Making the Decision to Franchise
You have a successful business and see its potential for expansion: do you grow it yourself or franchise it to other owners? The decision has a lot to do with your business model and your interest in being involved in the growth of the business. Franchising can be a low-cost way to expand your business. Instead of borrowing funds to open a new location, you find an investor, who is poised to successfully run a branch of the business and let them invest the funds required to open the new location. You secure a steady flow of income from that new business location in the form of monthly royalties.
In a franchise, the franchisor (the person owning the business system and brand) licenses the system and brand to other owners (franchisees) under certain conditions. These conditions should be strict so as to preserve the brand and ensure the success of the franchisee. If your business system is well-tested, then you might have the ability to bring that system into a new location with a new owner with ease. The key to success is whether your business model and system are easy to replicate in different communities (e.g. in a new neighbourhood or different province). Usually, the cost of operations, supplies and labour needs to be similar across communities for the model to replicate. In addition, the new business owner must have the requisite skills to run the new location successfully. A thorough operations manual is required to ensure that the system is replicated correctly.
If your business isn’t yet ready to replicate in this manner, then expanding through additional corporate-controlled locations might be a better choice. By taking this course of action, you can test out how the business model and system work in different environments prior to franchising. However, franchising is a whole new business in and of itself. As a business owner, you will need to assess whether you want to, and have the capacity to, make the transition from independent business to franchisor.
If your business is ready to franchise, then you should be aware of the fact that most Canadian jurisdictions regulate franchising to some degree. For the most part, franchise statutes require franchisors to provide a disclosure document to all potential franchisees for some length of time prior to closing a franchise agreement. The disclosure document requires extensive detail and can be incredibly time-consuming to put together. If the disclosure is incomplete or incorrect, the franchisee has the right to terminate the franchise.
Once you have decided that franchising is the right way to grow your business, you need to start looking at compiling the required documentation. As aforementioned, each province regulates franchising differently. In Ontario, franchising is governed by the Arthur Wishart Act. This statute establishes that franchisors are required to provide their prospective franchisees with a franchise disclosure document at least 14 days prior to a franchise agreement being signed or to funds being paid. The disclosure must be complete and accurate. It must also contain the information required in the regulations. If the franchisee does not receive a valid disclosure document within the required time-frame, they can rescind the franchise agreement. They must do so within 60 days from the date of signing. The franchisee can also rescind the franchise agreement at any time in the 2 years following the date of signing if the disclosure document is inaccurate. The purpose of the disclosure document is to allow potential franchisees to adequately assess the risks of entering into the agreement.
In addition to the disclosure document, a franchise needs to have a thorough franchise agreement, which sets out all aspects of the franchise relationship, including, but not limited to, fees, royalties, marketing costs, term, trade-mark licensing, location expectations, conditions of default and terms of resale. Some of these points are addressed in greater detail below.
Finally, a complete and up-to-date operations manual is crucial to setting clear expectations for the franchisee and helping the new franchise succeed. It should be very business-specific. As a result, the operations manual is often withheld from the franchisee until after the franchise agreement is signed, in order to preserve confidentiality over things like trade secrets.
Key Issues Governing the Franchise Relationship
The following is a non-exhaustive list of some of the key factors that need to be addressed in a franchise relationship. Depending on your business’ size and the industry in which your business operates, there may be other factors to consider as well.
- Franchise Fee: This is the initial fee that a franchisee pays to the franchisor in exchange for the right to open a franchise. It is usually a flat fee. The price of this fee varies, depending on the type of business you are franchising and how well-established your business is.
- Royalty Fees: This is the ongoing (usually monthly) fee that the franchisee pays to the franchisor. It is usually fixed as a percentage of gross sales (often in the range of 4-6% of gross sales, although royalty fees vary widely). Some franchises set a minimum payment per month, while others have royalty fees that increase over the course of the agreement, as the franchise grows.
- Marketing Fees: Many franchise agreements also include a regular (monthly or annual) fee that the franchisee pays to the franchisor for centralized marketing. The marketing fee can be a set amount or a variable amount. In addition, many franchise agreements require the franchisee to spend a fixed percentage of gross sales on local marketing each month.
- Term: The term of the franchise agreement is important. Franchise agreements often preclude the franchisee from having the right to terminate the agreement (except where there is an approved sale to a new franchisee or if certain default circumstances apply). 10 years is a standard franchise term.
- Renewal: It is important to also set out the terms for renewing the franchise agreement at the end of the term. Typically, the franchisee has a right to renew the agreement for an additional set term, provided that they are not in default. Upon renewal, the franchisee might be expected to pay a small renewal fee (much lower than the initial franchise fee). The franchisor might also make updates (including rate changes) to the current franchise agreement.
- Termination: As noted above, most franchises do not allow for termination of the agreement by the franchisee. The agreement usually gives the franchisor a number of grounds for termination, including the franchisee being in default on any terms of the agreement. Franchisees are often given the right to sell the franchise; however, the franchisor always retains the right to approve the sale and there is often a fee payable (in many cases, the fee is up to 50% of the current franchise fee).
- Default: Franchise agreements will set out a series of circumstances in which the franchisee is in default of the agreement. Such circumstances include non-payment of fees, misrepresentation of sales, failure to protect the brand (and trade-mark), failure to use specified suppliers and failure to follow the dictated operations of the franchise. The franchisor will usually provide a period of time to “cure” these defaults, following which time the franchisor will have the right to terminate the franchise.
- Location: Assuming that the franchise requires a physical location, there are a number of factors that the franchisor must consider with respect to the location:
(1) Protected Radius: One important factor to consider in selecting a location for a franchise is deciding how close it will be allowed to be to other franchisees. This will be highly dependent on the type of business and the market the business operates in. Usually, a franchisee will have the right to have exclusivity within a particular radius with respect to their location. Sometimes, a franchise will have exclusivity over an entire city or region. Most franchise agreements will also provide the franchisee with a right of first refusal over new franchises adjacent to the existing one.
(2) Selection of Location: Franchisors almost always reserve the right to approve the location. Sometimes, the franchisor even has primary selection rights. Often, the franchisee is given a few options to choose from. Prime locations will depend upon the demographics of the franchise’s customers, amongst other factors, such as nearby businesses.
(3) Landlord/ Tenant: Another location-based issue is whether the franchisee or the franchisor will rent the location (assuming that it is rented and not owned). Many franchisors wish to be the tenant and sublet the premises to the franchisee. If the franchisee defaults on the agreement, the franchisor is still the tenant at the franchise location and can sublet to a new franchisee. If the franchisor does not step in as the tenant, then they usually retain the right to approve the lease. The franchisor might also require the inclusion of a term, which stipulates that the franchisor has the right to assume the lease if the franchisee defaults on the franchise agreement.
(4) Space & Fit Up: Most franchises that have a physical location also have strict expectations as to the size, amenities and fit up of each location. Many franchise agreements will specify that the franchisor will perform the fit up (usually at the cost of the franchisee) and that the franchisee must purchase construction services, fixtures and supplies from specific suppliers. All of these factors go to the protection of the brand of the franchise.
(5) Suppliers: As noted above, most franchise agreements set out which suppliers the franchisee can use. Often, the franchisor will set product and supply rates centrally. Most franchise agreements also provide that the franchisor need not pass any savings (e.g. negotiated discounts for buying in bulk) on to the franchisee.
- Trade-mark & Other IP Protection: The trade-marks and other intellectual property (IP) that are owned by the franchisor (including, but not limited to, trade secrets, copyright and patents) are a key component of any franchise agreement. Franchisees must use the franchisor’s brand and other proprietary information to grow the business. In order to protect its IP, the franchisor should ensure that the franchise agreement clearly sets out that the franchisee has a limited license to use its IP (conditional upon the agreement being in force). In addition, franchisees must act to protect third parties from infringing the franchisor’s IP and report any infringements to the franchisor.
- Franchisor Obligations: The franchise agreement should also address what the franchisor will be providing to the franchisee in return for the franchise fee and ongoing royalties. The use of the brand is obvious; however, the system, training, support and marketing that will be supplied should also be detailed.
Franchise agreements may include any number of additional terms in order to govern the franchisor-franchisee relationship. A franchise agreement should be tailored to meet the unique needs and capabilities of the business it concerns. A good franchise agreement will typically give the franchisor a certain degree of control over the franchise and set clear expectations for the relationship.
How Momentum Can Help
Franchising is not the right choice for all business expansions, but it is a valuable option for growing businesses to consider, where the right conditions for franchising exist (the right business and right franchise owners). Contact us today to discuss your franchising plans. We can help you draft your disclosure documents, franchise agreements and other franchise documentation.