What Every Prospective Franchisee and Franchisor Should Know

Investing in a franchise business is a major financial and personal commitment for the franchisee. Unlike starting a business from scratch, franchise ownership means stepping into someone else’s brand, system and rules, which are governed by the franchise agreement. Likewise, the franchisor must take seriously the fact that it is entering into a long-term business relationship, often measured in decades, with a third party that will engage in business under the auspices of the franchisor’s brand; thus, obviously, choosing the “right” franchise is crucial for any prospective franchisee. This article is a survey of various key aspects of the franchisee–franchisor relationship from both sides, as well as related real estate issues that will impact many, if not most, franchise businesses.

Negotiating the Franchise Agreement

Prospective franchisees too often treat the franchise agreement as a “take it or leave it” document. While franchisors are, understandably, less willing to negotiate certain core provisions such as royalty and marketing fund fee rates, there are other key provisions which reasonable franchisors should be willing to negotiate. Franchisees should be wary of franchisors who regard their franchise agreements as non-negotiable – unfortunately, things sometimes go wrong during the franchise relationship, and both parties will be in a better position to resolve their issues if they begin their relationship as “team players” rather than adversaries. The following is a non-exhaustive list of issues that should be addressed when negotiating a franchise agreement. 

Territory and buffer zones

In addition to ensuring that each franchise location includes a “protected territory”, it is also important to negotiate a defined “buffer zone” surrounding each franchise territory. Seek to provide for a “right of first refusal” or “right of first purchase” if the franchisee is seeking, directly or by another franchisee, to open within the buffer zone. This will protect the business against competition from other franchisees and the franchisor, if either seeks to open a location outside but close to the protected territory which, in the absence of a buffer zone, would still compete in your market – which is, of course, within your protected territory.

Fees and caps

While franchisors are usually hesitant to negotiate royalty and other fee rates, it is important for franchisees to seek to limit potential increases over the life of the franchise relationship, and it is reasonable to seek a “cap” or limit on the franchisor’s ability to raise its fees unreasonably.

Term length and renewal rights

“Evergreen”, or perpetual, franchise terms are ideal, but not necessarily typical. Generally, longer initial terms and the right to multiple renewal options provide the franchisee with the ability and time to build substantial equity in the franchised business. Franchisees should also look to negotiate certain provisions in the franchise agreement to incorporate key negotiated provisions, such as royalty and marketing fund rates, renewal and transfer provisions, and the territory renewal agreements (if possible), rather than being required to sign the franchisor’s then-current and potentially less favourable form of franchise agreement on renewal.

Personal guarantees

A full guaranty of every obligation under the agreement – sometimes required from both the franchise owner and, often, a non-owner spouse – should if possible be negotiated to a limited guaranty, tied only to the ongoing financial obligations of the franchise and post-termination covenants.

Transfer rights

Franchise agreements typically include “rights of first refusal” on a sale, which can discourage third-party buyers, as they risk losing the deal at the last minute after investing time and money. A “right of first purchase”, where the deal is presented to the franchisor before it is marketed, is more favourable to a seller. For succession (and estate planning) purposes, the franchisee should also seek an exception from typical franchisor consent requirements (and rights of first refusal) when the franchisee’s principal desires to transfer its interests in the franchise to spouses, family members or trusts in favour of family members.

Default, termination and cross defaults

Franchisees should carefully negotiate these provisions, including:

• an exception to standard cure periods for breaches of a nature that genuinely cannot be fixed within the stated window, so long as the franchisee is “diligently” working towards a resolution; and
• a reasonable requirement with respect to how frequently a non-compliance issue must occur, or how material non-compliance must be to trigger the ultimate remedy of termination.

For developers of multi-unit locations, franchisees/developers should seek a limit on the cross-default rights of the franchisor (where a default at one unit may jeopardise all units) to certain, egregious conduct.

The right to close the business in the event of sustained losses

Franchise agreements often do not provide the franchisee with an exit strategy if the business fails. It is worth seeking to negotiate a contractual right to close a business in the event of losses, but, understandably, this should be subject to certain limitations (eg, losses in the form of calendar quarters in excess of “x” per quarter or, cumulatively, losses in the form of consecutive calendar quarters in excess of “x” per quarter).

Restrictive covenants

The length and geographic scope of non-competition and non-solicitation clauses should be reasonably drawn to reflect the actual market size. For example, a city-wide or multi-mile restriction makes less sense in a dense urban territory than in a rural one, and a shorter, narrower restrictive period is a reasonable counterproposal to an exceedingly long one.

Dispute resolution

Generally, arbitration is the favoured method of dispute resolution in franchise agreements. Notwithstanding this norm, it is beneficial for both parties to first use negotiation and then mediation to resolve their disputes, as these forms of alternate dispute resolution will be cost-saving and give the parties opportunities to resolve their dispute(s) before diving into costly and time-consuming arbitration or litigation. Franchisees should also make sure that a mutual “fee shifting” provision is in the franchise agreement, as this incentivises each of the parties to seek to resolve their dispute rather than to engage in a costly fight.

Structuring multi-unit deals

A franchisee developing more than one location should consider negotiating a single form of addendum with consistent, favourable terms applied across all of the individual franchise agreements, rather than being bound contractually by the franchisor’s “then-current form of franchise agreement” and negotiating each one separately.

While these requests are reasonable, a franchisor’s willingness to engage in negotiation varies by brand and market.

What Can Go Wrong as a Franchise Owner?

Even well run, reputable franchise systems carry real risk for the individual owner, as is the case with any business. Common problem areas include the following.

Pre-sale misrepresentations

Under the Federal Trade Commission (FTC) Franchise Rule, as well as various state laws, franchisors must give prospective franchisees a Franchise Disclosure Document (FDD) covering 23 “Items” relating to the system’s history, litigation record, development costs (Item 7), fees, and, if the franchisor chooses to provide it, financial performance data in Item 19. A mature system that does not share any performance information can be sending a warning sign, particularly if the franchisor’s franchisees make unflattering comments to prospective franchisees, 12 to 15 of whom should be reached out to before they commit to the franchise. Misrepresentations made in the FDD, or informally by a sales representative or broker, are frequently the basis of costly legal claims against franchisors when the franchised business does not perform as promised.

Runaway fees

Royalties, marketing fund contributions, technology charges, and required purchases from approved suppliers can add up well beyond the franchisee’s expectation at the outset, particularly as franchisors pass along rising costs from inflation, tariffs or supply disruptions. Franchisees should carefully read Item 6 when reviewing an FDD and negotiate appropriate caps, if possible.

Escalating operational requirements

Mandatory suppliers, point-of-sale systems, and brand standards can become more financially demanding over time.

Personal guaranty and lease exposure

Many franchisors require a full personal guaranty from franchisee principals and, often, their spouses, covering every obligation under the franchise agreement.

Liquidated damages

Many franchise agreements provide for liquidated damages provisions that are triggered in the event of the termination of the franchise agreement. This could cause the franchisee to be on the hook for specific damages calculated by a formula, which is typically a multiple of royalties and marketing fund fees over a defined period of time.

Many of these risks can be reduced through the kinds of negotiated terms described above, and negotiating territory, fee and guaranty protections before signing is far easier than trying to fix them after the business is operating.

What If I Have a Problem and the Franchisor Will Not Help?

Under many state laws, franchise agreements generally include an implied duty of good faith and fair dealing. This means that a franchisor cannot use its contractual discretion to unfairly deny the franchisee the benefit of the deal. That duty has real limits, though, because the covenant does not override clear, express terms of the franchise agreement. What the agreement actually says, and what it does not say, matters when a dispute arises. When a franchisor is unresponsive to a legitimate problem, franchisees have several options, although none will necessarily guarantee a quick resolution or apply to every situation.

Alternate dispute resolution

As discussed above, a well-negotiated agreement channels disputes through negotiation and mediation before arbitration. Even when a franchisor is simply unresponsive, it is usually worth formally invoking that process rather than escalating straight to a demand letter or lawsuit. Mediation is confidential and non-binding, and costs to engage are typically not excessive, while preserving every right to escalate if it does not work.

State franchise laws with private rights of action

15 states, including California and New York, require franchisors to register their disclosure documents and provide franchisees with the right to sue over violations of those laws. California’s Franchise Investment Law and New York’s Franchise Sales Act (NYFSA) both allow a franchisee harmed by a registration or disclosure violation to recover damages, and where the violation was wilful (and material, in the case of the NYFSA) to offer rescission and reasonable attorney’s fees as well. These state-specific remedies can give a franchisee more leverage than the federal rule alone, as the FTC’s Franchise Rule does not allow an individual franchisee to sue directly.

State relationship laws

About half of US states regulate aspects of the franchisor–franchisee relationship directly, including rights regarding termination, encroachment and fair dealing, regardless of what the agreement says, and many give franchisees a private right to sue.

State unfair trade practices statutes

Many states have their own Little FTC Acts allowing franchisees to sue directly, sometimes for enhanced damages and attorney’s fees.

Franchisee associations

Many relationship laws protect a franchisee’s right to join or form an independent association without retaliation, and collective leverage can sometimes accomplish what an individual franchisee cannot, as the relative bargaining power between individual franchisees and franchisors often puts individual franchisees at a disadvantage.

What Happens If My Franchise Fails?

Franchise failure through underperformance, default or closure sets off a series of contractual and legal consequences worth reviewing and understanding before financial distress hits.

Termination and cure periods

For a default, often but not always relating to the non-payment of fees, most agreements and many state relationship laws require written notice and a chance to cure – often 60 days or more, except for serious or incurable defaults such as health and safety violations, trade mark and IP-related violations, or abandonment of the franchise, which can permit faster termination.

The franchisor’s step-in and repurchase (buy-back) rights

Most agreements provide the franchisor with a right to take over operations temporarily by managing the location for a fee, or after termination, particularly where a franchisee is failing financially or has abandoned the business or committed a serious default of its franchise agreement. Termination often, but not always, comes with a franchisor option (not an obligation) to purchase a part or all of the business’s assets, frequently using a formula well below fair going-concern value. Some state relationship laws improve on this – for example, requiring the repurchase of assets, inventory or goodwill at fair market value – but available protection varies considerably from state to state.

Bankruptcy

A struggling franchisee’s bankruptcy filing generally triggers an automatic stay that halts the franchisor’s enforcement efforts. In a Chapter 11 reorganisation, a franchisee that was not in default at filing may be able to keep, or assume, its franchise agreement and lease, while one that was in default faces a harder path, typically needing to cure and demonstrate that it can perform going forward.

Personal exposure

Personal guaranties typically survive the underlying business, so closing or losing a struggling location does not necessarily end an owner’s personal liability for its debts. Guaranties should be carefully negotiated and limited.

Can I Run My Franchise “My Own Way”?

Franchise systems exist because of the need to have consistency across a franchise brand. While franchisees are owned and operated independently, franchise ownership inherently involves the franchisee surrendering some independence with respect to how they operate their businesses. The following are several examples of how a franchisee is limited in how it can operate independently.

Mandatory brand standards

Franchisees cannot alter the design, signage or store layout without franchisor permission, which is not easily obtained.

Pricing and suppliers

Minimum resale pricing and required supplier provisions can limit commercial flexibility, subject to antitrust and state law limits.

Marketing

Franchisees are almost always required to contribute to a national marketing fund and typically cannot conduct local marketing without franchisor review and approval.

Technology and software

Franchisees are typically required to utilise franchisor-mandated technology and software, including, for example, specific point-of-sale and inventory management systems.

Restrictive covenants

Franchise agreements impose certain in-term and post-term restrictive covenants and non-solicitation provisions, limiting the franchisee’s ability to compete with the franchisor.

The Franchisor’s Obligation Regarding Registration and Disclosure

Franchising in the USA is regulated by a patchwork of federal and state franchising laws. In 1978, the FTC promulgated 16 CFR Part 436, which was subsequently amended in 2007 (the “FTC Franchise Rule”) to regulate the offer and sale of franchises in the USA. While many states have franchise-related laws, surprisingly there is no uniform legal definition of a “franchise”. The FTC Franchise Rule imposes a pre-sale disclosure requirement on franchisors that applies to the offer or sale of all franchises throughout the USA, obligating franchisors to furnish prospective franchisees with information and data regarding the material terms of the franchise relationship prior to negotiating with prospective franchisees or consummating the sale or offering of a franchise. This “disclosure” takes the form of an offering prospectus commonly referred to as the Franchise Disclosure Document (FDD).

15 states have state registration and/or disclosure franchise statutes that require the franchisor to register the franchise with the appropriate state agency before the franchisor is permitted to offer and sale franchises in that state, and to provide an updated FDD to prospective franchisee before any fees are paid or any agreement is entered into. 25 states have Business Opportunity Laws which require franchise sellers to register their business opportunity – ie, filing a form with the appropriate state agency that discloses certain limited information to prospective consumers who purchase business opportunities, including franchises.

Selecting the Franchisee

There is an old joke in franchising.

• Question: “What does a franchisor look for in a prospective franchisee?”
• Answer: “Anyone with a pulse and a checkbook”. 

This joke reflects the fact that many franchisors are desperate to achieve growth and sometimes are not discerning as to which franchisees they select for their franchise system. Franchisors are well served when they select their franchisees after a screening process known as franchise due diligence, which evaluates, for example, a candidate’s financial stability, operational readiness, reputation, character and compatibility with the system before awarding a franchise.

Expansion

Franchisors have different ways to accomplish their goals of franchise expansion. In addition to selling single-unit franchises under a franchise agreement, many franchisors also offer multi-unit (or area) development deals to well-financed franchisees, under a multi-unit development agreement. Under this arrangement, the area developer pays a development fee to the franchisor and contracts to open and operate a set number of franchise locations within a specific geographic territory, over a defined timeframe and in accordance with a defined development schedule.

Alternatively, franchisors, especially international franchisors seeking to expand their franchise system into another country (such as the USA), contract with a “master franchisee” which functions as a “sub-franchisor” for a large territory (often a large state or entire country). Under this arrangement, the master franchisee (sub-franchisor) recruits, trains and supports the sub-franchisees within its territory on behalf of the master franchisor (the franchisor), and the master franchisee pays the franchisor a percentage of the royalties and initial franchisees paid by the sub-franchisees.

Lease Protection

In the event that a franchisee defaults on its lease for the franchised premises, the franchisor wants to ensure that it does not “lose the location” as part of its franchise system. To prevent this from happening, franchisors seek to contract their right to assume (take over) a franchisee’s lease under these circumstances. Franchisors achieve this by requiring their franchisees, and their landlords for the anticipated demised premises, to enter into the franchisor’s form of “Collateral Lease Assignment” and “Lease Rider”. Counsel for the franchisee may seek to negotiate certain terms of these agreements. Typical provisions include:

• providing the franchisor with “step-in rights” to allow it to “take over”, even temporarily, the operations of the franchisee’s location;
• a pre-agreed landlord’s consent to a lease assignment to the franchisor or its affiliate; or
• the right for the franchisor to cure any defaults under the lease by the franchisee.

Dispute Resolution

All franchise agreements need to have procedures in place to resolve disputes with franchisees. Many franchise agreements provide that, before the franchisor or franchisee can commence a court litigation or arbitration proceeding, the parties must engage in good faith negotiations and, if they do not resolve the dispute, non-binding mediation where a neutral attorney with experience in franchise law seeks to facilitate a settlement. Some franchise agreements require that disputes be determined by a judge in a public court litigation (which typically permits the parties to engage in a significant amount of “discovery”), while others require that disputes be determined by an arbitrator (usually a franchise attorney or former judge) in a private and confidential arbitration process (which usually permits more limited “discovery” by the parties), and where the parties may be required to pay the arbitrator’s fees in advance for the time that the arbitrator spends handling the case; the successful party in the case is reimbursed for its attorney’s fees by the unsuccessful party.   

Brand Protection

In order to expand its franchise system, a franchisor must be able to protect its brand. A franchisor accomplishes this by requiring its franchisees to sign various agreements, including confidentiality and non-disclosure agreements, together with non-competition and non-solicitation agreements. Successful franchisors remain vigilant in protecting their confidential and proprietary information – including, for example, IP (trade marks), operations manuals, customer lists and related information – from unauthorised use or disclosure by their franchisees. 

Choice of Location

A franchisee’s choice of the retail location from which it will operate is a critically important decision. While a franchisee’s success will ultimately depend on many factors, the selection of a quality location is close to the top of the list. Franchisors typically require their franchisees to submit site selection information to the franchisor, and the franchisee is required to obtain the franchisor’s approval with respect to the selected location prior to moving forward and negotiating a lease. 

Lease Negotiation

Commercial leases are drafted by landlord’s counsel and are typically drafted to strongly benefit the landlord. Franchisees are well served by retaining knowledgeable real estate counsel to review the proposed lease and seeking to negotiate a variety of key provisions, including, without limitation:

• what, if any, lease guaranty will be required;
• the term of the lease and options to renew the lease, along with insuring co-ordination of the timing between the expiry of the lease and the franchise agreement; and
• transfer and assignment-related provisions.   

Lease Guaranties

When a franchisee seeks to purchase a franchise and enter into a commercial lease for the location from which it will operate the franchised business, the principal(s) typically form(s) a new single purpose entity, sometimes with minimal assets, which will enter into both the franchise agreement and lease. Accordingly, most landlords require a franchisee/prospective tenant to provide a lease guaranty, most often (but not always) from a principal of the tenant, as an inducement for the landlord to enter into the lease. From a franchisee’s/tenant’s perspective, providing the landlord with a “good guy” guaranty of the entity’s principal is significantly more preferable than providing a “full” individual personal guaranty for all of the obligations under the lease. A good guy guaranty is a conditional limited personal guaranty which limits the guarantor’s financial liability (provided that the tenant vacates the leased premises, often in “broom clean” condition, and with defined advance notice, for all rent and additional rent through the agreed-upon surrender date).   

Rights of Transfer and Assignment

From a franchisee’s/tenant’s perspective, the ability to negotiate assignment and transfer-related provisions is very important. When landlords prepare commercial leases, they often seek to require a great deal of control over when, and under what circumstances, the tenant is permitted to assign or transfer the lease. However, the franchisee/tenant will always seek to maximise the value of the franchised business, and therefore will want to negotiate the assignment/transfer-related provisions in such a way as to provide it with as much flexibility as possible. For example, franchisee counsel should seek to negotiate a provision that will permit the tenant to assign the lease to the franchisor or any of its affiliates, or to any “approved” existing or new franchisee of the franchisor, without having to obtain the “consent” of the landlord.

Franchisee counsel should also seek to negotiate a provision that if the new tenant (assignee) provides the landlord with a good guy guaranty (in the same form provided by the existing guarantor) with the guarantor having a net worth that is at least as much as the existing guarantor, the landlord will then release the existing guarantor from liability following the effective date of the lease assignment. In any of the above circumstances, the existing franchisee/tenant should be released from liability under the lease (and franchise agreement) as well.

Lease Term, Options and Renewals

From a franchisee’s/tenant’s perspective, the expiry date of the initial lease term and all renewals should “match” exactly with the expiry date of the initial franchise agreement. As the franchisee/tenant should seek to maximise the value of the franchised business, it should negotiate a potential, total lease term, including lease options to renew the lease, which cumulatively is at least 20 years. For example, if the term of the initial franchise agreement is ten years and the franchisee has, at a minimum, either one ten-year option or two five-year options to renew the franchise agreement, the franchisee/tenant should negotiate a lease term that mirrors the initial term and renewal term(s) of the franchise agreement, and the expiry of the lease term(s) should always match the expiry dates of the franchise agreement term(s).