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Top 10 legal pitfalls in franchising (and how to avoid them)

20/11/2017

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United Kingdom

The top 10 common legal pitfalls in franchising and how to avoid them.

1. Align your trade mark portfolio with your franchise strategy

A franchise system’s trade mark is a key intellectual property right and creates value in the franchise system. Investing in a registered trade mark should therefore be a priority. It is important to ensure that the trade mark registration covers all of the necessary classes of products and services which comprise the franchise system. Trade mark protection should also form a central plank of any international expansion strategy, to ensure that a franchisor can expand into key strategic markets. They say imitation is a form of flattery, but some international jurisdictions operate a “first to file” system, meaning that if a franchisor does make its application early, it might have to pay a hefty fee to remove an incumbent registrant. Also, the process of applying for a trade mark should flag the existence of any third party rights, meaning that a franchisor can then take a view on whether to enter that market at all or whether the system needs to trade under an alternative name – all very important to know before advancing discussions with a franchise partner. A number of household brands have run into this problem – for example, Burger King has to trade as Hungry Jacks in Australia.

2. Check that you own it before you license it

In addition to trade marks, franchise systems will comprise of a number of other intellectual property rights, such as copyright, design rights, patents and database rights. It is likely that the franchisor has engaged third parties to create aspects of the system, or taken licences from third party providers. It is therefore important that prior to commencing a franchise expansion, a franchisor identifies the intellectual property within its system and determines whether or not it either owns it or has the right to sublicense it. A common pitfall is copyright ownership – it must be assigned in writing, failing which it vests in the author. If you have engaged a third party to write your manual, create store designs or marketing materials or software but the terms of engagement do not cover copyright assignment, you may find yourself having to pay twice.

3. Learn to walk before your run

Operating a successful corporate business and running a franchised business require different skill sets and are different business models. It is therefore advisable to “road test” your franchise model before rolling it out. Indeed, “pilot” franchising is a membership requirement most national franchise associations, including the BFA in the UK. A pilot allows a franchisor to adjust the concept and model so it is demonstrably viable for both franchisor and prospective franchisees. If a franchisor does not take this initial step, it runs the risk of building a castle made of sand. If a franchisor does pilot the franchise, it is important to ensure that the pilot phase is regulated properly by contract, as the pilot franchisee is still privy to confidential information and know-how and may generate IP for the system (see point 2 above) . In the early years, franchisors should be careful not to sign up too many franchisees too quickly before they have the management structure to support them properly. This can create a litigation risk if franchisees do not feel adequately supported.

4. Know your franchisee

It is important to make sure you know who your prospective franchisee is, the identity of their owners and their business interests before entering into the franchise agreement. This can be an awkward conversation to have when the parties are still discussing the potential deal, but the sooner it happens, the better. This prior knowledge might have an impact on terms you need to include – for example, does the prospective franchisee having any competing business interests, do they operate using affiliated or third party operators (in which case the documentation needs to regulate the multi-tiered relationship appropriately), is there an issue under any sanctions laws and do they have sufficient capital? It is also important to ensure that any preliminary documentation enables you to back out of a deal without problems.

5. Make sure the franchisee knows you

In a number of jurisdictions, it is a legal requirement for a franchisor to issue a disclosure document, or make “adequate disclosure,” about a franchise system before the franchise agreement is signed. Even in markets whether it is not a legal obligation, it is best practice and serves to protect both franchisor and franchise. From a franchisor’s perspective, a key litigation risk is misrepresentation and the process of pre-contractual disclosure can help reduce and limit that exposure. It also encourages franchisors not to oversell the franchise, to be realistic, to manage expectations and to provide honest, reliable financials. 

6. Don’t throw in the kitchen sink

If a franchisor is offering a territory based franchise, it should only give the minimum and impose performance targets, to ensure it is fully exploited and that the franchisee has the capability of utilise it fully. Understanding your target territory and the capability of the franchisee is crucial. For example, it is very rare that a single partner can realistically cover markets as vast as China, India and Russia. Franchisors should resist the temptation to grant blanket exclusivity and if necessary use rights of first refusal. It is easier to increase the territory later than reduce it. Franchisors of certain systems (particularly in the retail and leisure and hospitality sectors) should think increasingly about exclusivity both in terms of geography and “channels”.

7. Ensure you can evolve the system

Franchise agreements are often long term commercial contracts which are set in stone on the day they are signed. The operational manual is a living and breathing document which will evolve over time as the system changes, and it is therefore vitally important to ensure that the franchise agreement and operational manual work in tandem and strike the right balance between legal and financial certainty for the franchisee and the franchisor’s need to innovate and drive changes through the system to ensure that the franchise remains competitive. If the right balance is not achieved, a franchisor may find itself unable to develop the system or forced into developing a two or multi-tiered system in which a consumer’s experience of the brand may vary from market to market, or from franchisee to franchisee. Conversely, franchisors should feel duty bound to develop and innovate the system and franchisees will see this a key obligation of franchisors – Dunkin Donuts franchisees in Quebec, Canada recently sued their franchisor for not innovating the system in the face of competition from Tim Hortons.

8. Manage your credit

In most franchise systems, the franchisor will supply products to its franchisees. As the network grows, it becomes increasingly important for franchisors to manage the supply chain in a standardised way and to ensure that the credit risk exposure is kept under control. If franchisees are late in paying, or don’t pay because they are in financial difficulty, the situation can quickly spiral out of control – a natural temptation is keep supplying product in the hope the franchisee will trade its way out of difficulty, but if it doesn’t, a franchisor could find itself in an existential crisis. It is therefore important to ensure that a franchisor’s finance team is fully engaged with the network, regular assessments are made and appropriate safeguards are put in place, such guarantors, bank guarantees, letters of credit, credit risk insurance and/or contractual rights to switch to pre-payment terms.

9. Police the network

A common complaint amongst franchisees is that the franchise agreement is one-sided and drafted heavily in favour of the franchisor. However, this does benefit franchisees that follow system and operate successful businesses. Their business can be adversely impacted by the actions or omissions of a non-compliant franchisee, and they will look to the franchisor to take action. This can only be done if the franchise agreement gives the franchisor robust contractual rights. Franchisors therefore have duty to themselves and the rest of the network to ensure that franchisees are audited regularly and that non-compliant franchisees are not allowed to continue without sanction.

10. Know your exit strategy

Franchisor’s should plan for an exit that is smooth, causes the least disruption to the network and maximises the value. It is important that your franchise agreements facilitate this and do not act as a blocker on any potential investment into or sale of the franchisor. Change of control and assignment provisions must enable a franchisor to dispose of its business without having to seek individual consents from franchisees.

All of the above are relevant to domestic and international franchisors. However, for international franchisors, an 11th pitfall to avoid is to failing to take local law advice on your franchise agreement before the deal is signed. Common issues which arise in international franchising include obligations for pre-contractual disclosure, franchisor and/or franchisee registration, trade mark licence registration, restrictions on remitting franchise fees overseas, the international tax treatment of payments and enforceability of foreign law contracts in local courts.

Franchisors and prospective franchisors should therefore ensure that they are investing sufficiently in their franchise systems and management teams and using experienced franchise counsel, all to ensure that their networks are built on solid foundations and that deal risks and local law issues are identified, reduced and managed effectively. Penny wise and pound foolish.

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