Ongoing Obligations of a Franchisee - What have I gotten myself into?

The First Day

You have read a lot about franchising, made enquiries and settled on your franchise.

The brand looks good, the system is up and running and you feel confident that with the training and support from the franchisor you will be able to run a successful business operation.

The doors are open, the opening promotions and hype are over and you now take a moment to review how you got to be here.

You then remember the wise words of your lawyer at the time. There are three things to remember:

• Once you sign up you are committed
• There is no easy exit (apart from the cooling off provision); and
• There is no guarantee of a return on your investment, nor a guarantee that at the end of your franchise you will realise a capital gain (since the goodwill is that of the franchisor).

Franchise agreements are nothing more than a contract. They set out the rights and obligations of each party. They are also governed by the Franchising Code of Conduct, a mandatory code under the Trade Practices Act 1974. Issues such as unconscionable conduct and misleading and deceptive conduct all fall outside contract law and are governed essentially by the law of equity (equitable principals). These are in effect principals of fairness taking into account disadvantage and the need to make proper disclosure of information.

You then remember the further wise words of your accountant: “Are doing this for the right reasons? Does the business suit your skills? Will it deliver your personal and financial goals?”

The decision to acquire a franchise should always be made with the assistance and support of objective and experienced franchise advisors in the industry. There are trips and traps and there are experienced franchise lawyers and consultants who can assist you to make an informed and objective decision.

With all of the above in your mind you close the doors after the first day of trading with slight trepidation. What will the future will hold? What have I done?

Basic Lessons

You must remember that you are operating your own business which has to conform to the systems, guidelines, polices and training provided by the franchisor.

No two franchise systems are alike. There are, however, common obligations.

As with any agreement, it is important to be aware of not only the entry costs, but also the exit costs and other recurring costs to your business.

You will have prepared a cash flow projection and budget so that you are able to measure your progress against that budget.

The budget can of course be changed, however it should be realistic and based on available information, bearing in mind that many franchisors do not provide any financial information and specifically decline from making any statements or providing any data as to any return from the business.

As with any business there is a degree of risk.

Basic Contractual Obligations

As with any contract the key obligations are apparent, such as the obligation to pay commission or royalties on sales or a fixed fee, or to pay a margin on the supply of products. It may be a combination of all of these. There are additional contributions to advertising and marketing and obligations to attend annual events and training sessions. These all add to your cost of doing business

Many franchise agreements include provision for a refit and upgrade of the fitout at the franchisee’s cost, at the commencement of each franchise term or at the franchisor’s request.

Tip: If you have purchased an existing franchise which may have an outdated fitout you need to ensure that you will not be obliged to meet the cost of a refit shortly after you have taken possession or take that into account in your budget or purchase price. This equally applies to the plant equipment which must be maintained and in working order.

Operations Manual

The obligations in the operations manual are also contractual obligations and a failure to comply with them generally constitutes a default under the franchise agreement.

Minor infractions often do occur and these may be subject to an audit by the franchisor on visits. These are nothing more than a request that you comply.

The operations manual sets out in detail the day to day procedures, rules and policies of the franchisor company which the franchisee must follow.

It is important that franchisees accept that compliance with the operations manual has as much importance as the agreement itself. The operation manual will cover a number of issues which will also assist the franchisee to ensure compliance by all other franchises on matters such as occupational health and safety, employment obligations, complaints handling procedures.

The operations manual is a living document that will be updated throughout the course of the franchise and franchisees are expected to adopt all changes made to it.

In some cases key financial obligations may well vary through the operations manual rather than by changes to the franchise agreement.

Case Example: Telecommunications Company issues franchisees with operations manual setting out commissions payable for sale of mobile phones and contracts. The franchisees use this for their cash flow and budget. After six months the franchisor issues an amendment via the operations manual revising commission payments to franchisees. Franchisees argue that this is a material change to their revenue stream and is unreasonable.

Supply of Goods and Services

The franchise agreement will usually place restrictions on the franchisees supply of approved goods and services.

• The franchisee may only be able to supply goods and services obtained from the franchisor or from a supplier approved by the franchisor; and/or
• The franchisee may be obligated to supply the franchisor’s entire range of goods and services.

These restrictions may not be specified in the franchise agreement and may appear in the operations manual.

Case example: A franchisee sees that their revenue is falling and decides to implement a “new range” of products and services similar to those sold by the franchise system, but which are not approved. This increases their revenue however undermines the franchise system. The franchisor does not recover royalty on this revenue stream from non approved products and services. This is a clear breach of the obligations under the franchise agreement.

Performance Targets or Minimum Performance Criteria

Most franchise agreements set out minimum performance criteria which the franchisee must meet throughout the term of the agreement.

The criteria should set realistic targets increasing in each year of the term. The criteria may be set by the franchisor, with or without input by the franchisee.

The consequences of failing to meet the minimum performance criteria can be a breach of the agreement, giving rise to the franchisor’s right to terminate (subject to notice and an opportunity to remedy the breach) or a franchisee losing its right to an exclusive territory, or require the franchisee to undergo ongoing training at its own cost.

Case example: The franchisee is given minimum performance targets. It is meeting criteria in some areas however the sales in other areas are not taken into account as part of the performance criteria. The franchisor alleges the franchisee is in default even though the gross sales “over all” meet the minimum performance criteria. Is this a breach of the agreement. It was argued by the franchisee that there was no breach as “over all” he had met the performance targets. The franchisor did not agree and the matter went to mediation.

Keeping Records and Audits

Many franchise agreements require the franchisee to maintain accurate records including the provision of regular profit and loss statements. Franchise systems are now becoming more sophisticated and many systems now have live web based back office and point of sale systems and can access sales data automatically.

An issue often arises that franchisees perceive this to be an invasion of their privacy.

It should be understood that the franchisor requires the data in order to improve and manage the system and identify areas of profit and those areas were a franchisee may not be performing.

Tip: Web based live accounts systems are a valuable management tool to assist the franchise system as a whole. It is recommended that franchisees ensure that any private and confidential information outside of the business that it does not wish a franchisor to access should be held on a separate stand alone system, and that the business system only maintain business records.

Most agreements allow the franchisor to audit franchisee records and provide that if there is shortfall in reporting of revenue by a percentage the cost of the audit is payable by the franchisee.

Case Example: Franchisor seeks to enter the franchisee’s premises and take a mirror image of the franchisee’s hard drive. The hard drive contains personal information of the franchisee and its customers, which they wish to retain “in confidence” being confidential patient information. Can the franchisor enter the premises and take that information?

Marketing Fund

Many franchise systems provide for franchisees to contribute to a marketing fund.

Regardless of whether the franchisor operates a marketing fund, many franchisees will also be required to undertake their own local marketing.

Often the franchise agreement will restrict the franchisee to marketing within a limited area (for example, their territory or a radius surrounding their business premises).

The franchise agreement will require the franchisee to seek the franchisor’s approval before implementing any local marketing initiatives.

It should be recognised by franchisees, that the money contributed to the marketing fund may not necessarily be utilised for their own franchise business directly or in their territory or even necessarily the State in which they operate.

Intellectual Property and Confidentiality

The grant of a franchise is also the grant of the license for the franchisee to use trade marks, brand names, logos and slogans associated with and owned by the franchisor in the operation of their business. The franchisee will not be permitted to use the intellectual property for any other purpose, and will not be allowed to use any other trade marks or logos in the operation of the business.

Most franchise agreements also include provisions requiring the franchisee to retain the confidential information of the franchisor in confidence. Franchisees need to ensure that their employees also maintain the franchisor’s confidentiality.

Non Compete Provisions

Franchise agreements usually provide for a non-compete or restraint of trade provision on termination or expiry against the franchisee.

The provision prevents the franchisee (and/or its directors and principals) from being involved in a business similar to the franchised business for a period of time, for example twelve (12) months and within a defined area. These provisions on their face are seen as anticompetitive and unenforceable. However, they are enforceable where they are no more than is reasonable to protect the franchisor’s goodwill.

This maybe set out as a cascading provision both in time (i.e. 3 years - 2 years – 12 months – 6 months) and in area (Australia – Victoria - 100kms – 50kms – 20km).

The reason for this cascading provision, is that if ever tested by a Court, if one restraint combination for example, 3 years and Victoria was considered by the Court to be an unreasonable restraint the Court can then rely on the lesser time and area in the agreement which would still be enforceable.

Tip: This is one reason why there is a distinct benefit for a franchisor to hold the head lease to the franchise business. If the franchisor holds the head lease they have greater control in the event there is a breach by the franchisee and at the end of the franchise term.

If the franchisee holds the lease at the end of the term the franchisee can continue to operate from the premises but subject to any restraint.

Transfer of the Franchise

If a franchisee wishes to sell their business, the franchise agreement will require the franchisor’s consent and it is usually subject to a number of conditions such as;

• The franchisor will often have a first right of refusal to purchase the franchise.
• If the franchise is sold to a third party, the franchisor will have a right to approve the proposed new franchise.

The Franchising Code of Conduct provides that a franchisor must not unreasonably withhold its consent to the sale/transfer of the business.

Reasonable circumstances for refusal include the proposed transferee being unlikely to meet its financial obligations or not meeting the selection criteria of the franchisor (for example, not being a reputable person with the necessary experience and capabilities).

Under the Code, the franchisor may also withhold consent to a transfer where the franchisee owes money to the franchisor or is in breach of the franchise agreement unless an arrangement has been made with the franchisor to remedy the defaults or pay outstanding money from the settlement proceeds.

There is a generally a fee for transfer of the franchise agreement. The fee is payable by the outgoing franchisee. The fee may be a set amount, or a percentage of the purchase price for the sale.

Tip: If you are selling your franchise and are aware there is a franchise transfer fee, ensure that your sale price incorporates that fee as part of the sale price. It is unlikely that you can pass that obligation on to the purchaser and you will be left with less in hand. Further it is often a issue as to whether on a sale or transfer of the franchise the franchisor will provide the new franchisee with a new franchise agreement rather that transferring the existing franchise agreement.

In that case it should be made clear whether the franchisor is expecting the new franchisee to pay the franchise fee to the franchisor, in addition to the purchase price payable to the existing franchisee selling the business. Those issues need to be considered and discussed at the outset before the sale takes place.

Default and Termination

The Franchising Code of Conduct sets out strict criteria’ regulating the ability of a franchisor to terminate a franchise agreement.

The Code permits a franchisor to terminate a franchise agreement without notice only in certain circumstances, for example the franchisee:

• No longer holds a licence necessary to carry on the business;
• Becomes bankrupt or insolvent;
• Voluntarily abandons the business or the franchise relationship;
• Is convicted of a serious offence;
• Operates the practice in a way that endangers public health or safety;
• Is fraudulent in connection with the franchised business; or
• Agrees to termination of the franchise agreement.

If a franchisee is in breach of the franchise agreement and the above circumstances do not apply, the franchisor must follow the procedure set out in the Code before terminating the franchise agreement, requiring the franchisor to give the franchisee reasonable written notice that they propose to terminate the agreement and indicate what the franchisee must do to remedy the breach;

The franchisor must allow the franchisee “reasonable time” to remedy the breach (no more than 30 days);

If the breach is not remedied within the time required, the franchisor can then terminate the agreement.

This means that if a franchisee is in breach of an agreement and remedies the breach as required within the time required by the franchisor, the franchisor cannot then proceed to terminate the agreement.

The franchise agreement may also include a provision allowing the franchisor to terminate the agreement without a breach by the franchisee on reasonable notice provided the reasons for the termination are given.

Dispute Resolution

The Franchising Code of Conduct sets out dispute resolution provisions that must be included in a franchise agreement and the procedure to follow.

The procedure is instigated by notifying the other party in writing of the nature of the dispute, the outcome sought and what action is ought to settle the dispute.

The parties should then try to agree how to resolve the dispute, and failing that should refer the matter to a mediator (either a mediator the parties agree upon, or a mediator appointed by the Office of the Mediation Adviser) mediation to try to resolve the dispute. If a franchisee instigates mediation the franchisor is required to attend and attempt to resolve the matter acting in good faith. A failure to do so is a breach of the Code by the franchisor.

The process of mediation can be used effectively by a franchisee where there are legitimate issues in dispute as;

• The cost of mediation is far less than Court action;
• The mediation requires the franchisor to focus on the particular dispute;
• and therefore the parties can discuss the issues openly with a view to finding practical solutions; and
• The outcome is in the hands of the parties, not a third party (i.e. a Judge).

The parties must pay their own costs of attending the mediation and are equally liable for the costs of mediation, unless they agree otherwise.

Renewal

A franchise agreement will usually be for a set term (eg five years) and often with a further term or terms at the option of the franchisee (eg two further terms of five years each).

The agreement will set out preconditions for renewal. The franchisee will have a certain period in which they must give notice of intention to renew the agreement (eg between three and six months before the end of the term). Often the franchisor will require the franchisee to enter into a new franchise agreement, the terms of which may have been updated.

There will be usually be a fee for renewal. This may involve the full franchisee fee, or be a lesser amount (for example $5,000.00) to cover the franchisor’s legal and administrative costs of the renewal.

If the franchisee does not request a renewal in the time specified, the agreement will continue as a monthly licence on the terms of the franchise agreement, with either party able to terminate on reasonable notice.

Clearly, there is an abundance of regulation in operating a business on both franchisors and franchisees. The key to any good business is good financial management, proper training, systems and protocols, which will keep you from dispute and from the attention of the regulators.

This article appears courtesy of Wisewoulds Lawyers