Updating your franchise agreement to meet growth

All commercial agreements are a compromise, a balance of risk and reward.

It has been said many times by those involved in commercial negotiation that it is a big error to be too greedy; to go for everything you can.  Good negotiators always leave something on the table for other parties.

When an independent business owner sells his business, there is normally no ongoing business relationship with the purchaser; the owner sells the business and if he is smart, like a client of mine did last week, heads up North for an indefinite holiday. Franchising is quite the opposite; the sale of the business or franchise is just the start of an ongoing relationship.

So how does this impact on the approach to drafting a franchise agreement for a new franchise system.  There is no franchisee to negotiate with, you haven’t even met them yet, you are just putting together a deal or a business format offering to promote to prospective franchisees.

A franchise system is built from the franchise unit up. The design starts with the creation of a viable business unit. The franchisor’s business is all about supporting leveraging and making the franchise unit work.

Whether your revenue comes from rebates or commissions from suppliers, from selling franchises or businesses, selling products and services to franchisees or collecting royalties, your success depends on the success of the franchisee and the growth of the system.

Much of a franchise agreement is dedicated to managing the risk taken by a franchisor when he lets his idea into the hands of an unknown, independent franchise owner. It has to be done without sanitizing or destroying the enterprise of the franchise unit. A bit like raising teenagers; you have to give them some rope but be able to real them in (I wish).

This balance of risk and reward changes continually during the life of a franchise system.  It changes as the system grows, it changes in response to the complexity of your business, it changes in response to your market place and your position in that market (and this includes the market for supplies to your system, supplies to your franchisees including the grant of the franchise itself and the end consumer market in which your franchisees operate).  It changes with changes in your responsibilities to the many stake holders in a franchise system.

A New Franchisor

I recently had to look at the agreement for the very first franchise granted by a client of mine.  It was coming up for renewal.  It was seven pages long.  Contained seven operative clauses (and another seven clauses that dealt with definitions governing law, unforeseen circumstances, entire agreement etc.  All those things at the end of franchise agreements that nobody reads).

At the time this was a perfectly acceptable document and has served both the franchisor and the franchisee well for the last five years.

A Mature Franchise System

I also recently looked at the franchise agreement for Curves Gymnasium franchise.  A business which from a customer’s point of view would be scarcely more complicated than my new franchisors business.  The agreement ran to exactly 60 closely typed pages.  I didn’t do a word count but my estimate is that there would be 20 times the volume of material in the Curves agreement.  The clause headings however are strikingly similar to the clause headings in the novice franchisors document.  They included grant of franchise, term of agreement, fees and payments, standards of operation, assignment, termination and dispute resolution.  So what happened. 

The First Agreement

Every new franchisor has to decide what issues to deal with in the agreement and what to leave alone and how to deal with each issue;  whether to be tough and prescriptive or try to be balanced.

For a new system the strongest motivations are normally;

1. Get the fundamentals right.
2. Keep the cost down.
3. Don't make it too complex or you will frighten off prospective franchisees.

A Mature Franchise System

Because business is ever changing, a mature franchisor has to take the same approach to reviewing its agreements as David suggested in his paper a new franchisor would take.  That is, have your eyes 5, 10, 15 years down the track and build into your franchise agreement, the option for renewal contained in the agreement and your operations manual, the ability to adapt and change for those circumstances.

Some Things Cannot Change

Franchisors often ask for a clause to be included in the agreement along the following lines:

"The franchisor and the franchisee recognise the franchised business operates in an evolving and competitive market and that changes in the franchise system are inevitable and desirable.  The franchisor and franchisee agree the franchisor may make the changes to this agreement and to the franchise system generally as it deems appropriate and necessary for the benefit of the franchisor and all franchisees in the system."

Sounds simple enough and sounds very appealing.

There are mechanisms to provide for unilateral variations to the agreement and to the system but a clause which purports to give carte blanche authority to a franchisor to change the commercial terms of the franchise agreement will be unenforceable.

So what can be changed and what must be left alone and how do you make the changes?

Four Tools to Prepare for Change

1. Keep the agreement to the key financial terms.  You are stuck with them.  Put everything else in the operations manual.
2. Include the ability to charge for additional services.
3. Shorten the term.
4. On renewal, must sign current agreement.

What Sort of Things Can You Change in the Operations Manual?

In my opinion, the following are types of matters than can be introduced or changed by the operations manual:

• New products
• New training and meetings
• Image
• Inspection and audit
• Reporting mechanisms
• Point of sales systems
• Central ordering and things of that nature

A warning on these types of unilateral changes however.  Section 51AC of the Trade Practices Act provides that corporations (including franchisors) must not behave unconscionably (whatever that means).  I think it just means unfairly - in all the circumstances - in the opinion of a judge looking at the circumstances long after the event happens, after a franchise has been terminated for failure to comply.  Perhaps by a Judge who is looking to find a way to compensate a franchisee who has lost his business and his home.

In my view, a well drafted franchise agreement will look well into the future and make detailed provisions in relation to the types of system changes it has agreed the franchisor may make and the process and parameters leading to those changes.

What Sort of Things Can I Change on Renewal or Assignment of a Franchise?

Most franchise agreements provide that on renewal (and often on assignment) the franchisee shall sign the franchisor’s then current franchise agreement. One might speculate just what authority that alone gives a franchisor to depart from the terms of the original grant.  I am not aware of this issue having been tested by a court in the franchise setting.

In my view there is real merit in expanding this provision to be more specific and detailed about where the changes might be.

How Can I Change a Key Commercial Term?

What if there has been a fundamental error in the design of the system?  My budget is wrong and I cannot sustain the franchisor business and services with the agreed royalty income. 

What if we have misunderstood the market and have not taken enough care in planning territories, we have allowed franchisees to take territories that are far too large or far too small?

We have all heard of examples where a territory is too large and cannot be serviced adequately by the franchisee.  The agreement excludes another franchisee from the territory.  All it serves to do is leave room for a competitor to come into the marketplace, deprive the franchisor of revenue and limit your ability to establish strong penetration and brand presence.

Territories can be wrong for other reasons, apart from size alone.  Inadequate attention may have been paid to demographics or the demographics may have changed.  The demand for the product may have changed and the competitive environment may have changed.

In my view, even this key commercial term can be unilaterally changed by the franchisor if the groundwork for the change is laid out in the franchise agreement.  Particularly on renewal or assignment of an agreement, I see no reason why if the franchisor has developed an accurate detailed and scientific approach to territory allocation, a franchisees exercise of a right of renewal might be for an amended territory. 

The groundwork may include details on what to do with the customers outside the new territory; there might be some financial adjustment between the franchisee and the franchisor.  But even though a key financial term, if the groundwork for its change is set out in the agreement it can be done.

As your system emerges, you may want to remove the concept of exclusivity, or even remove the concept of territories altogether granting site specific franchises only.  It takes a franchisor with a very long term view to anticipate this when drafting the first franchise agreement.  There were certainly no provisions like that in the seven clause franchise agreement of the novice franchisor, but there are a number of franchise systems that have successfully transitioned over a period of years from exclusive territories to location based franchises.

Another example of a key commercial term which could be changed or introduced is the marketing fund contributions.  Many franchise systems do not have a marketing fund when they commence, but it does not take a great deal of foresight to contemplate a marketing fund might be needed in the future.

Your franchise agreement can accommodate this by spelling out the parameters for the introduction of a marketing fund.  You might contemplate that the marketing requirements may vary dramatically from one party of the country to another.  Your franchise agreement might reflect this by providing that the introduction of a marketing fund must be approved by a particular majority of franchisees in a particular region or area. 

There are any number of formulas and criteria you might use.  The message I want to impress on you is that each franchise system is unique and that these are the types of matters that bear careful consideration each time you come to review your franchise agreement.

Have here a franchise agreement for a relatively new franchise system in the fast food (food court) sector. It was drafted by a lawyer from Robert James Lawyers in Melbourne. That firm has far more experience in franchising than. Let me finish by reading to you the clauses on changes to the system and on the requirement for a new agreement on renewal. I think you will like the approach.

By Paul Kean - MCW Lawyers