Understanding the Franchise Agreement
Franchise agreements are contracts, often long, multi-page contracts that may use legalese that non-lawyers find confusing. Under the Franchise Rule published by the Federal Trade Commission (FTC), before you invest to buy a franchise, generally you must receive a copy of the written franchise agreement that franchisee will sign. After you sign the franchise agreement, the franchisor must give you a fully signed copy of the franchise agreement. Also, the Franchising Disclosure Document (or ‘franchise disclosure document’) and franchise agreement should both accurately describe the same things, such as what is conveyed under the franchise agreement, other material terms, franchisor’s obligations, franchisee’s obligations, and exclusivity.
What will I See in a Franchise Agreement? You are likely to see definitions section; scope of franchise granted; trademarks, service marks, and copyrights; initial and ongoing franchise fees; term and renewal; franchisor and franchisee performance standards; how to audit and make payments; the rights to use the system and the franchisor’s confidential information; regional, national, or territorial exclusivity; site application and approval; lease obligations; transfer of franchise agreements and leasing obligations; leasehold improvements; purchasing obligations and the performance of services; equipment obligations; remodeling , upgrading, and resale obligations; training obligations; quality and customer satisfaction obligations; support for franchisees; rights to inspect and visit; rights to approve suppliers and subcontractors and supply chain rules; permitted sources and materials; rights to implement new equipment systems; and the right to receive updates of the franchise system.
What are Some Common Terms That I will See? Some common terms include: You can read about some of these terms in the following sections.
Are Franchise Agreements Binding? Generally, yes, franchise agreements are binding and enforceable contracts. But like many contracts, under some circumstances there are ways to escape enforcement. Courts may find part of a contract, or a contract itself, unenforceable, for example: Just because you can escape a contract does not mean that you should. Many times, especially with a franchise agreement, it is better if you understand and follow the contract so it does not ‘blow up’ and explode later. You might get a chance to buy another franchise agreement or to renew your franchise agreement but you should not assume this will happen.
Reasons You May Wish to Terminate a Franchise
Some of the reasons why a franchisee may want to or need to exit a franchise are as follows.
Financial difficulties
It is not uncommon for some franchisees who are having financial difficulties to look for options to exit their franchise. This need may be put in motion when a franchisee falls behind on royalty payments. The franchisor will usually give the franchisee a limited opportunity to make their plan to catch up on royalty payments. If the franchisee is unable to pay the past due royalties, the franchisor may terminate the franchisee’s right to operate the franchise. Sometimes the franchisor offsets the past due amount against the franchisee’s deposit on hand. This is something that should be addressed in the franchise agreement and the franchise disclosure documents. Sometimes the financial difficulties make keeping the franchise unaffordable. This may happen when a franchisee has gotten behind on the royalties to a point where they can no longer catch up.
Disputes with the franchisor
Whether the franchisee believes that the franchisor has violated the franchise agreement or whether that the franchisee has believed that the franchisor has mistreated the franchisee. There are many circumstances that lead to franchises wanting to exit their franchise relationship. Some of the reasons for why a franchisee would want to break or terminate their franchise are as follows. Disputes over territorial assignments, quality control, pricing policies, product lines, trademarks, and others. Many times, disputes can be resolved, but other times, if the sides are so far apart on their disagreements, the only way that there can be an accord is by exiting of the franchise agreement.
Underperforming business
Some times franchisees make a bad business decision or the franchise is poorly structured for the location. Other times, the franchisee may have made a bad choice in how they manage their franchise. Sometimes a franchisee may leave a franchise to open a competing franchise or have a different business.
Review Your Franchise Agreement
Mindfully reviewing your franchise agreement is an essential process and can save you from costly mistakes down the road. This document will be the basis for all of your dealings with the franchisor, and all areas of the franchise relationship will hinge on the agreement terms. When you look at the agreement, consider what happens if you wish to exit. Whether that means selling the business, transitioning ownership to a family member, or closing the doors entirely, what then? Most agreements have a multitude of clauses that dictate termination rights and obligations that can have a substantial impact on your ability to exit. If you want, or need, to exit you should get an attorney to review the provisions and help you interpret what the possibilities are.
Legal Grounds for Ending the Franchise
Aside from common law grounds for termination and those contained in the agreement, there are several legal grounds for termination that may enable a franchisee to exit a franchise arrangement prior to the expiry of the franchise term. The most obvious is where the franchisor has materially breached the franchise agreement. A franchisee can terminate its agreement on these grounds in some situations – for example, if a franchisor has failed to provide agreed assistance and/or training, or has failed to provide advertising or marketing materials. A franchisee can also terminate its agreement on the grounds of misrepresentation. In common law terms, misrepresentation is a false statement that induces the other party to enter into an agreement. There is no requirement that the inducing statement be a contractual term. Misrepresentation can also be a tort, and there is even an employment outgrowth – employees can claim damages for misrepresentations made by their employers during the hiring process. Trailing out from the common law, the franchisee’s statutory rights under the Franchising Code may be grounds for termination. Both parties must comply with the Code and either party is in breach if it does not. Lastly, generally, the Code provides that a franchisee and franchisor may both mutually end a franchise agreement before its expiry. A franchisee should check with their franchisor and legal advisers to see if a notice of termination is required.
Negotiating Your Exit
The franchise disclosure document should set out the process for terminating your franchise, but it may not sufficiently address the timeline. An early start is important—as long as you are a franchisee, you are responsible for costs and other obligations in the normal course. It will be important to identify who is responsible for expenses following your termination.
When negotiating a settlement with the franchisor, there are various strategies you can deploy:
Severance – under certain circumstances, particularly in a highly-regulated business environment, the franchisor may agree to provide you with severance or a settlement payment in exchange for your release of claims.
Sell your business – a franchisor may have an interest in acquiring your business, particularly if it wishes to keep certain key employees as independent contractors. Be wary though!! Remember that what is good for the franchisor may not be good for you.
Transfer ownership – where selling the business is not customary, the franchisor may consider allowing you to transfer ownership to a third party. They will consider whether that party is a good fit for the business and whether they are not likely to disturb the status quo (i.e. retains the same staff, uses the equipment, etc.).
Transfer of rights to suppliers or other licensees – supply contracts or other contractual arrangements between you and third parties may also be considered, particularly if you make payments to the suppliers.
Financial Factors to Weigh
Your franchise agreement should contain provisions relating to the amount of money you have paid to the franchisor and the potential penalties for terminating the franchise early. The penalties are usually in line with the following considerations:
- The amount of your initial franchise fee
- The amortization period for the start-up costs
- How long the franchise system has been operating in your market
- Whether franchisees within your geographic area are considered to be in the "black" or the "red" based on the system-wide average profits and franchisee performance during your time with the franchise system.
If you have been making money and have had a positive experience with the franchise system , the penalties will usually be lower than otherwise set. If you have suffered a lot of losses because the franchise system has not provided you with the support you need to be successful, the penalties will likely be higher.
You should also be aware that if you are in the middle of a term when you choose to exit, your franchisor will likely require you to buy out a portion of its "unamortized" costs. They may also seek to recover a portion of their management salaries and bonuses from you. You should carefully review the "indemnification" provisions in your franchise agreement with your attorney to determine if you will be on the hook to pay for any legal services associated with closing down your franchise during the exit process.
Alternative Dispute Resolution
Many franchise agreements contain mandatory or voluntary ADR provisions. ADR is typically defined as including mediation and/or arbitration. Many franchise agreements mandate that you resolve disputes via these procedures before you can file a lawsuit, but a lawsuit is the only way to get access to some courts. You must read your franchise agreement to determine whether you have to submit disputes to the ADR process, or your current negotiations if any.
Arbitration is a private settlement process where the parties agree to arbitrate their claims in lieu of bringing an action or motion for relief in front of a court. Arbitration is sometimes used when litigation has already commenced, but the parties want to avoid using judicial resources.
Mediation is a facilitated negotiation. If the negotiation is successful, the parties may enter into a written settlement agreement. A settlement agreement is also known as a "Release and Settlement Agreement."
Mediations are typically held at a mutually agreed upon location that is neutral to all parties involved. The facilitator might be at the location to assist with the facilitation. Or the parties might go to a neutral mediator’s office. If the parties and/or the facilitator decide to "separate" during the negotiation, the mediator is able to communicate with each party via "caucus" and therefore, is often referred to as a "caucus facilitator."
The bottom line: ADR, whether in the form of mediation or arbitration, may be an effective method to settle disputes before either parties incurs significant litigation expenses. In a mediation, there is no requirement to use an attorney to draft the Release and Settlement Agreement. In an arbitration, the parties do not have the discretion to settle on the terms of the Release and Settlement Agreement. This may be a drawback to some parties who may want more flexibility in the terms of the Release and Settlement Agreements, since arbitration awards are typically limited.
Finding Professional Support
It is advisable to work with a lawyer that has significant experience dealing with exit of franchise relationships, as well as the transition from the franchise relationship into the new structure you will need to undertake to be successful. Some franchisors will have published information about how to make the transition from their franchise model to that of an independent operator, and in some instances even provide transitional support services. However, many franchisors do not and a specific plan will need to be developed to make the switch successfully.
In addition to legal counsel, you may also want to engage a franchise consultant to help you with the process of exiting the franchise model. A franchise consultant can bring an outside objective perspective to your situation and offer sound advice based on experience. The specific adviser you select should be a close fit to your specific situation, having either industry experience or experience with your specific industry area of expertise.
There are many franchisors that have a consultant base that can help guide you through the change. Sometimes those folks are employees of the franchisor. Is this the right person for you? Maybe and maybe not. It will depend on the situation and the dynamic you see.
In this regard, you may want to consider that when the person providing you with advice on leaving the model is affiliated with the franchisor, the best interests of that franchisor and its franchisees might not always be your best interest. For example, that adviser might not suggest that you sue the franchisor if it harms your business, taking into account that his or her company wants to maintain positive relations with the franchisor. Therefore, ask yourself the following questions: (1) what is your goal in exiting your franchise relationship, (2) what is the status of that relationship, and (3) what resources can the franchisor give you to assist you?
Finally, a significant part of the transition process is developing and implementing a marketing strategy to kick off your new business. It can be very difficult to make that transition in a short time frame and you need to have a strong plan for the launch of that new business. Again, working with qualified counsel that has experience in this area can be very helpful. It is something that the franchisor should be able to help with. If not, then you should have a robust adviser by your side during this process.
Things to Consider After Termination
The bulk of your considerations when it comes to exiting the franchise agreement will occur during the process of exiting the franchise agreement itself. However, there are a few items to consider in the aftermath. Much of this will be driven by the language in your franchise agreement, as all franchisors do not draft these clauses in the same way.
The most common form of post-termination or post-expiration obligation is the non-compete clause. The franchise agreement will likely contain a radius within which you are prohibited from opening a business that competes with the former franchisor or with other franchisees. These clauses are generally enforceable to the extent that they are geographically reasonable, and they often contain time limits of 1-2 years . At this stage, you may not have plans to open a competing business, but you may also want to keep your options open in the future, so keep the timing of any competition in mind. It may be possible to petition the franchisor to vary the time period. In addition, the agreement may prohibit access to the former franchise location for a certain period of time. This can also impact potential competition if you wanted to open a similar business in the same area. If you are going to be opening a similar business in the future, whether or not your franchise agreement prohibits it, you will want to maintain a good relationship with the former franchisor and its employees, within the bounds of the agreement of course. This will not only make the transition smoother, but may present business opportunities as you maintain communication with your former colleagues in either your new business or in the form of referral fees.