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What you need to know about preferred supplier terms

Sarah Stowe

There are a number of issues that franchisees need to think about when considering signing a franchise agreement or thinking about acquiring a franchise. Franchise agreements often contain terms that require the franchisee to acquire the products necessary from the preferred suppliers, approved or nominated by the franchisor.

If such a term is found in a franchise agreement, then the franchisee must acquire the products from the preferred supplier, or else risk breaching the franchise agreement. If the franchisee breaches the franchise agreement by not acquiring these products from a preferred supplier approved by the franchisor then the franchisor may have the right under the franchise agreement to terminate the franchise agreement and/or sue the franchisee for damages.

The practical result of termination of the franchise agreement will be the end of the franchisee’s business with no compensation to the franchisee for all the money and time he or she has invested in the franchise business.

The obvious solution to avoid this commercial risk is to comply with the franchise agreement. However, in practical terms this may not be a solution for all.

Although franchisors will often emphasise that there is a benefit to the franchisee in using preferred suppliers this may not be necessarily correct. If a prospective franchisee is acquiring a franchise in a national chain consisting of numerous franchises there may indeed be a benefit in the franchisee acquiring goods from a preferred supplier. Due to the volume of sales that a supplier may be able to make to a large franchise chain, the franchisor may have been able to make arrangements with the supplier to secure the supply of products to its franchisees at a very competitive price. Franchisors often describe this potential benefit to the franchisees in terms of bulk buying power.

There are a number of reasons why such an arrangement that is potentially of benefit to the franchisor, may be disadvantageous to the franchisee:

If the franchise chain is not a large franchise chain there is no guaranteeing that the franchisor can secure competitive supply arrangements with suppliers. Even if it is able to enter into arrangements with suppliers, there is no certainty that the franchisee would not have been able to secure the arrangements with the same or other suppliers.

The franchisor may enter into commercially advantageous arrangements with the supplier in the form of a kickback or incentive rather than on the franchisee.

Once the arrangement between a franchisor and a supplier is in place it may lock franchisees into acquiring goods and products at a price, which is commercially competitive at the start on the arrangement but becomes uncompetitive in terms of price during the course of the term of the franchise.

In summary, a prospective franchisee when faced with a franchise agreement containing preferred or approved supplier terms has a difficult decision to make.

If the prospective franchisee decides to enter the franchise agreement containing these terms they must be aware of the potential benefits and risks of agreeing to a term that forces the franchisee to acquire products from a preferred supplier.

If the expected benefits of such a term in the franchise agreement do not deliver, the franchisee may find that he or she is contractually obliged to acquire the products at prices higher that the franchisee is able to obtain from alternative suppliers of the same products. It is difficult enough in the current economic climate to successfully operate a small business without being locked into commercial arrangements that are not competitive.

This is only one potential commercial risk franchisees face when deciding whether to enter into a franchise agreement. The risk cannot be removed or avoided and the best action the franchisee can take to protect his or her interests is to assess the risk by undertaking a thorough due diligence. They need to ensure that the franchisor’s arrangements with a preferred supplier compare with the prices paid for products by other franchisees and other terms of the supply.

Given the many commercial risks that a franchisee must assess prior to entering into a franchise agreement, the franchisee should obtain legal advice from an experienced franchise lawyer.

This article is written by Bill Morgan of Turner Freeman Lawyers .