Franchise contract – the rights and obligations

The franchise contract is the document in which the whole transaction is drawn together. It must accurately reflect the promises made and it must be fair, while at the same time ensuring that there are sufficient controls to protect the integrity of the system. By Martin Mendelsohn, a now retired leading lawyer and author on franchising.

The contract is, of course, important, although it does seem to attract a disproportionate amount of emphasis because no matter how excellent a contract the underlying commercial transaction must first be properly developed. The contract must:

  • Deal correctly, in legal terms, with the various property rights owned by the franchisor.
  • Provide the basis of the operational aspects and the controls necessary to ensure the maintenance of standards.
  • Provide the franchisee with security in his operations and in his ability to develop and sell an asset.

In the final analysis, it is an insurance policy for both parties if things go wrong. If the contract has to be read after signature by either party, it will usually be because there is a problem, and not because one of the parties has insomnia for which dull legalese may be a cure.

Relationship

The personal relationship between the franchisor and the franchisee, together with their common desire to succeed in their respective roles as the business relationship develops, are far more important than the formal contract. In most franchise schemes, the franchisor will own:

  • A trade mark, or trade name, and the goodwill with which it is associated.
  • A business format – a system recorded in an operations manual, which will contain elements, some of which are regarded by the franchisor as secret and confidential. The franchisor will regard the manual in its entirety as secret and confidential. In some cases, there will be formulae, secret recipes, specifications, design drawings and operational documents.
  • Copyright in some of the above items which are in written form and capable of copyright protection.

The recruitment literature of the franchisor will certainly have indicated the nature and extent of the initial services it will provide; the range of continuing services upon which the franchisee will be able to call; and the cost of joining and belonging to the franchise system.

We shall look at each of these factors in turn. However, before we do so, it should be noted that the BFA has, in common with other European franchise associations, adopted the European Franchise Federation’s Code of Ethics and published a best practice guide, The Ethics of Franchising. Whether or not you are considering taking up a franchise with a BFA member you should obtain a copy of this guide (which includes the text of the code of ethics) since it describes provisions in contracts which the BFA considers to be in conflict with the code of ethics.

The initial set up costs, which may include payments for shopfitting or for a vehicle or to suppliers, should invariably include all the items and services necessary to open for business.

The franchisor will also invariably charge a fee to cover the cost to him of providing the initial range of services to the franchisee, as well as a charge for entry into the system.

There can be no hard and fast rule in calculating these fees as each system and what it offers differ. Ignoring the lower end of the cost range, the average amount of the initial franchise fee seems in practice to be in the region of 5 to 10 or more per cent of the total initial costs depending on the range of services provided.

Continuing fees enable the franchisor to finance the provision of the on-going services and back-up. The average continuing fee, together with funds specifically allocated to advertising and promotional expenditure (see below), is usually in the region of 8-11 per cent of franchisee turnover.

It is vital that the franchisor should not have undisclosed sources of income at his franchisees’ expense, nor should he be able arbitrarily to increase the cost of the products which he supplies to his franchisees. The franchisor is as entitled as any other manufacturer, wholesaler or distributor to make a profit on products so supplied.

The initial and continuing fees, however they are described, are essentially a payment by the franchisee to the franchisor in return for the services provided by the franchisor. They are the gross income which the franchisor receives for the provision of services and upon which his business depends to cover its operating costs and to make a profit.

Most franchise systems provide for the advertising and promotion to be handled by the franchisor, who will receive from his franchisees a contribution for that purpose. The most common method of calculating this contribution is the same as for franchise fees, namely as a percentage of the franchisee’s turnover. In some cases, a franchisor may include the advertising expense in the continuing fees and undertake to spend a percentage of the fee on advertising and promotion.

There are also cases where local advertising, rather than national, is more important and a franchisee may find that the franchisor does not seek a contribution, but imposes on the franchisee the obligation to spend a certain amount each year on approved local advertising.

Initial services

The nature of these services will vary, bearing in mind the type of business. Obviously, a van-based mobile franchisee does not need site selection assistance, and conversely, a shop-based franchisee does not need to be taught how to contact and attract his customers, as does the mobile operator.

The general principle is that the franchisor’s initial services (including training) should be sufficiently comprehensive to set-up a previously inexperienced person in business so that he can trade effectively, in accordance with the franchisor’s system, as soon as he opens.

Continuing services

Having established the franchisee in business, the franchisor has the responsibility to provide a continuing range of services to support him. These include:

  • Performance monitoring to help maintain standards and profitability.
  • Field support including visits to the franchisee’s trading unit.
  • Continuing update of methods and new innovations.
  • Market research and development.
  • Promotion and advertising.
  • Benefit of bulk purchasing power.
  • The provision at head office of a specialist range of management services.

Features of the contract

The normal features of a contract will be as follows.

1) The establishment and identification of the franchisor’s intellectual property assets which will be made available to the franchisee.

This will include with such things as trade marks, trade names, goodwill associated therewith, copyright material and the franchisor’s business system and know-how comprising confidential information.

2) The nature and extent of the rights granted to the franchisee.

The franchisee will be given the right to use the franchisor’s intellectual property. It is relevant at this point to mention territorial rights, since these create practical difficulties. There are significant aspects to the problem which arise when exclusive territorial rights are a feature which will be dealt with later in this article.

3) The period of agreement.

The basic principle should be that the franchise relationship should be capable of subsisting on a long-term basis. There may be various reasons, such as the legal position in relation to the tied supply of products, for a relatively short initial period (say five years), but most franchise schemes allow for the franchisee to be able to exercise a right of renewal. If the agreement is for a short period and does not grant a right of renewal a prospective franchisee should proceed with caution. It may mean that the franchisor will not even be prepared to agree any renewals or will try to make renewal unreasonably expensive. Beware of relocation clauses which may appear innocent enough, but which could entitle a franchisor to require a franchisee to close down and move to other premises. In effect, this could result in a franchisee being required to open a new business in a new location or risk losing his franchise! Another provision which may give cause for concern is one under which the franchisor can require a complete refit rather, than as is usual, updating to the latest style and image, and a redecoration.

4) The nature and extent of the services provided by the franchisor both initially and on a continuing basis.

The initial services, which enable the franchisee to be initiated, trained and equipped to open for trading should be detailed.On a continuing basis, the franchisor will be providing services which should be detailed in the agreement (see ‘Continuing services’ above). It is absolutely vital that the contract reflects what is promised as initial and continuing services in the franchisor’s sales literature.

5) The initial and continuing obligations of the franchisee.

These will range from accepting the financial burden of setting-up in compliance with the franchisor’s requirements to undertaking to comply with operating, accounting and other administrative systems to ensure that essential information is available to both parties. These systems will be described in an operations manual which will be introduced to the franchisee during training and which he will continue to have available as a reference guide after he has opened for business. The manual should be regularly updated by the franchisor as the system develops.

6) The operational controls imposed upon the franchisee.

The controls are to ensure that operational standards are properly maintained – failure to maintain standards in one unit can harm the whole network. Franchisees will rightly be alarmed if any of their fellow franchisees fails to maintain standards and the franchisor allows them to continue to do so. Often operational controls are very detailed with cross references to the operational manual. The contract will impose the substantive obligations and the manual will explain how these obligations are to be discharged and provide details of how the franchisor’s system is to be operated.

7) Sale of the business.

One of the reasons for the success of franchising is the motivation it provides to the franchisee, which comes with self-employment and the incentive at the end of the day of making a capital gain. For this reason, the franchised business should be capable of being sold. However, there will always be controls. If there are none, it should be a matter for suspicion. After all, if a franchisor is highly selective when considering applications for franchises, there is every reason for him to be equally selective about those who want to join the network by buying a business from an established franchisee. It should be borne in mind that when a franchisee seeks a purchaser for his business it is the only time that someone other than the franchisor takes the initiative in recruiting a franchisee.

The criteria by which a prospective purchaser will be judged by the franchisor should be set out in the contract and should be the same as those applied by the franchisor when considering new applicants for a franchise. The procedure to be followed should also be described in the contract.

Some franchisors insert in the contract an option to buy the business if the franchisee wishes to sell. If such a provision is inserted in the contract, it should provide for the payment of at least the same price as is offered to the franchisee by a bona fide arms length purchaser. Any artificial formula (e.g. net asset value) which might enable the franchisor to buy at less than market value should be resisted.

8.1) Franchisee demise.

In order to give the franchisee peace of mind, provision should be made to demonstrate that the franchisor will provide assistance to enable the business to be preserved as an asset to be realised, or alternatively taken over, by the franchisee’s dependents if they can qualify as franchisees.

9) Arbitration.

Arbitration is in reality private litigation with a judge (arbitrator) chosen by the parties. It has advantages in that the proceedings are private; the arbitrator chosen can be selected because of his special knowledge of the business, which is the subject of arbitration; the timing of the proceedings can be fixed to suit the parties’ convenience; the parties may establish the rules for the arbitration and save time and expense in so doing.

There are also disadvantages. Not every dispute under a franchise contract will be resolved by the decision of an arbitrator (e.g. the franchisor will not want an arbitrator to judge whether his quality standards and system are being maintained; the franchisor’s right to an injunction may be impaired if the arbitration agreement does not reserve those rights to him; the wrong choice of arbitrator may result in a compromise decision which will not satisfy either party).

Bearing in mind the long-term relationship involved in a franchise, those areas where genuine misunderstandings can arise may be considered suitable for arbitration (e.g. fee calculations, rights of renewal). The BFA has introduced an updated arbitration scheme.

The BFA has also introduced a mediation service in an endeavour to assist in the resolution of disputes. Mediation is becoming increasingly used in commercial disputes. It involves the appointment of an independent person as mediator who without taking sides or making judgments, seeks to assist the parties in reaching a settlement which they find acceptable. All contacts and discussions are off the record, and no-one is bound to a deal unless they agree. One of the advantages of this procedure is that the parties are able to open up to the mediator about what really troubles them in the knowledge that he will not pass that information to the other unless they specifically authorise it. With the knowledge acquired one hopes that the mediator can find a route to the common ground which is so necessary to achieve a solution.

Another development in 1999, which has had an impact on dispute resolution, was the radical change in litigation procedures which are intended to make litigation quicker and cheaper. Whether the system which has been put in place will prove capable of achieving its objective remains debatable. However, there will be an emphasis on mediation proceedings in an attempt to cut down the volume of litigation.

10) Termination and its consequences.

Invariably, there will be express provision for the termination of the agreement in the event of a default by the franchisee. The franchisee should be given the opportunity to put right minor remediable breaches so as to avoid termination, providing that he does not persist in making such breaches.

The consequences of termination will usually involve the franchisee in taking steps to ensure that he ceases to claim any association with the franchisor. The franchisee will no longer enjoy the use of the trade mark/trade name, and other property rights, owned by the franchisor. In addition, the franchisee will be under an obligation for a period of time within an area which will include his trading premises or territory not to compete with the franchisor, nor will he be allowed to make use of the franchisor’s system or other methods.

Territorial rights

We have now reviewed the 10 features of a franchise contract. Under item 2, I referred to the fact that the granting of territorial rights gave rise to two types of problem and I would now like us to deal with them.

Firstly, there are the commercial considerations which have caused many problems for franchisors over the years. It must be recognised that it is very difficult to determine a territorial arrangement, which is fair to both parties, especially when the extent of the likely penetration of the market cannot be judged. Indeed, quite often even the total size of the potential market cannot be estimated.

In the past, many franchisors, who have chosen the exclusive territorial route, have found that there is no effective way of ensuring that the potential of the area was fully exploited.

The effect of this is to harm the whole network. Quite apart from the fact that within the area a market and demand is being created by advertising and promotion which is not met by existing resources, the way is prepared for competition to move in and do better. Also, disgruntled customers, or potential customers, are not likely to look elsewhere within the same network for their requirements. The franchise thus gets a bad name.

The obvious response is to suggest that performance targets should be established. Since the assessment of fair performance targets is dependent upon the same factors as have to be considered in defining a territory, the problem remains basically the same. Additionally, if performance targets are set to be effective they must take into account the potential expansion of the business as well as inflationary factors. These are also difficult matters to deal with in a fair and equitable way.

There are also the implications to consider of the EU block exemption for vertical agreements in situations where the benefit of the regulation is sought (see appendix four).

Technological changes have to be considered and contracts need to deal with the resulting issues.

UK Competition Law

The Competition Act 1998 is similar to, but not identical to, the EU Competition laws and does provide for the exemption of agreements. Agreements which benefit from the exemption granted by the EU block exemption agreement for vertical agreements will be exempt from the Competition Act prohibition. There will be many agreements which may not be affected by the Competition Act.

In a brief article of this nature, it is not possible to cover every aspect in detail. The points highlighted above will I hope have explained some of the basic features of the franchise contract and should enable the reader to approach it in a reasonably enlightened way. It is essential for readers to obtain professional advice as to how the law, particularly competition law, may affect them and their businesses.

The law relating to data protection has been extended and franchisors will need to take advice to ensure that they and their franchisees comply with it. Franchisors, particularly those who would like or need customer details, will have to pay close attention to this law (see more below). In addition, there are laws on e-commerce which have to be complied with and if your franchise involves this sector make sure you have up-to-date advice.

Data Protection Law

Regard has to be paid to the effect of data protection law (privacy laws) which impacts the way in which personal data is processed. Dealing with customer information can be affected by this legislation.

Consumer credit regulation is another area of the law which applies in certain circumstances. The basic requirement is that franchisors and franchisees need to obtain advice.