The Core Principles of a Franchise Agreement

This article will consider some of the key rights and obligations which should feature in a franchise agreement.

Before we get into the detail, we should be clear about what we are talking about.

• This article will comment from the perspective of English law, which is a common law system. This matters because a common law franchise agreement tends to be much more comprehensive than its cousin, the civil law franchise agreement, which will rely on (and not repeat) a number of legal principles and terms which sit within the relevant civil code of that jurisdiction.
• Franchise agreements come in many shapes and sizes, such as unit franchise agreements, master franchise agreements and multi-unit development agreements. This article will not consider the different structures and their relative merits and uses, but will instead focus on the key terms which feature in most forms of franchising.
• Franchisees are not a homogenous group; franchisees range from inexperienced "mom n pop" owner/operators, to large multi-unit/multi-brand second or third generation family concerns, to listed corporate entities, which might be specialist operators in certain types of retail channels, such as air and rail. Franchise agreements therefore vary depending on the category of franchisee and the relevant channel. Again, this article will aim to focus on the commonalities.
• Franchising is a legal and commercial model for selling goods and services, which is applied across various sectors, such as food and beverage, services, retail, hospitality, leisure and education. Franchise agreements vary depending on the sector, but again this article will aim to be sector agnostic in its observations.

So, having hopefully demonstrated that franchising is a very broad church, here is a selection of some of the key rights and obligations which form part of a franchise agreement.

1.    Intellectual property/grant of rights

The franchise agreement is primarily a licence of intellectual property (IP), typically comprising of trade marks and operational know-how, which defines a system. Franchisees must operate the system in a uniform manner.

From a franchisee perspective, it is important that the IP is protected (such as registered trade marks) and that the operational know-how is made available in a comprehensive "manual", which sits alongside the franchise agreement.

Franchisees should be wary of investing into a franchise which does not have adequate IP protection, as the costs associated with having to change the name of the business could be high. Franchisees should make enquiries as to whether the franchisor itself owns the IP, or the IP is licensed by a third party. From a franchise brand perspective, it is common to have the IP registered in a different group company and licensed to the franchisor company. However, if rights in the IP and/or system are held by third parties, that should sound alarm bells.

Franchisors should not disclose the full content of their manual to franchisees before the franchise agreement is signed. That should not mean that franchisees cannot have a good "look under the bonnet", but this can be achieved through discovery days, onsite visits and in some cases, selective disclosure of extracts of the manual. It is important that franchisors do not disclose this commercially sensitive document in full to franchisees before they commit fully to becoming a franchisee, as every prospective franchisee is a potential future competitor. That all being said, franchisees need to know that the franchisor can provide sufficient guidance on how to operate the business, as this is how franchisees will be judged.

Whilst this will always remain a delicate balancing act, the risk is only really meaningful when a franchisor is in the early stages of its growth, as there is always a risk that its system is not yet fully formed.

Finally, franchise networks can act as incubators (deliberate or accidental) of innovation in the system, and it is important that any new IP which is generated by franchisees in the course of operating the system reverts back to the franchisor. A good example of this is the McDonald's Drive Thru, which was conceived by a franchisee in the US.

The franchise agreement should be clear about what rights the franchisee is being granted, and consequently what rights it is not obtaining. For example, does the right relate to operating the franchise at a specific location, or does it extend beyond? Does the franchisee get a zone of exclusivity around any defined premises, or within a certain area? If so, what does that stop the franchisor from doing? Can the franchisor still operate close by, but not appoint other franchisees (aka "sole rights")? Does the exclusivity refer to all formats of the franchise, or does the franchisor reserve certain channels (such as air, travel and other "captive environments")? How does geographical exclusivity work in the digital space?

These issues are equally important for both parties to understand. A franchisor needs to ensure it is maximising opportunities for the business, but it also needs to ensure that franchisees have sufficient space to build a business and do not start cannibalising each other. It is also important that what is sold is a true reflection of the case studies and figures which were provided in the pre-contract sales phase.

2.    Term and renewal

A typical franchise unit will get between 5 to 10 years to operate, with a right to renew for the same amount of time.

The initial term needs to be sufficiently long in order for the franchisee to have a reasonable return on its investment, and a renewal is usually a contractual right, subject to certain conditions, as opposed to something which the franchisor can offer or withdraw at its discretion.

From a franchisor perspective, it is important that franchisees are not inadvertently offered longer than an initial term and one renewal term, just as a landlord should avoid granting a tenant rights of occupancy which extend beyond the term of the lease.

As part of the renewal conditions, a franchisor will typically require that the franchisee waives any and all claims which arose during the initial term, and the franchisee enters into the then current franchise agreement. A blanket requirement for a waiver may be deemed to be unfair if there is a bona fide dispute and/or the franchisee finds itself liable for acts or omissions of the franchisor.

In relation to the then current form of the franchise agreement, what happens if that new form is substantially different from the existing agreement? Whilst it will always be a blurred line, a renewal franchise agreement should not be so radically different that it materially alters the commercial and/or legal "bargain". Yes, some fees might increase (particularly in this inflationary environment), and yes, after 5 years it is likely that certain elements or the system have become obsolete, or have evolved, and yes, the law is not static and legal updates may be required (in the last 5 years, we have had GDPR, Brexit and the updated competition law block exemptions), but if the balance of these changes result in a different looking business, both in terms of funding requirements, profitability and expertise, then there is a problem. It is not a genuine renewal.

3.    Initial and ongoing training, support and services

The franchise agreement should clearly set out what is being provided initially to get the franchise up and running, what is being provided on an ongoing basis, and crucially, how much of that is paid for by upfront fees and ongoing management fees, and how much is charged as extra.

Franchisees should understand (and franchisors should stipulate) in what circumstances travel and subsistence expenses and/or salary costs are payable (and whether there are any limits to this). Franchisors should be wary of making commitments to provide a certain level of support, as this can be a source of challenge by franchisees (i.e. my franchise is not performing because you have not provided me with support). Setting specific service levels is still uncommon, but this remains a source of miscommunication and fertile ground for disputes.

As franchise systems become increasingly digitised (e.g. mobile apps, loyalty schemes, CRM systems, integrated POS) franchisors are procuring IT systems and platforms from third party suppliers. It is therefore important that the franchise agreement, in tandem with the manual, sets out a clear framework for how franchisees should participate in and contribute towards these aspects of the system.

4.    Right to sell/changes in ownership

Most franchise agreements will include a right to sell the business for a "going concern" valuation during the term of the franchise agreement.

This will come with a set of conditions, the most important for the franchisor being that the incoming franchisee must have suitable experience, adequate funding, and that the outgoing franchisee will pay for the franchisor's costs in assessing their suitability (even if the sale does not proceed).

From a franchisee perspective, conditions which might be problematic include the condition to require a new agreement (as with renewal, is it materially the same agreement?) and whether the incoming franchisee is getting the residual term of the original franchise, or a new term (this will have an impact on valuation).

A sale of business can of course take the form of a share sale or a sale of assets, and it is important that the franchise agreement deals with both scenarios, and indeed with what happens when there is a change of minority interests. A franchisor will typically have a right of first option to buy the franchise back at the price offered by a third party, but these clauses are increasingly the subject of negotiation, as franchisees evolve into larger operators with complex funding and shareholder structures.

Valuations can often be a source of disagreement. A franchise business by its very definition has a limited shelf life – i.e. the residual term of the franchise agreement – and it will not have many, if any, intangible assets, because the system is owned by the franchisor. This can lead to a difference of views between how a franchisor values a franchisee's business, and how a franchisee perceives it. Again, a franchise agreement should help resolve these ambiguities, and contain a third party valuation mechanism in the event the parties cannot agree.

5.    Breach/Liability/Termination/Expiry

The balance of obligations within a franchise agreement will be heavily tilted towards the franchisee, and a franchise agreement will contain a long list of grounds for termination in favour of the franchisor, with limited or no contractual termination rights for a franchisee.

This does not mean that a franchisee cannot claim damages if the franchisor is in breach of its obligations, but any claim will usually be subject to a limitation on the franchisor's liability, where no such limitation will apply to the franchisee's liability. Irrespective of what an English law franchise agreement says, a franchisee will always have a common law right to terminate for "repudiatiory" breach.

Franchisors will typically have more scope to deal with breaches. Certain breaches may be curable and will be subject to a breach notice, whereas other types of breach may warrant immediate termination. A franchise agreement will usually set out the range of remedies which might be available to deal with a breach, other than termination. For example, withdrawing certain contractual rights or incentives, imposing fees, or seeking injunctive relief.

When it is the franchisor which is subject to a breach notice, they should carefully consider the merits of the claim before asserting a limitation or exclusion of liability under general exclusion clauses. Given that many franchise agreements are presented as "standard form" agreements which are not open to negotiation, with an unequal bargaining position of the parties, reliance on these types of limitations and exclusions will need to pass the "reasonableness test", as set out in the Unfair Contract Terms Act 1977.

Franchisees which have had their franchise agreements terminated will usually be subject to a number of post termination obligations, such as restrictions on their ability to operate a competing business, returning or destroying all franchise related materials, and enabling the franchisor to take back their business. Franchisees, and their owners (if they have provided guarantees), may face considerable liability if the franchise has accrued debts, in addition to a claim for future looking damages for loss of revenue over the remainder of the term.

If the franchise agreement expires, many of the same post term obligations will apply, but some franchise agreements do make a distinction between "good leavers" and "bad leavers" and the terms on which the franchisor can buy back the business on expiry may be more favourable than on termination for breach.

Conclusion

Whilst it is clear that there is no one size fits all form of franchise agreement, and the types of businesses which use franchising are evolving rapidly to take account of changes in consumer habits and technology, a number of keys principles remain the same, and it is important that both parties have a clear understanding of their respective rights and obligations.