Franchise Agreements

Understanding Franchise Agreements

When buying a franchise you are really buying the rights to operate a business using the franchisor’s brand and business systems.

Those rights are given to you under the franchise agreement, which is a contract between the franchisee and the franchisor and deals with how the franchise relationship will operate. The franchise agreement is therefore one of the most important documents you will sign, as it requires you to comply with a series of important obligations and responsibilities.

Key clauses in the agreement

Everything detailed in the franchise agreement is important as it all forms part of the contract you have with the franchisor. These are some key issues to particularly look out for:

Grant of the franchise
Be clear about exactly what rights are being granted to you.  For a service franchise, is it the right to operate as many vans or vehicles as you want or are you limited to one van?  For a site based franchise, are you limited to operate from one location only?
Term of franchise
The franchise agreement does not last forever, however it will specify how long it will operate, whether there is an option to renew for a further term and the conditions attaching to that option (which may include payment of a renewal fee and an obligation to refurbish the business).

The term of the agreement should be long enough to:

  • enable the franchisee to recover its investment and repay loans associated with the purchase of the franchise
  • allow sufficient time for the franchisee to establish some goodwill in the business and then be able to sell the franchise and still secure a reasonable return

Once all the option periods expire:

  • the franchisee has no right to continue operating under the Franchise Agreement.
  • all of the rights under the agreement cease automatically.
  • the franchisee must stop operating the business and remove all of the signage and equipment
  • the franchisee must essentially walk away

Questions: Is there a right to renew?  What conditions are imposed on renewal? Check whether there is a renewal fee or a requirement to refurbish premises (all additional cost). Is the renewal linked to securing another lease?

Franchise fees
The franchise agreement will deal with what upfront fee you must pay and what ongoing fees you must pay.  Ongoing fees may include a periodic royalty or service fee, advertising fund contributions and ongoing training fees.

Typically franchisees must pay:

(a)           An upfront franchise fee

(b)           training fees

(c)           costs for initial purchase of stock/consumables

(d)           royalty fees

(e)           advertising contributions

(f)            franchisor’s legal fees

(g)           costs to fit out the premises or purchase equipment

The key is to check what is included in the franchise fee and what is charged as an additional expense.  Does the franchise fee include training fees, uniforms and stock — or are those additional payments? The lowest initial franchise fee is not always the best.

Questions: Are the ongoing fees charged as a percentage of turnover or as a fixed amount? What support are you getting in return for payment of your fees?  Are the turnover fees based on GST inclusive or exclusive sales (this makes a difference to the amount you must pay)? If it is a fixed amount, where is the incentive for the franchisor to help build your business?

Who pays for advertising?

Do you pay into a central advertising fund?  If so, how is the fund spent?  What is the balance of the fund and are other franchisees up-to-date with their payments?  Must you also spend money on local advertising?  Do you have to contribute to a shopping centre promotions fund under the lease?  All these can add up to a large expense on marketing — do you get value for this?

Territory rights
The agreement will specify whether you have any territory rights, and whether they are exclusive or non-exclusive. This can be an extremely important issue and can be critical to the success of the franchise.

The territory should:

(a)            be big enough, but not too big

(b)           be tailored to the franchised business

(c)            consider demographics, not just size or population.  Is there a big enough customer base to support the business?

Questions: Is there an allocated territory?  Is it exclusive or non-exclusive?  Check whether the franchisor or other franchisees can compete in the Territory and whether the franchisor can establish other franchises.  If the franchisor sells products over the Internet, do you receive a share of online sales from customers in your territory? Are you entitled to receive leads or referrals from customers in your territory? Are there conditions attached to exclusivity – for example, minimum sales targets? Are those targets reasonable ie. can you meet them?

Branding requirements
The agreement will contain rules regarding the use of the franchisor’s brand, including provisions regarding signage, packaging, uniforms and fit out or sign-writing requirements. The branding obligations allow the franchisor to maintain consistency across all franchisees in the network.
Operational obligations
There will be numerous provisions regulating how you can operate the business including the products or services you can sell and rules about where you must buy your products. You might be required to buy products only from the franchisor or from a preferred supplier.
Selling your business
The franchise can usually be sold however the franchisor will retain a degree of control over the sale and will want to ensure that the buyer meets its normal criteria for the new franchisees. You may also have to pay a transfer fee as well as the franchisor’s costs in relation to the sale.
Typically, the franchisor will have the right to terminate the agreement if the franchisee breaches its obligations under the franchise agreement. Some breaches allow the franchisor to terminate the agreement without notice, but most breaches will require the franchisor to first give a notice explaining the breach and what must be done to remedy it. If the franchisee does not remedy that breach after receiving that notice then the franchisor can terminate.
Consequences of termination
The agreement will specify what happens after the termination or expiry of the agreement. Most franchise agreements restrict the franchisee from then operating a similar business elsewhere for a period of time. This means the franchisee has little prospect of being able to continue to operate the business in any way or to sell the business.
Leasing arrangements
Leasing arrangements are generally structured in one of two ways:

  1. the franchisee holds the lease
  2. the franchisor holds the lease and grants an occupancy license

If  the franchisor holds the lease then the franchisee usually:

(i)              will be asked to provide a personal guarantee under the lease.

(ii)             will be asked to provide a bank guarantee to secure the lease.

(iii)            has no right to deal directly with the Landlord

Questions: Who holds the lease? Are fitout contributions payable – if so, to who? What security must the franchisee provide? How long does the lease run and are there options to renew? Does the term match the term of the franchise agreement? Are there relocation or demolition provisions in the lease?.