This article has been written by Bushra Asif, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.
Table of Contents
Introduction
As the old adage goes: “a chain is only as strong as its weakest link.” It applies equally to franchises and their “links”- the franchisees. In order for a franchisee not to become that weak link, he has to ensure a better understanding of the Franchise system to be adopted by him.
The Franchise business model seems the most viable and attractive option if you want to start a business on your own but don’t have a good idea of your own yet. The Franchisor being the parent company that has developed the brand and its operating systems. Whereas, a franchisee is an entity that buys the rights to sell the product or services of a Franchisor and utilize the proven and established systems. Franchising is a way for companies to expand and bring their products and services to consumers without the company owning and operating their locations directly.
It is a great pathway to running your own business. There are a number of benefits you could reap from an established brand that already has a popular product or service. A Franchisee buys a brand and a system by paying a fraction of what it would cost him to do it on his own. There’s also access to continuing support with readymade advertising and marketing and operation manuals to streamline the way you run your business. In a nutshell, you can have a bite at an apple pie made by someone else. Warren Buffet quite rightly stated: “Buy companies with strong histories and profitability and with a dominant business franchise”.
However, it is not all that hunky-dory as franchising will stifle your control over how, where and for how long you may run the business. As at the end of the day, it is not your own creation and it’s a borrowed business.
Hence, before you embark upon this journey, it is highly recommended that you consult an experienced business adviser, accountant or lawyer. Generally, you will need to focus on the following points in order to be in a better position to make an informed decision.
The Franchise Model
You need to know what you are getting yourself into. How will it affect the way you will conduct business?
Benjamin Franklin, in 1731, started the modern-day franchising business by entering into the first Franchise Agreement with Thomas Whitmarsh to provide printing services in Charlestown, South Carolina. Then, in the 1850s, Isaac M. Singer franchised to distribute the Singer sewing machines. But, it was Ray Kroc who really can be held responsible for the franchising to become really popular.
There are three basic types of franchising:
- Business-format franchising.
- Traditional or product-distribution franchising.
- Social franchising.
Business-format franchising
The business-format franchise will receive a fully established system for delivering a Franchisor’s product or service. The Franchisor’s responsibility will be to define the business system and establish the brand standard whereas, the Franchisee is independent to run that business on a day-to-day basis in pursuance of attaining those standards.
Traditional franchising
Conversely in a traditional franchise, the Franchisor licenses its trademark and logo to its Franchisee but does not provide the entire system for running the business. The Franchisee typically just sells the products as made by the Franchisor. Examples of it are franchising soft drinks, automobiles and accessories like Coca-Cola, Ford Motor Company, and John Deere.
Social franchising
It is the latest form of franchising. It basically addresses the needs of people who live at the base of the economic pyramid (BOP). BOP refers to the estimated three billion people in the world who live on less than $2.50 per day. It applies business-format franchising’s techniques and methods to the delivery of products to these people. The main focus is on basic needs such as safe drinking water, adequate food supply, authentic drugs, quality healthcare, education, sanitation, and energy.
According to Julie McBride, senior consultant for social franchising for MSA Worldwide, “Social franchising breaks the cycle of poverty by helping local entrepreneurs develop and expand businesses that solve social needs while at the same time generating profits for the local business owners and creating jobs in the communities they are serving.”
Identify Your Financial Risks
Running a franchise business will not mean everything will be smooth sailing as it has its own financial risks, especially in relation to factors out of your control, such as competition and the state of the local, national and even global economy. Moreover, your franchisor might want you to conduct the business in a certain way or change their systems or the look of their stores and you will usually be responsible for the cost of these changes. How much is required upfront in terms of fees, equipment, training, property, and startup capital must be taken into account?
Territory
As a franchisee, you will be allotted a territory in which you will be allowed to operate your business. You’ll need to know how many territories the franchisor has, how many are available for sale, how many are planned for the future, whether other Franchisees can compete within your territory and how online sales are managed within the territory.
Ongoing Fees
Mostly, in franchise arrangements, the franchisee is supposed to pay a royalty fee to the franchisor on a weekly, monthly or yearly basis. It is important to know how it will work, whether it will be a flat fee or a percentage of your sales and whether there will be separate charges for other heads, like marketing or advertising.
Understand the Franchise Agreement
This will be your dominating document to adhere to. It sets out everything that will be relevant, ranging from where and how you will run your franchise, your rights and responsibilities, etc.
The Franchise Agreement is paramount and will govern everything about how the franchisee shall run the business and also what the franchisor will be obliged to do. Let us try to delve into it in order to understand it better for anyone who wants to enter into such an agreement.
What is a Franchise Agreement?
The Franchise Agreement is the main legal document that defines the dynamics of the commercial relationship created between a franchisor and a franchisee. It provides a license by virtue of which the franchisee is granted the legal right to establish a franchised outlet and operation wherein the franchisee, among other things, obtains the right to utilize the Franchisor’s trademarks, trade dress, business systems, operations manual and sources of supply in offering and sell the products and/or services designated by the Franchisor.
It is quite extensive and complex in its nature which is not readily subject to change, at least from the franchisee’s side. It reflects the uniqueness of the Franchise offering, thus should never be duplicated – that is the single biggest mistake a Franchisee can make.
I have tried to lay down the key clauses that must be looked at carefully as their impact is the greatest on the Agreement.
Salient points to look for in a Franchise Agreement
Relationship Matters
The parties to this agreement will delineate how their relationship will work – their rights and obligations respectively. How the business shall be conducted by the Franchisee. The business standards to adhere to, the ownership of IP rights and the overall running of the business shall all be covered in the Agreement.
Just recently, interestingly it was held in Ochoa v McDonald’s Corp (2017) that the franchisor and the franchisee can be held jointly liable as employers for employee issues. McDonald’s had to pay $3.75 million to settle the class suit in which it was named as a co-defendant on a theory of direct and vicarious liability.
The courts will start to look past the franchisee to the franchisor as the source of violative practices. This paves the way for class suits and is a wake-up reminder to demarcate the roles and responsibilities of the parties in a Franchise Agreement.
However, in Browning-Ferris Indus. of California v. NLRB, (2018), and recently coming into effect in April 2020 (NLRB Ruling), it has been held that for the Franchisor to be considered as a joint-employer, it must possess and exercise substantial direct and immediate control on the essential terms of the employment conditions of the Franchisee’s employees, such as wages, hours of work, supervision, benefits, etc.
Therefore, it is extremely important that such a provision is clearly identified in the Franchise Agreement as otherwise, the court may interpret it looking at the facts of the case and if there is any control that can be proven that the Franchisor has over the franchisee’s employees, direct or indirect, it may hold the Franchisor jointly liable for employee-related issues.
Initial and continuing fees
The franchisee generally pays an initial and continuing fee to the franchisor for entering into the bargain and to continue remaining a Franchisee. The agreement also might include a number of side fees that the franchisee shall be liable to pay as they progress with the contract. Such ancillary fees can be related to marketing, changing the brand image, setting up the place according to the standard stipulated by the franchisor or augmenting the service or product according to changed consumer’s taste. In most cases, a franchisee will have to pay a royalty fee to the franchisor on a regular basis. It is imperative to understand how this royalty fee works, whether it’s a flat fee or a percentage of the sales and whether there are separate fees for advertising and marketing.
Assigned territory
The Franchisee might not be given exclusivity for the franchise in a given territory always. The specifics of the territory thus must be defined without ambiguity. Franchisors also need to deal with the reservation of their rights within a Franchisee’s territory, including alternative distribution sites and sales over the internet. Watch out for any overlaps in territories or unclear boundaries, as these could cause major issues competing with other Franchisees.
Usually, a territory clause is written linked with a proper map and stating whether the Franchisee has exclusive right over it or not. For example:
“Territory – The Territory for the purposes of this Agreement with respect to (Product/ Service) shall be (Area) as designated in the map attached as Schedule A. The Franchisee shall have exclusive distribution rights in this Territory with respect to the (Product/ Service) under the terms and conditions of this Franchise Agreement.”
Site selection and development
Usually, the franchisees allocate their own sites and develop them according to the franchisor’s standards. The franchisor generally will retain the right to approve the location demarcated by the franchisee and then further approve that the site is built and designed according to the standards set by the franchisor which meets the requirement of its brand.
Initial and ongoing training and support
It is the franchisor’s product or service on the line at the end of the day, therefore, to keep its goodwill afloat the franchisor generally provides pre-opening training and continuing support including training infield, and headquarters support, supply chain, operating manuals, marketing plans and procedures, and quality control. It is essential to keep a certain standard of the Brand in the market.
Take the example of McDonald’s, perhaps the world’s best-known franchise. It has always taken the lead in training its managers and franchisees. It revolutionized business learning and training by opening its ‘Hamburger University’ in 1961, to teach the secrets of opening and running a high-quality Franchise.
Use of intellectual property including trademarks, patents, and manuals
The most valuable asset of any brand or a franchise system lies in its IP. This may change as the frand evolves. The franchise agreement defines what is licensed to the franchisee, how the franchisee can use the IP, the ownership of the IP and the rights of the franchisor to evolve the system through changes to the franchisor’s operating manual. Like in the case of 7-eleven v Grewal (2014), it was found that the franchisee had continued using the 7-eleven trademark even after the termination of the Franchise Agreement, and the judge ruled it heavily against the franchisee.
Advertising
The advertising commitment is primarily dictated by the franchisor who will state the fees Franchisee is required to pay towards those costs. It is important to define who shall have control over advertising and how much, this issue arose in Lokhandwala v KFC Corp.(2018) where the court held that the Franchisor had ample control over franchisee advertising and could dictate what to include and what not to.
Insurance requirements
Franchise Agreements will require the franchisee to maintain minimum insurance all through the Term of the contract, including the period prior to opening and continuing all through till the franchise ends.
Record-keeping and the right to audit the Franchisee’s records
Since the franchisor usually has a stake in the earning of the franchisee, it retains the right to determine how the records shall be kept and maintained, the software franchisee will be eligible to use, and its rights to access and audit that financial information. In 2016, in Steak ‘n’ Shake Enterprises v. Globex it was held by the court that a franchisor can prescribe the minimum or maximum price to be set on its product and the franchisee does not have the right to sell outside of these boundaries.
Boilerplate
These clauses, usually called boilerplate, nevertheless, are quite important and must be given adequate attention. Among the myriad issues contained in the Franchise Agreement are the franchisee’s successor rights, default, termination, indemnification, dispute resolution, resale rights, transfer rights, rights of first refusal, sources of supply, local advertising requirements, governing law, general releases, personal guarantees, restrictive covenants and roll-up provisions.
Conclusion
For a startup it is an easier option as for some starting from scratch might sound a bit daunting as it may or may not work. Although there are no guarantees that a Franchise will be profitable, the chances of picking a good Franchise and making it work for you are much higher. You pay the fee and get a ready-made mould of a business that you will have to run on given guidelines.
Conversely, if you get the crucial Franchise Agreement messed up then however brilliant the Franchise maybe you will land into trouble. So, better get help from a professional lawyer who can easily help you avoid pitfalls that you might be completely unaware of.
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