Franchising in a digital world – risks and rewards of implementing consumer-facing tech in a franchise network

Changing consumer habits and technological innovations, accelerated by the pandemic, are having an increasingly significant impact on the traditional franchise model. This article considers the nature of those changes, the inherent legal risks they pose and some practical guidance for managing them.

Introduction 

A 2021 survey of QSR brands found that on average as much as 75% of their sales are from orders made online or over the phone, the majority of consumers prefer to order via an app than in person, and 25% of consumers spend more on off-premises orders.¹ 

The potential upside for investing in consumer-facing tech is beyond doubt. Many brands operating in the QSR and wider F&B and hospitality sector use a franchise model, and manage a mixed network of franchisor owned stores and stores which are owned and operated by third party franchisees (at least in the brand's home market). Franchisees clearly stand to benefit from franchisor-led innovation in developing and deploying consumer-facing tech, leveraging off the network buying power to access a level of tech which they could not afford as an independent business. However, the dynamics of franchise networks also pose a number of challenges and risks to the manner in which this tech can be deployed, which do not apply to brands which do not franchise. This article will not consider how brands should engage with tech suppliers in the design and build of an app or other form of consumer facing software. That is a topic in its own right. Instead this article will consider some of the key areas of potential disruption in the franchisor and franchisee relationship.

The Bigger Picture

Three root causes of the emergent risks and challenges of the increasing dominance of tech in a franchise network are:

• Brand centralisation and operational integration: the inevitable drive towards greater centralisation, integration, and brand uniformity which arises from the deployment of system-wide tech, conflicts with the reality that franchisees are independent businesses. Most franchisees will view themselves as entrepreneurs, perhaps not in the purist sense, but they will certainly place a value on their independence and ability to generate sales and promote the brand within a locality. These instincts are at odds with a partial surrender of control that comes with using franchisor-controlled tech to process sales and drive promotional activity and customer engagement. There is also a risk that franchisor-owned stores may move at a different rate of adoption to the franchised store estate, creating tensions and differences within the overall network.
• With great power comes great responsibility: as franchisors reclaim greater levels of control by driving more sales and promotional activity through centralised and integrated tech, there is a risk that franchisees will become increasingly reliant and dependent on their franchisor. This further undermines the common perception that franchisees are independent and ultimately responsible for their own performance. Greater reliance on the franchisor (actual or perceived) can lead to increased legal responsibilities and liability for a franchisor.
• Contractual certainty versus flexibility: franchising requires a long term commitment, with a high degree of mutual investment and cooperation, underpinned by long term franchise agreements which require mutual written consent to vary their terms. This contractual edifice comes under strain in a commercial environment, which is changing rapidly. Implementing new tech can require a significant upfront and ongoing capital investment, which in turn has the ability to fundamentally alter the original “commercial bargain” over a relatively short time horizon. A careful balance needs to be struck between contractual certainty and flexibility.

This article will consider some practical examples of how these risks and challenges can play out.

Examples of risks and challenges​

(a)    Contractual authority  

Before new technology is rolled-out across the franchise estate, it is important that franchisors review their franchise agreements and manual (and any disclosure document, if relevant) to ensure that they have the requisite contractual authority to mandate the roll-out and that there are no terms which would undermine the ability of the franchisor to implement or update such systems. Typically, a franchise agreement will include a clause which requires a franchisee to follow the "System", as it is updated by the franchisor from time to time. Ideally a franchise agreement will include additional terms, such as an acknowledgement that this may include updates to technology which may include significant capital expenditure. If there is no contractual authority to mandate adoption, a franchisor may be faced with a voluntary adoption and using the point of renewal to introduce new terms into the franchise agreement, but this will delay system wide implementation.

(b)    Testing/Pilot Phase

The key to a successful roll-out and communication strategy will depend in part on whether the franchisor has tested the technology in a few selected franchisee stores before rolling out across the network. Having an initial pool of franchisees allows for tests and modifications before the network incurs the cost of a full roll-out. Assuming the test phase is a success, it will provide the franchisor with franchisee advocates and empirical case studies to help win "hearts and minds". Franchisors are likely to want to ensure that they have control over which franchisees will participate in these tests, and also document the legal basis of the test phase. Franchise networks with constructive franchisee associations may well have an advantage over those without.

(c)    Communication

Having hopefully determined that it has the contractual authority to mandate the adoption of the relevant technology, a franchisor should emphasise the benefits, both in terms of future cost savings and operational efficiencies, and show an awareness of how the roll-out will impact each franchisee. Where the proposed new tech requires a significant investment, franchisors should consider where franchisees sit in their contract life-cycle. If a franchisee has just signed up, or signed a renewal, and this is news to them, there could be a risk of misrepresentation. If a franchisee only has a few years left to operate, is there a reasonable prospect of a return on investment? Pushing ahead without taking these factors into consideration could lead to a distracting conversation over breach of contract and implied terms of good faith.

Franchisors should ensure that they have scoped the costs of the rollout – including software licence fees, necessary equipment (e.g. scanners for QR codes) and insurance costs. It should also be made clear whether any costs will be covered by fees that the franchisees are already paying (e.g. royalties, advertising fees) or whether they will all be new costs (such as obtaining insurance for data breaches and cyber security).

(d)    Timings

The roll-out of technology will take time. Franchisors should ensure that time has been factored in for training in the operation of the technology for the employees of the franchisees.  This may require the franchisor to invest in its own support resources, meaning that a slower than expected rate of adoption could have a financial impact on a franchisor which has increased its head office/operational resource.

(e)    Selecting an appropriate contracting structure

Franchisors will usually provide tech to their franchisees via some or all of the following general contracting structures:

• The franchisor sits in the contractual chain between the tech vendor and the franchisee, and the franchisee will not have any direct contact with the tech vendor. This model can facilitate a quicker adoption and easier day to day management, but it can increase the risk to the franchisor, which may be expected to assume liability towards the tech vendor for the performance of franchisee stores, as if they were franchisor-owned stores.Setting out terms in relation to reporting of faults or failings with the technology is also key. It is necessary for franchisors to ensure that they have sufficient reporting systems in place for franchisees to inform the franchisor of any failures in the technology products/services, particularly where the franchisor may be liable to the franchisee for these failures or where the reputation of the brand may be put at risk. The service levels that tech developers agree to should be consistent across the franchise network and franchisees should be made fully aware of the relevant timings and processes for reporting.
• The franchisor may provide certain services directly to franchisees, particularly in cases where the franchisor is in fact the proprietor of the tech solution. This creates new dimensions in the traditional franchisor-franchisee relationship, such as tech support service levels, new fees and a different approach to liability.
• The franchisor may establish a framework arrangement with a tech vendor, procuring tech directly for its own stores and setting a uniform contractual basis on which franchisees will contract directly with the tech vendor. This can mitigate some of the risks in (i) above, but it can slow adoption rates and create new risks for a franchisor, as franchisees are having to accept terms which have been negotiated on their behalf.
• The franchisee will require the franchisee to engage directly with an approved tech vendor, with little or no involvement in the terms. Again, less risky than (i) and (ii) but it results in a lack of uniformity and oversight. There will be less control over roll out and the network will not necessarily be able to leverage its buying power as effectively.

The reality is that different types of tech will require different approaches and, just as a franchisor may segment its product supply chain into "core" and "non-core" lines, with quality approval processes, franchisors should consider taking a similar approach to the type of tech that is required in a franchisee's business.

For some of the bigger, business critical, "core" products/services, it makes sense for franchisors to spend the time negotiating the terms and to ensure that franchisees enter into pre-negotiated terms and conditions. However, for smaller "non-core" products/services, it is not necessarily realistic in practice for franchisees to enter into separate agreements with developers. It is also not practical for franchisors to get specific back-to-back agreements with franchisees for every different piece of technology that they use.

Ultimately, there is no "one size fits all" approach to the contractual relationship with developers in relation to the implementation of technology in a franchise network. Careful drafting should be undertaken for technology service agreements to minimise the potential liability as far as possible, while giving the network access to the benefits of new and ever evolving technology.

(f)    Introducing new terms – manual update or contractual variation?

Given the length of most franchise agreements (and the scope for change in technology solutions over their life-cycle) the franchise agreement should have broad and flexible language to accommodate changes in technology. It makes sense for the bulk of the details in relation to technology to be included in the manual – which can be updated from time to time to reflect changes in technology and the various agreements with third parties.

However, there are limits to a franchisor's ability to introduce new terms via an update to the manual. The manual should be seen as an operational playbook/rulebook, but the franchise agreement is the correct place to document financial arrangements and onerous/material terms which impact on legal liability. For example, limitations or exclusions on liability which are specific to a particular contracting structure or type of tech should form part of the franchise agreement, or be documented in a standalone "tech agreement", as should new fee structures. Overreliance on the manual can risk the enforceability of the new terms, but the quid pro quo is that franchisors may therefore need to treat certain terms as a formal contractual variation or new agreement, which will require consent, unless the terms are presented as standard form, non-negotiable terms, which creates the risk discussed below.

(g)    Impact of the Unfair Contract Terms Act 1977

Continuing on this theme of valid incorporation of new terms, if franchisors seek to introduce material terms limiting or excluding their liability by circumventing a typical variation process, or by presenting a new agreement as standard form, non-negotiable terms, it raises the risk that franchisees can challenge the enforceability of such terms as failing the "reasonableness test" under UCTA, given the lack of negotiation and the unequal bargaining position of the parties. Even if the parties do address these changes through a variation or new agreement, any onerous terms (such as liquidated damages or indemnities) should not be tucked away in standard terms and conditions, as the "red hand principle" operates in a similar fashion to UCTA, and could render the term unenforceable through lack of proper incorporation.

(h)    Changes to the model

Payment Structures: the implementation of new technology can have a fundamental impact on existing legal rights and commercial structures in the franchise relationship, and these changes should also be addressed. For example, the trend towards more centralisation subverts the traditional understanding of the franchise model; namely (i) franchisee revenue is collected by the franchisor, as opposed to being collected by the franchisee and the royalty then being paid to the franchisor and (ii) franchisees have less scope to advertise and promote their business locally. This triggers questions such as does the payment section of the franchise agreement need to be updated (e.g. is royalty deducted from franchisee revenue before being remitted)? Does the advertising contribution/fund need to be reconfigured to allow for funding of tech infrastructure? Is a minimum advertising spend now redundant? Consider if a policy of reimbursement is necessary for gift cards/loyalty discounts which are redeemed on franchisee sales – is there a threshold over which there needs to be some reconciliation?

Exclusivity: some franchise systems operate on a non-exclusive basis but others provide a protected area around premises. Either way, these rights are often granted in the context of bricks and mortar/physical operations. The increasing rise in online sales can create new tensions around network competition. Franchisors will have to effectively delignate delivery zones on their own e-commerce platforms, and these zones may then also conflict with the way the aggregators assign orders to individual outlets. If this is not managed carefully, it can lead to conflict and/or the creation of exclusivity by the back door.

Aggregators: in the context of third party aggregators, having established the most appropriate contractual structure (see 3(e) above), it is necessary to ask who is licensing the brand IP to the aggregator? Typically, a franchisee has no right to sub-licence, so this needs to be waived, or the franchisor needs to grant a direct licence. How is the franchisee royalty/service fee calculated on sales generated through these platforms? Does it apply to gross sales before or after commission? This can be a bone of contention. Are delivery charges excluded? Does the standard definition of royalty/service fee and gross turnover in the franchise agreement need to be updated? What rules and responsibilities need to be established for data sharing and promotional activity.

Data/Cybersecurity: closer integration between franchisee and franchisor increases the flow of customer data in a highly regulated environment and increases compliance/insurance risks and costs for all parties. Additional training is advisable, and general contractual indemnities may need updating.

(i)    Other considerations

Competition law has a significant impact on the franchisee/franchisor relationship, and the following regulatory issues arise when new tech is being implemented in franchise networks:

• Information Exchange: given that franchisor controlled e-commerce platforms require greater levels of information exchange between independent parties which are selling their products and services on the same platform, there is a competition risk that franchisors could abuse this power and drive more sales to their own company owned stores. In reality, this is unlikely to be the case, and the regulators in the UK and EU had the likes of Amazon in mind when updating the recent block exemption rules. Nevertheless, the competition law applies to franchising and the updated block exemptions each contain a list of information which falls outside the safe harbour, such as franchisee-collected customer data and future pricing information. Franchisors therefore need to carefully risk assess the type of information they are sharing with franchisees (particularly in relation to future pricing and discounting) and consider whether firewalls are required, or if certain information is not actually required.
• Pricing: Given the drive towards greater centralisation, it could be tempting for franchisors to use these platforms as a means of controlling franchisee pricing, menu range and promotions, or not build in adequate flexibility when the tech is developed. Price fixing is a "hardcore" restriction and will render a franchise agreement null and void, and the brand could be liable for significant fines.
• Online bans: obligations which directly or indirectly have the object of preventing "effective use of the internet" are also "hardcore" restrictions. Does the use of a franchisor-controlled e-commerce platform/mobile app and control of the aggregator channel mean that franchisees have no real ability to operate their own business online? New tech must be designed to allow for a degree of franchisee customisation and, outside of that, brands should also be aware that bans on franchisees using an entire online advertising channel, such as search engines or digital comparison tools, may amount to an effective ban on the use of the internet.

Finally, there are other regulations that may apply to use of these new technologies, such as advertising regulations that apply to promotions within apps and sector specific regulations (such as food-labelling requirements and payment regulations), the impact of which on franchisees needs to be thought through.

Final comments

Ultimately, changes in technology have created exciting new services that can be of huge benefit to brands. However, where such technology is being implemented across a franchise estate, there are additional factors to take into consideration and it is worth ensuring that these issues have been considered well ahead of the rollout of such technology. Franchisors must have a technology strategy to ensure that they can reap the benefits of the advances in this area.