How well do you know your franchise agreement?
This article was first published by Global Franchise Magazine in June 2018. It speaks to a UK audience of businesses and individuals who are new to franchising and provides guidance on key issues to cover in the franchise agreement.
What is a franchise agreement?
Sounds like an obvious question, in its broadest sense the "F" word describes any third party relationship in which one business is licensing its key intellectual property, such as the trademark, copyright in materials, any proprietary software and its know-how to enable another business to replicates how it operates and sells its products and services. Typically this is characterised as a "business format" franchise, but the relationship can have varying degrees of control and different monikers, such as "JV partners", "franchise partners", "licensees".
The franchise agreement will also cover the franchisor's provision of initial and ongoing support and training, and also some centralised services. There will be a long list of the franchisee’s obligations to follow the system and comply with guidelines. The franchise agreement will also set out the key financial obligations and what happens when the relationship comes to an end.
The franchise agreement sits alongside the operations manual and the business plan – all three documents together form the foundation of a franchisee's business, so it is essential that both parties fully understand the terms of the franchise agreement, otherwise they will not have a strong foundation on which to build a successful business relationship.
Why are franchise agreements so one-sided?
Franchise agreements differ from many other forms of commercial contract in their one-sided nature. But there is a good reason for this: by joining a franchise network and growing a business using the franchisor's brand, know how, products and support, a franchisee is entering into a legal relationship which is very different from bi-lateral commercial agreements. The franchisor has to be able to monitor, audit and effectively police its network of franchisees in order to ensure uniformity of brand experience and brand standards. Equally, the franchisor is placing its core business asset, its IP, in the hands of a third party, so there has to be a firm commitment to adhere to standards and develop the business in accordance with certain standard.
The upshot is that the franchise agreement must therefore be biased in favour of franchisor, otherwise the network is built on a house of cards. The litmus test for any compromise on a franchisor's standard terms is; "what would happen if this compromise was given to all franchisees"? If the answer is that it would lead to an erosion of the franchisor's ability to protect its IP, change and update its system/consumer offer and police and enforce brand standards, then the compromise must be rejected – crucially, this unilateral approach will benefit compliant franchisees, as it means that quality standards will be high, it shows that the franchisor cares and that bad performing franchisees should not be able to undermine the network.
What laws apply to franchising in the UK?
There is no franchise-specific legislation in the UK. However, the general principles of contract law apply to franchise agreements. The Unfair Contract Terms Act 1977 applies to exclusions and limitations of liability in standard form business to business contracts (business format franchise agreements usually fall into this category). UK and European competition law also applies to franchise agreements, and in particular to terms which deal with online rights, exclusive territories, retail price maintenance and non-competition restrictions.
The British Franchise Association (BFA) is a trade body which promotes ethical franchising in the UK. Its franchisor members (and their franchise agreements) are required to adhere to the BFA’s Code of Ethics as a condition of membership.
From a franchisor's perspective, what are the 5 key issues to cover in a franchise agreement?
1. Clarity over the grant of rights, and what is reserved to the franchisor
If a franchisor is offering a territory based franchise, it should only grant the minimum required territory and impose performance targets, to ensure that the territory 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. 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”.
2. The ability to 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.
3. Protecting the know-how
Restrictive covenants ("RCs") are very common in franchise agreements. They seek to protect goodwill and customer relationships by limiting the licensee’s right to operate a competing business both during the term and after the termination or expiry of the agreement. RCs will typically comprise of undertakings of non-solicitation, non-dealing, confidentiality and non-competition and have a specific duration and/or geographical reach. RCs can be vital in protecting the integrity of a brand's network.
RCs must comply with applicable competition law and common law principles on restraint of trade. To be enforceable, RCs in franchise agreements must therefore strike a delicate balance between protecting the franchisor’s legitimate business interests and at the same time not being overzealous in their scope and duration. Poorly worded RCs could render the entire clause, or possibly the franchise agreement, unenforceable. RCs that fall foul of competition law also risk exposing the parties to the agreement to investigation by the UK or EU competition authorities and fines for infringement of the competition rules. A franchisee that suffers loss as a result of an anti-competitive RC may also have a damages claim against the franchisor.
4. Managing risk
From a financial perspective, it is important that the franchise agreement clearly sets out all of the relevant fees and payment obligations. A common blind spot is who is responsible for the franchisor's costs in providing initial and ongoing support and assistance and conducting inspections and audits in the franchisee's territory. Equally, where a franchisor supplies goods on credit to the franchisee, or facilitates a direct relationship between each franchisee and its nominated supplier, it is important that the franchisor can monitor the credit risk and take action, as the risk of systemic financial exposure and damage to the brand is significant.
Other areas of increasing importance are those sections in the franchise agreement which relate to online promotional activities, e-commerce and data protection. All 3 are key touch points with customers, so it is important that the franchise agreement sets the framework for how these interactions should operate.
5. Exit/investment planning for the franchisor
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.
From a franchisee's perspective, what are the 5 key issues to look for in a franchise agreement?
1. Is the franchisor the owner or licensee of the IP and know-how, and what are they prepared to guarantee about a franchisee's such of such IP and know-how?
One of the key pieces of due diligence on a franchisor is to check what trade mark protection they have in place and whether they own those registrations, or are simply licensed to grant franchises.
In relation know-how, the European Code of Ethics for Franchising ("Code of Ethics") – which is designed to promote ethical franchising in Europe and provides the franchise industry’s foundation for voluntary self-regulation - was recently updated and one of the new obligations on franchisors (i.e. franchisors who are members of a national franchise association like the British Franchise Association in the UK) is to guarantee the right to use the know-how transferred and/or made available to the franchisee, which know-how it is the franchisor's responsibility to maintain and develop.
This is an interesting addition to the Code of Ethics, particularly in light of recent case law in key franchise jurisdictions such as Canada, where franchisees have successfully sued their franchisor for failing to protect their businesses from innovative competitors;
2. Obligation to evolve the System and police the network
For franchisees, franchisors should be duty bound to develop and innovate the system and keep it competitive against other similar systems. Furthermore, the franchisor's desire to have the broad rights to monitor the network and enforce contractual terms should arguably extend into an obligation to police the network and sanction franchisees that do not play by the rules.
3. Online rights
Franchisees need to understand how they promote their business and even sell their services and products online. Therefore, it should be incumbent on a franchisor to inform prospective and individual franchisees of their internet communication and/or sales policy. It should not be acceptable for some franchisors to hide behind the opaque pretence of "prior written consent" before a franchisee is allowed to participate in online activities.
4. Good faith and fair dealing
There is clear recognition in the Code of Ethics that the franchisor/franchisee relationship should be underpinned by the principles of good faith & fair dealings. Both are expressly included in the preamble to the Code of Ethics, which emphasises the importance of franchisor-franchisee relations based on fairness, transparency and loyalty, each of which contribute to confidence in the relationship. Franchisees should check dispute resolution clauses to see if they contain an escalation process for resolving complaints, grievances and disputes with through fair and reasonable direct communication and negotiation. If this fails, the agreement should be clear how disputes are finally resolved, for example through the courts, mediation or arbitration. Arbitration can be a very expensive blunt tool for resolving for domestic disputes in the UK (although it has advantages in an international context).
5. Exit planning
Franchisees should have the right in most cases to sell or transfer their business as a going concern during the term of business. For larger franchisees, it is also important to ensure that they have the ability to transfer shares between existing owners, assign rights as part of a corporate restructuring exercise, or take third party investment, provided that such activities do not materially change the ultimate management of the franchisee or compromise the franchisee's contractual obligations around issues such non-compete restrictions and secured interests.