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:
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?
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?
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?
- the franchisee holds the lease
- 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?.