Understanding a franchise agreement
When you buy a franchise, you will no doubt have to sign a franchise agreement. Franchise agreements vary in size some as short as 10 pages, others exceeding 100 pages. Either way, it is critical that a prospective franchise owner fully understands all of the terms of the franchise agreement and the workings of a franchise system. The franchise agreement is the fundamental document governing the relationship between franchisor and franchise owner. It sets out the rights and obligations of both parties. Often it will incorporate by reference other documents such as procedure manuals and it is important that the prospective franchise owner understands those documents as well.
Review of franchise agreement
It is prudent for all prospective franchise owners to have the franchise agreement and any other related documents reviewed by a lawyer who has experience in advising prospective franchise owners. The Franchising Code of Conduct (the Code) requires franchisors to, at the very least; recommend this course of action to franchise owners. Some franchisors will not approve franchise owners unless they obtain such advice. The cost will vary from lawyer to lawyer but a "ball park" cost for reviewing and advising on a franchise agreement is about $2,000.
What is a franchise?
Many clients who I have seen do not initially understand what a franchise is. It is not a business - rather it is merely the right to conduct a business using someone else's trade marks, brands, systems and other intellectual property for a limited term (not indefinitely) and, in some cases, within a territory. The franchisor does not own the franchised business and its tangible assets - the franchise owner does.
What happens when the franchise ends?
When the term of the agreement comes to an end, the right to conduct the business under the franchisor's trademarks, brands, systems and other intellectual property is lost without any right to compensation. Often, all that a franchise owner is left with is a bundle of second hand plant and equipment.
Further, in most franchise systems, the franchise owner cannot even continue to operate a "de-branded" business whether from the same premises or nearby premises. This is because most franchise agreements:
1. Are structured in a way whereby the franchisor "controls" the site, by either being the franchise owner's landlord or by securing the right to have any lease transferred to the franchisor, once the franchise agreement comes to an end; and
2. Contain restraints prohibiting an ex franchise owner from conducting a similar business for a period of time within a certain territory.
Worse still, some franchise agreements give the franchisor the right to buy the franchise owner's plant and equipment at written down value on expiration of the term - this value may be less than the true value.
Therefore, the first thing I want my clients to understand is that their capital investment in the franchised business will, on the whole, evaporate at the end of the term and it is unrealistic to expect that any capital gains will be earned from operating a franchised business, unless it can be sold at a gain well before the end of term.
One sided agreement
Prospective franchise owners also need to understand and, ultimately accept, that the franchise agreement will substantially favour the franchisor. This is because the franchisor needs controls and flexibilities to protect its brands and systems. The need for this, in theory, is to benefit the whole of the franchise system, including the franchise owners in the network.
Hence there are often terms in franchise agreements which may ultimately allow the franchisor to alter the franchise system to something quite different to that initially represented. Franchise owners must be aware of the risk associated with these types of flexibilities before they make their decision to proceed.
Franchise owner obligations
Most franchise agreements spell out the franchise owner's obligations in great detail (often over many pages). Financial obligations may include:
- The obligation to pay the initial franchise fee
- The obligation to pay a periodic royalty (which may be fixed or a percentage of sales or profit)
- The obligation to pay contributions into an advertising fund
- The obligation to pay a fee to the franchisor when the franchise owner sells the franchised business
- The obligation to pay the franchisor's legal costs and any assessable stamp duty
- The obligation to pay for stock and other purchases
Operational obligations may include:
- The obligations to wear appropriate uniform
- The obligation to fit-out business premises or a motor vehicle in a particular way
- The obligation to have properly trained staff
- The obligation to properly maintain and keep clean business premises or a motor vehicle
- The obligation to provide excellent customer service
Franchisor obligations
Most franchise agreements, when spelling out the franchisor's obligations, leave a great deal of discretion to the franchisor. Clauses such as "the franchisor will, if it thinks it appropriate" do such and such, are not uncommon. The primary obligation of the franchisor must be to provide the intellectual property and the components of the franchise system - the latter is often done via an Operations or Procedures Manual ("the Manual").
The Manual is a moving document, which franchisors will often amend from time to time to suite their operational needs. As franchise owners promise to operate the business in accordance with the Manual, they too, need to recognise that they may need to be flexible to the franchisor's needs and desires as reflected in amendments to the Manual. 21.09.2007
FCA Member
Contact Mason Sier Turnbull
315 Ferntree Gully Road
Mount Waverley
VIC 3149
Tel: +613 8540 0287
Fax: +613 8540 0202
