What does a franchise agreement cover?

By Christine Lau | 12 Dec 2019 View comments

Put simply, a franchise agreement is a business contract that requires your full attention.

Starting a new franchise is similar to starting any business. The only additional legal document is a franchise agreement between the franchisee and the franchisor, which sets out the rights and obligations of their relationship.

So, once you have identified a new franchise territory, what should your next steps be? Doing research, or due diligence, is a fundamental part of preparing to be a business owner, and understanding your franchise agreement is critical.

What is a franchise agreement?

The right to operate a franchise derives from the franchise agreement you sign with the franchisor. You will need to understand your rights and obligations as franchisee, as all the terms of this agreement are binding on you and define the operation of your franchised business.

Some of the important issues/terms you need to be aware of are:

The term

How long will you have the right to operate the franchise for? Do you have the option to extend your franchise for a further term? You will need to factor this into your investment decision and note also that you should negotiate a further lease term to align with this.

The initial franchise fee and other upfront fees

  • Initial franchise fee: This is a one-off payment to acquire your rights to operate the franchise.
  • Training fee: Where training is required and provided by the franchisor, you will be required to pay a training fee before you start training and get approved as a franchisee.

The territory

Is your allocated territory suitable for the franchised product in light of the demography and existing competitors? Do you have the first right of refusal to acquire other territories offered by the franchisor when they become available?

The ongoing franchise fee and other fees

Aside from the initial and upfront fees that you will pay, the franchise agreement should also detail the ongoing fees that you will incur. These include;

  • Franchise/royalty fee: What is the ongoing franchise fee you need to pay? Find out how this is calculated. It is usually expressed as a percentage of gross revenue (it will be defined in the agreement).
  • Marketing fund: You may be required to contribute to a marketing fund maintained by the franchisor, usually expressed as a percentage of gross revenue.
  • IT licence fee: This is applicable where you are required to use a particular IT system necessary for the franchise group.
  • Staff training fees: If you or your staff require training during the term of the franchise or where required by the franchisor, additional fees are usually payable.
  • Assignment fees: When you seek to sell your franchised business during the franchise term, there is usually a fee payable to the franchisor, expressed as a fixed fee or a percentage of the sale price.

Your obligations to operate the franchise

There are a few key obligations that are set out in your franchise agreement that you must abide by. They are;

  • Your rights to use the intellectual property of the franchise system. Are you clear on what your rights and restrictions are in using the franchisor’s branding and other logos etc. of the products/services?
  • How and where do you obtain your inventory, materials for your products/services?
  • Are you required to purchase certain products and/or materials from the franchisor or its nominated supplier? What does the franchisor or the nominated supplier/s charge for the products that you need in your business? Have you factored this cost into your evaluation of the franchise business?
  • Do you need to maintain a certain level of inventory? If so, is the level viable for your business?
  • Equipment and capital costs: Are there equipment and other capital costs, whether one off or maintenance costs, that you need to be aware of?

Termination and consequences of termination

What occurrences will constitute default under the agreement? Find out the remedy periods granted for you to rectify a breach before the franchisor will have the right to terminate your franchise.

It is important to note that a franchise agreement is a binding legal document which sets out the entire agreement between the parties, just like any other business contract. You should obtain both financial and legal advice on the franchise agreement before signing on the dotted line.