Targets are important in franchising and take various forms depending on the type of franchise agreement that is being granted. In the typical unit franchise agreement, franchisors may want to set minimum payments to be made by franchisees to the franchisor.
Author: John Pratt, Partner at Hamilton Pratt
Usually, continuing fees – often called management service fees – are calculated on a percentage of a franchisee’s turnover and, accordingly, setting minimum payments to the franchisor have the same effect as setting minimum turnover levels on franchisees.
There are difficult issues in relation to setting targets in unit franchise agreements. Such targets are particularly important when exclusive territories are granted to franchisees because the last thing that a franchisor wants is for a franchisee having been granted an exclusive territory to not fully develop that territory.
Whilst, of course, it is standard for a franchise agreement to contain a contractual obligation on a franchisee to promote and develop the market in the allocated territory, it is sometimes difficult to prove that the franchisee has failed to do this.
From a legal perspective it is much clearer if a franchisor specifies specific payments or turnover requirements because then, in theory, it is, or should be, very straightforward for a franchisor to argue that a franchisee has failed to achieve the minimum payment/turnover requirements. All of this is simple and understandable, the practical implications are considerably more complex.
The extent to which, for instance, a new franchisor or a franchisor from overseas entering the UK market can set sensible targets when the franchisor has no or very few outlets in the UK can set challenging, with no actual franchisee performance figures on which to rely. Franchisee lawyers are always anxious to ensure that minimum payments/turnover targets have not simply been plucked out of thin air and are achievable by their franchisee clients.
As a result, often franchisors with no existing franchisee performance figures relating to the UK do not impose performance requirements for the first three years, by which time they would hopefully have obtained relevant information about what is or is not achievable.
Another issue is the extent to which, if a franchisor grants non exclusive territories, it is possible and fair to set minimum performance obligations that apply to all franchisees. The issue is quite simply that a franchisor may grant non exclusive territories in which there are a number of franchisees operating when other franchisees, who have also been granted non exclusive territories, may find themselves operating without competition from other franchisees in their territory.
Additionally, even when exclusive territories are granted and the targets apply equally to all franchisees then the franchisor will have to demonstrate that all territories are calculated to offer the same potential.
It is very arguable that minimum target obligations are difficult to justify, unless they are set at an appropriately low level. The British Franchise Association (BFA) is sensitive to issues relating to minimum payments/turnover and has set out the basis on which it would accept such clauses in its members’ franchise agreements.
The basis is that they have to be set based on the average performance of franchisees and cannot be set at more than 70% of such average performance. In other words, they will be set at a very low level to emphasise the fact that the targets are a “safety net” for the franchisor to enable the franchisor to deal with a substantially under performing franchisee and have not been set as a challenging target to encourage franchisees to promote and extend their business.
Another issue is whether franchisors should set minimum performance targets linked to the period of time during which a franchise has been operating. The unequivocal answer is “yes”. It would be unfair for a franchisee in its first year of trading to achieve figures that are not based on what other first year franchisees have actually achieved. If a first year franchisee has to achieve a percentage of the average figures of all franchisees, including those that have been operating for ten years, then that is unlikely to be achievable and is therefore unfair.
A final issue to consider is what happens if a franchisee fails to achieve the minimum performance. The most draconian result of such failure could be the termination of the franchise agreement but there are serious issues as to whether that should, in all cases, be an option in favour of the franchisor. It is generally considered to be best practice to set out a list of possible implications of a failure to achieve targets, which build up in terms of severity for a franchisee.
What this means is that, the first failure to achieve targets would result in assistance being provided to a franchisee to improve performance. That assistance could be provided free of charge or, more usually, at the franchisee’s cost. A second failure could lead to the removal of exclusivity, a reduction in the size of the allocated territory or the removal of certain products or services which a franchisee could offer.
There can be any number of further intermediate steps, such as the removal of the right, in favour of the franchisee to renew the franchise agreement, with the right to terminate being the final step.
As an alternative to setting minimum payment/turnover figures, some franchisors adopt an approach based on valuations. Whilst complicated it has some advantages – apart from anything else valuation provisions do not seem to be regulated by the BFA. This approach envisages an obligation on franchisees to obtain regular valuations on a basis clearly set out either in the franchise agreement itself, or in the operations manual and further imposes a contractual obligation for the valuations to always increase.
The failure to record such an increase would indicate that the franchisee was not growing its business and, as with a failure to achieve targets would lead to certain results which could include termination or the loss of the right to renew. The downside with this approach is that obtaining valuations may not be inexpensive and generally franchisees would not want to incur that cost.
Whilst, of course, franchisors can insert contractual provisions dealing with performance, much the best way to improve franchisee performance is for a franchisor to provide guidance, support and training on a regular basis to its franchisees. As always in franchising, by far the best way to improve the performance of franchisees is not to rely on contractual provisions but work with franchisees to assist them to achieve their objective.
As indicated at the beginning of this article, the approach taken by franchisors to targets depends on the type of agreement that is being entered into. The above elements relate to a single unit franchise agreement, but there are other agreements that are frequently used in franchising such as development agreements and master franchise agreements.
In relation to development agreements franchisors allow a franchisee to reserve an exclusive area in which a specified number of franchises will be opened by the developer franchisee in order to retain exclusivity or for the development agreement to continue in force. These area development agreements are particularly common in fast food businesses. Clearly no franchisor would be prepared to allocate very large exclusive areas in which a franchisee will open a number of outlets if the area developer franchisee fails to “perform”.
As a result, it is standard for franchisors to set out in the area development agreement a development schedule which obliges a developer franchisee to open a specified number of units by annual anniversaries. Failure to do so would either lead to termination or removal of exclusivity with perhaps also removal of the right to open further outlets. In this way franchisors can ensure that large areas are not removed from the market without the benefit of an active franchisee opening outlets in that area.
In addition, some development schedules are more sophisticated than simply setting out the minimum number of units and may include minimum turnover either for each unit, if the unit is to be included in the development schedule or total minimum turnover for all units at specified annual anniversaries.
Master franchise agreements
Turning next to master franchise agreements, here again, development schedules are absolutely standard. The issues identified above in relation to area development agreements apply to master franchise agreements, but are even more important. Usually master franchise agreements relate to whole countries with a master franchisee investing very considerable sums to, in effect, act as a franchisor in the allocated territory.
Usually these agreements impose obligations on the master franchisee to open a certain number of outlets itself before it starts recruiting franchisees which means that the commitment both in time, effort and money of a master franchisee can be very considerable.
During the negotiation of master franchise agreements, all parties are usually “excited” about the prospect for an incoming franchise system in the UK and, of course master franchisees are keen to demonstrate to a franchisor their confidence in the likely success of the franchise and their ability to grow the market in the UK.
This means that prospective master franchisees are susceptible to agreeing development schedules which, in practice, have little prospect of success. In our experience relatively few development schedules in master franchise agreements in the UK are ever achieved and hence it is very important that the consequences of failing to achieve a development schedule in a master franchise agreement are not too draconian.
What needs to happen but rarely does, is that foreign franchisors need to understand the market in the UK. Some countries, such as the U.S. and Australia, have a particularly entrepreneurial culture and an attitude to business failure which is not reflected in the UK. U.S. franchisors are often surprised at the lack of an entrepreneurial spirit and are equally surprised by the level of concern that would be expressed if a franchisor had a high franchise failure rate.
It is therefore very important for master franchisees to ensure that foreign franchisors understand the UK market and agree sensible development schedules.
It is also vital that the development schedules contain some protection for master franchisees. In an ideal world the development schedules would apply on the basis that the master franchisee was required to use its reasonable or best endeavours to achieve the development schedule and the consequences of any failure would only apply if the master franchisee simply wasn’t trying.
This would mean that if a master franchisee was able to show that it had devoted all appropriate resources to making a success of the franchisee, but had simply failed to open the required number of units then the exclusive rights or the rights to open further units or, at worst, the right to terminate the franchise agreement would not apply. In practice it is by no means common for development schedules to be drafted in this way.
About the author
John Pratt is the author of the UK’s text book on the legal aspects of franchising.
He has been: Legal Advisor to the BFA, chair of the International Bar Association’s Franchising Committee, chair of American Bar Association’s International Franchising Division and chair of Euro Franchise Lawyers – the grouping of Europe’s leading franchise lawyers.
Who’s Who Legal has rated Pratt as Europe’s leading franchise lawyer.