Understanding the Franchise Agreement

May 3, 2022by Brian Walsh

Franchising is a business model that enables an established business (the franchisor) allows an independent business owner (the franchisee) to use the franchisors brand, trademarks, proprietary systems to produce a product or service.

It is a very popular business model because it provides entrepreneurs the opportunity to participate in an existing, successful business with a proven track record, training techniques, established supply chains, a marketing program and ongoing support, dramatically reducing the risk often associated with starting a new business from scratch.

At its core a franchise is a relationship between a franchisor and a franchisee. That relationship is governed by a legal document known as the franchise agreement. A franchise agreement establishes the ground rules for running a successful operation as a unit of the franchisor’s network.

A typical franchise agreement gives the franchisee the right to establish and operate one or more franchised locations or outlets.

Critical Issues Covered
By The Franchise Agreement

The franchise agreement should not be confused with the franchise disclosure document (FDD).

The FDD is a disclosure document that provides information to prospective franchisees to guide the decision to invest in a specific franchise offering. The information provided and the format of that information are heavily regulated by the Federal Trade Commission and state governments.

While the FDD provides investment information and disclosures it is the franchise agreement establishes the terms and conditions for the business relationship in a legally binding contract.

Each franchise agreement is a stand-alone contract with terms that can vary widely from franchisor to franchisor; based on the industry of the business, the legal locations of the two parties (and the applicable state laws), and the business needs of the franchisor and franchisee. Moreover, they are negotiable.

14 critical issues covered in the franchise agreement:

  1. Identification of the franchisor and franchisee. The legal status (Individual, corporation, partnership, L.L.C.), addresses, contact information, and designated representatives are necessary to identify the parties bound by the agreement precisely. In Florida, the designation of “in-state” or “out-of-state”can affect franchisee rights.
  2. Term of agreement. Franchise agreements are typically ten years, subject to compliance with all contract conditions. The contract might include an automatic extension of the agreement or specific requirements for the renewal of the contract. Failure to extend is a termination of the franchise agreement covered in the End of Term provision.
  3. Location and territorial rights. The agreement specifies exclusive or non-exclusive rights to operate the franchise in a specific geographic area. When non-exclusive, franchisees are likely to compete with other units of the same franchisor. Franchisees may have options or requirements to open additional outlets within a designated schedule or the consequence of certain events. Franchisors typically retain the right to approve the location and appearance of all franchised locations, including the choice of furniture, fixtures, upholstery, landscaping, and signage that meet the franchisor’s standards.
  4. Operating Policies and procedures– The franchise agreement typically requires that a franchisee use the franchisor’s proprietary systems and methods in their operations, usually contained in a proprietary operations manual. The contract may restrict the franchisee’s choice of vendors and service providers or the products and services offered by the franchisee to its customers.
  5. Training and Support. The agreement establishes the franchisor’s obligation to provide training and support services before opening the franchise unit and during the entire term of the franchise agreement. Franchisors typically provide training in corporate offices and the field to franchisees and employees. Training may be optional and limited to specific staff. Fees and expenses for training may be included in the franchise fee or payable as a separate charge. Potential franchisees should expect full disclosure of franchisor training and ongoing administrative support, including required fees.
  6. Franchise fee– The franchise agreement should identify the initial franchise fee and the terms for its payment and any other expenses – upfront software license fees and initial inventory requirements and purchases – payable at the onset of the franchise relationship.
  7. Royalties– The most common ongoing fee is the royalty fee, typically charged monthly or weekly. Franchisors typically set royalties at a fixed percentage (the royalty rate) of the franchisee’s ongoing monthly or weekly gross sales. However, alternative royalty structures may apply with the agreement of the franchisor and franchisee.
  8. Intellectual property– A franchise’s value often depends on the franchisor’s proprietary systems, trademarks, patents, and other intellectual property. Under certain circumstances, a franchise agreement grants the franchisee the right to use the franchisor’s name, trademarks, service marks, logos, slogans, designs, and other branding indicia. The right to use the franchisor’s intellectual property is the foundation of the agreement.
  9. Restrictive covenants. Franchise agreements often contain restrictive covenants limiting what franchisees can do during and after the contract term. For example, Chick-fil-Afranchisees work in the franchised location full time. They are not permitted to operate a competing business during the agreement term. Agreements usually include non-compete clauses that become effective at the agreement’s termination. For example, a typical non-compete provision might prohibit a terminated franchisee from operating a competing business within five miles of the franchisee’s former location for three years following termination.
  10. Supply of critical inventory or servSome franchisors require franchisees to buy stock or services from a specific supplier or the franchisor for quality control. Language detailing alternative options or suppliers in the event of supply chain interruptions is essential.
  11. Advertising and Marketing. Most franchisors require that franchisees support franchisees with marketing and advertising expenditures, even designating a minimum percentage of sales set for that purpose. A “brand development fund” is the most common marketing fee charged by franchisors. The franchise agreement establishes required contributions to marketing or advertising, including participation in franchisor-led product promotions.
  12. End of Term provisions– Franchisor/franchisee relationships do end after a period, even in cases where family members of the franchisee assume the business. The franchise agreement identifies the tasks of each party to unwind the business relationship. Usually, this consists of a long list of specific obligations for the franchisee, including ceasing to use the brand name, taking down signs, returning the operations manual, and paying all amounts due.
  13. Insurance and indemnification. Franchisees are typically required to carry minimum property and liability coverage during the franchise term to protect the franchisor from derivative customer and employee lawsuits. Indemnification clauses are standard to “indemnify, defend and hold harmless” the franchisor against any claims, costs, damages, and expenses arising from the franchisee’s activities.
  14. Transfers and resales. A franchisee’s right to transfer ownership of the franchise operation may require the franchisor’s approval of buyers, specific financial and operating conditions (including the payment of a transfer fee or new franchise fee), or the franchisor’s right of first refusal. While a sale or transfer of the franchise may not be anticipated at the time of the agreement, knowing the conditions of a subsequent transfer is crucial.

Final Thoughts

It is important to fully review the franchise agreement to make sure that it embodies the business relationship you think you are getting into. You don’t want to enter into he agreement to later find out that you won’t be getting the support you thought you would be getting from the franchisor or that there are marketing assessments or other fees that you were unaware of.

Becoming a franchise owner can be a lucrative opportunity but you need to know and fully understand the ground rules before signing the dotted line. Franchise agreements are highly formalized documents filled with legal jargon and terms or=f art that you may not fully understand.

We highly recommend that you review the franchise agreement with one of our attorneys to make sure that the document says what you think it does. And that the deal is what you think it is.

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