Franchising is a commercial arrangement where the owner of intellectual property in a developed and proven business model, provides authority to another company or person to run their own business using that developed business model.

The parties to this arrangement are commonly known as the “franchisee” (the party obtaining authority to use the developed business model), and the “franchisor” (the party granting authority to use the developed business model).

In return for payment by the franchisee, the franchisor will provide initial advice, equipment and guidance, as well as ongoing support and other things such as products and packaging.  Ideally, out of the franchise arrangement the franchisee obtains much needed support from industry leaders.

Due diligence

For those considering becoming a franchisee, the first step is to seek out existing or previous franchisees within the business.  These people will have useful knowledge of how the business and the franchisor operate.

Franchisees and franchisors will work together for the duration of the franchise arrangement and must be comfortable with each other. It may take several meetings and discussions to ensure both parties are happy.

The agreement

The franchise records the obligations and rights of the franchisee and franchisor.  This document is drafted by the franchisor’s lawyers and the franchisee will receive it once they have made a decision to proceed with the franchise. It is essential that they get independent advice on the content of the  agreement before signing it. This advice should come from lawyers, intellectual property experts, accountants or business advisers.

The franchise agreement will state that it represents the entire agreement between the parties.  As such, franchisees should ensure that all representations and promises made by the franchisor are recorded in the agreement. The franchise agreement should also include the following:

  • Fees

Fees are structured differently depending on the industry.  However, a common fee structure consists of an upfront payment for the business model itself, plus  any equipment,  training and royalties (which is essentially a commission payment) on sales.

The upfront fee is hard to predict and also difficult to compare as fees for other franchises are not published.  However, a good business adviser will have industry information that may provide guidance on setting/comparing the upfront fee.  The royalty rate will typically be between 2% and 6% of gross sales, but can be higher in certain industries.

Franchisors may also charge fees for:

  • legal costs;
  • advertising to cover costs of marketing the franchise;
  • stationery;
  • uniforms;
  • sign writing; and
  • administration
  • Timeframes and extensions

There is a constant tug of war between franchisees and franchisors over the term of a franchise agreement.  Franchisors typically prefer long terms of 10 or so years, while franchisees prefer shorter terms with several renewal rights so that they are not tied to the arrangement for long periods of time.

Franchisees should be wary of handing over large sums of money at the start of a franchise in order  to operate for only a year or two without rights of renewal.Franchisors should try as much as possible to lengthen the terms of a franchise agreement so as to keep the franchisee operating for longer in order to get the most out of the initial investment and their intellectual property.

In many cases, the franchise agreement will allow the franchisee to extend the operation  after the end of the term. Franchisees must strictly adhere to any renewal/extension conditions, such as being up to date with royalties or applying for an extension by a certain date.

  • Ending the agreement

The agreement will record how either party may end the agreement and in what circumstances.  For instance, if a franchisee wished to sell the business to a third party after half of the first term, the agreement should set out how the franchisee may do so and what conditions the franchisor may insist on.  One such condition will be the franchisor’s approval of the buyer.

Usually, the franchisor may assign its rights without the franchisees consent.  This is so the franchisee may sell the whole franchise operation without needing to obtain the consent of all franchisees; a process that could take a long period of time and in most cases is unnecessary.

Franchisors and franchisees should discuss with their advisers what termination rights are reasonable in the circumstances.  For instance, either party should, in most cases, be able to terminate if the other party breaches the franchise agreement.

  • Support

It is common for franchisors to provide initial and ongoing training to franchisees.  The cost of this training may be included in the initial fee or may be charged separately. Franchisors may also assist with setting up and decorating a new business premises or even securing leases to new premises. If any of this support is discussed in initial conversations, it should be recorded in the franchise agreement.

  • Exclusivity

Franchisees should have exclusive rights over particular geographic areas.  This is to avoid the franchisee having to compete with other franchisees operating under the same brand.

However, franchisors should also insist on minimum sales targets and state that if they are not met, the exclusive area will be narrowed or the exclusivity removed. Franchisors should look to limit the size of the exclusive areas and if the franchisee wishes to get a larger area, they pay additional fees for that concession.

Franchisees should negotiate not just with fees, but on the size of the exclusive area. More revenue will be available to a franchisee with a larger exclusive area.

Conclusion

It is essential that any business person looking to start a franchise operation and seek franchisees, find expert legal, intellectual property, business and financial advice. This advice is just as essential to people looking to buy a franchise. James & Wells are your legal and intellectual property experts and we look forward to hearing from you.