with figures that indicate the performance of the promotion.
- How much of the franchisor’s advertising budget will be used to promote your business locally and nationally?
- Can the franchisor provide a detailed breakdown about how the marketing money is distributed?
Accounting
The franchise agreement will detail the type of reports you will need to produce in order to satisfy the franchisor that you are operating the franchise correctly. One of the most important reporting functions is accounting. The franchisor will provide timeframes for account submissions. It is likely that this section of the franchise agreement will include provisions advising that the franchisor reserves that right to audit your accounts and reports to make sure that everything is above board.
Personnel
This section of the franchise agreement deals with how you will recruit and train your employees to make your business a success. There has been contention about whether a franchisee and his or her employees are employees of the franchisor. It has been found that franchisors are not the employers of their franchisees and their employees. In order to avoid any doubt, the personnel section may include provisions that you are an independent contractor and not an employee.
Make the following enquiries in relation to the employees you plan to hire:
- Does the franchisor have a corporate HR function for all franchisees?
- Is there a specific process for recruitment, including specific interview questions?
- What are the policies in terms of holiday pay, sick leave and bonuses?
- Which systems are used to help manage the workforce?/li>
The answers to the above questions may be available in your operations manual but it is recommended that you make enquiries anyway.
Selling or transferring
Securing a franchise can be a long process, which involves a considerable amount of effort and resources. Therefore, you do not have the freedom to transfer your franchise in the same way that you would a standalone business. The franchise agreement will specify the circumstances when a transfer of the franchise can take place. When transferring the franchise, the franchisor needs to be involved in the process to ensure that the prospective franchisee is suitable. Franchisors could also include in the franchise agreement that they have the right to buy the franchise at the sale price.
Ask the following questions to clarify details in the sales and transfer section of the franchise agreement:
- How much input does the franchisor have in relation to the sale or the transfer of the franchise?
- Does the franchisor have to approve potential buyers?
- Is the franchisor entitled to a percentage of the sale? If yes, how much and when must this be paid?
Termination
When reviewing a franchise agreement, look out for actions that the franchisor can take to terminate the contract. There will be different remedies depending on the level of the breach of contract. Working for a competitor or failing to declare turnover are examples of grounds for termination of the franchise agreement.
You also have to pay close attention to the instances where you are allowed to terminate the franchise agreement.
Ask the questions below to ensure that you are aware of the grounds for terminating a franchise agreement:
- Can the franchisor provide an exhaustive list of instances when the franchise agreement can be terminated?
- When can you start termination proceedings if the franchisor fails to meet their obligations?
- Is arbitration available in the event that you and the franchisor cannot reach an agreement?
Red flags to look out for when assessing a franchise agreement
Seeking legal advice should help you to identify the majority of problems with a franchise agreement. However, you should be on the lookout for some red flags during the negotiation and review process including:
- Discounted prices
The best franchises are inundated with offers from people who want to be part of the business. A franchisor who is offering a discount should raise alarm bells as it could be an indication that the quality of the franchise is not as high as their competitors.
- Pressure to sign the agreement
There is a great deal at stake when operating a franchise. You should be encouraged to perform your due diligence to safeguard yourself and the franchisor. A franchisor who is trying to pressure you into signing the agreement is an indication of desperation. Alternatively, the franchisor may be trying to deter you from reviewing the contract properly to avoid you spotting unfair terms.
- Not providing documents
You have the right to review certain documents before you sign the franchise agreement. If the franchisor is withholding documents or providing them at the last minute, this could be an indication that the documents may contain adverse information that could be detrimental to you.
It is advisable that you seek the advice of an attorney when reviewing and negotiating a franchisor agreement. Irrespective of how small your observations are, your attorney should discuss them with the franchisor. Attorneys are skilled in this area of law and are able to deal with complexities that may arise.
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