Whether you are a seasoned entrepreneur or diving into business ownership for the first time, franchises can offer a great return on investment. At the base level, a franchise agreement provides the franchisee (the person opening the franchise) with a license to use the franchisor’s (the company) business identity (trade-marks); however, a franchise agreement also places strict restrictions on how the business will be run. Franchises usually provide the franchisee with a set of “business processes” to follow – while these can provide a new business owner with a good template for how the run the business, they can also provide restrictions on operating the business outside of these parameters. Often, franchises also include some level of centralized promotion of the business.
In Ontario, there are rules (called the Arthur Wishart Act), which require franchisors to provide potential franchisees with certain information before a franchise agreement is entered into. Oddly, there aren’t any rules, which determine the actual agreement between the franchisor and franchisee. Franchise agreements are almost always written to provide a number of rights to the franchisor and a few rights to the franchisee. Franchise agreements are rarely negotiable. The franchisor wants the franchisee's business to succeed, but every franchisee needs to be well-informed about what they are agreeing to in the franchise agreement before entering into it.
Some common issues to consider:
Costs and Fees
• Franchise Fee: There is almost always an initial franchise fee, which usually ranges from $10,000 – $200,000 (commonly around $50,000). This fee is rarely returned if you close the business and most banks will not finance the franchise fee.
• Royalty Fee: In addition to the initial franchise fee, there will almost certainly be an ongoing (usually monthly) royalty fee for the use of the business identity and the “processes” of the franchise. This is usually in the form of a percentage of the gross sales of the business.
• Marketing Fund: Many franchise agreements provide for marketing obligations at the local level (usually in the form of a set investment per year or as a percentage of sales) in addition to a contribution to a centralized marketing fund.
• Training & Conferences: Make note of any costs associated with mandatory training and conferences. Some franchises include mandatory annual conferences, which could involve travel and accommodations at the cost of franchisors.
• Equipment & Suppliers: Many franchise agreements require franchisees to purchase equipment and supplies from particular manufacturers (or even the franchisor themselves). Collectively, this can restrict the franchisee’s ability to control the costs of operating the business. The franchisor also regularly reserves the right to benefit from any bulk-buying discount from a supplier, and specifies that they are not required to pass those discounts on to the franchisee.
Branding
One of the key benefits of being part of a franchised business unit is the common branding and marketing which the franchisor undertakes. That said, this benefit comes with both restrictions and costs, and any franchise review should carefully identify those benefits, restrictions and costs.
The licensed use of the franchisor’s branding and trade-marks is key to any franchise. As with any license of intellectual property, there are strict rules regarding the use of the brand. From the franchisor’s perspective, misuse of the brand or poor performance of a franchisee can harm the brand. For this reason, most franchise agreements require franchisees to carefully follow certain business protocols and meet service expectations. A potential franchisee should consider how following those protocols and meeting those service expectations will impact how the franchisee wants to run the business. Note also the customary requirement, discussed above, to financially contribute to regional, national or international marketing campaigns to support the brand.
Financial Reporting
Franchise agreements almost always contain a requirement for financial disclosure by the franchisee to the franchisor. Franchise royalties are usually based on gross sales, and financial reports are usually required to be submitted monthly. There can be increased costs associated with this sort of financial reporting and a business owner may not be accustomed to providing such open access to his or her financial records.
Lease
If the franchise has a “storefront” or customer/client space requirement, then the franchise agreement will often contain expectations regarding the space. Some franchisors require that the franchisor itself holds the lease and then enter into a sub-lease agreement with the franchisee. This provides for continuity in the franchise's location even if the franchise agreement terminates and a new franchisor is brought in.
Termination of Agreement
Franchise agreements can come to an end in various different ways:
• Default: All franchise agreements include a list of conditions under which the franchisee will be in default under the agreement. If the default is not “cured” by the franchisee, then the franchisor will have the option to terminate the agreement. These default terms always include being in violation of the terms of the agreement, but can include additional terms, such as requirements for financial health (i.e. a certain amount of “working capital” in the business bank account), a certain level of business activity or certain questions of control of the franchisee corporation. Special note should be taken if the agreement provides for default when a franchisee is not in compliance with the terms of any secondary documents, such as operations manuals. Careful review should be made of all such documents before signing the main franchise agreement.
• Early Termination: Generally, franchise agreements do not provide for early termination of the agreement (outside of default by the franchisee). If termination for non-default reasons is provided for, then the provision usually allows for the franchisor to terminate, not the franchisee. This means that the only route a franchisee has to escape from a franchise agreement is to enter purposeful default, or attempt to sell the franchise (discussed below). Entering into default almost always exposes the franchisee to recovery of costs of the franchisor in dealing with the default (such as lawyer fees).
• Expiry of Term: Franchise agreements almost always have a fixed term and provide for renewal of the terms, if both sides consent to renewal. If the agreement is not renewed, then the agreement terminates in accordance with whatever terms are in the agreement.
• Sale of the Business: Most franchise agreements include an option for the franchisee to sell the franchise to an approved party. There is usually a “transfer fee” of some sort (often at least half of the original franchise fee). The approved new franchisee is usually required to sign the most current franchise agreement, even if the terms were preferable in the original agreement. As well, franchisors often reserve the right to approve the sale price for the franchise, which can limit the profit that the selling franchisee can make on the transaction.
It is also important to take note of what happens to the franchise agreement if the franchisor is in default, goes bankrupt or otherwise ceases to do business. A franchise agreement is usually assignable by the franchisor to a third party, but not assignable by the franchisee. This means that a franchisor is often permitted to sell its business, even though this would put the franchisee under contract to a new owner.
Non-Competition
However the franchise agreement terminates (early termination, sale of the business, default or expiry of term), one key factor to consider in the post-franchise relationship is whether there are non-competition provisions, which extend beyond the termination of the franchise agreement. It is common for a franchisor to restrict the franchisee’s ability to open a similar or competing business in a certain geographical area (typically around the franchised business) for a certain period of time after the agreement terminates. While the franchise agreement restrictions need to be "reasonable" to be enforceable, such restrictions tend to be more enforceable by the courts than are employment-based non-competition provisions. You can read more about non-competition provisions here: _______
These are some of the common issues which should be reviewed carefully when entering a franchise agreement and relationship. That said, each franchise agreement is differentand small changes in the way that a clause is worded can make a significant difference in how the relationship operates, and the costs and expectations facing a franchisee. A franchise relationship is a long-term relationship: figure out what you expect to receive out of the relationship and what you are willing to give in return. If one franchise relationship isn’t the right fit for you, another one might be. Have a lawyer review the agreements for you and have an accountant review the health of the franchisor for you.
How Momentum Can Help
We can review the franchise disclosure document and the franchise agreement, summarizing and explaining the key terms, and putting them into context for the actual operation of your business. We can also help you understand what is standard in a franchise arrangement and what is outside of the norm. We can highlight areas of concern and we can help you through the decision-making process. If the franchisor is open to negotiation, we will help you negotiate changes to the agreement.
We can incorporate a company and help you organize it to run the franchise, and we can assist you in your purchase of an existing franchise, negotiating with both the franchisor and franchisee. We are also happy to connect you with project management and other professional services to help you through the entire planning process, including site selection, negotiating with landlords, obtaining permits and approvals, and accounting and book-keeping assistance.
Please contact us so we can offer you ongoing legal support as you operate and grow your company.