By Lyndsay Gough, commercial lawyer at Keystone Law
What is franchising?
Franchising is essentially the licensing of a business format by a franchisor to a franchisee, which allows the franchisee to operate his own business under the franchisor’s brand, using an established business method.
Quality and standards are carefully controlled by the franchisor to ensure uniformity across the franchise network. Consider the well-known franchised brand McDonald’s, where the Big Mac is the same the world over and to the outside world, each branch’s franchisee IS the franchisor.
Franchising can be an effective business structure. The franchisee will benefit from the franchisor’s know-how and share the benefit of the brand awareness already in the public mind. According to a June 2012 report of the British Franchise Association, the franchise industry is thriving in spite of the economic downturn. ‘While UK GDP grew by 0.7% in 2011, the franchise industry increased economic contribution by 8% as turnover rose to £13.4 billion.
The legal framework
The franchising industry in the United Kingdom depends largely upon self-regulation, with the British Franchise Association requiring its members to comply with the European Code of Ethics for Franchising. There is, however, no legal requirement for membership of the British Franchise Association. A carefully worded franchise agreement which defines the legal arrangements between the parties is, therefore, of paramount importance to any franchise business.
The essence of a franchise is that, in order to maintain uniformity of franchised goods or services across the franchise network, there must be a uniform agreement for all franchisees. The franchise agreement, often extending to over 50 pages, is usually presented as non-negotiable, but concessions are often made in a separate side-letter, which is signed at the same time as the franchise agreement and which is legally binding.
The franchisee may be a sole trader, partnership or limited liability company. Many franchisees, wary of carrying on business without limited liability, plump for the company route. In such circumstances, the franchisor will usually seek personal guarantees from the individuals operating what is likely to be a newly-formed company without a trading history.
The franchisee usually pays an initial fee at the start of the relationship. There are also on-going management services fees, usually based on a percentage of the franchisee’s turnover, in return for training, advertising and on-going support.
The franchise agreement
It is important to note that the franchise agreement is not the franchise itself. A well-drafted franchise agreement does not indicate that a particular franchise format is going to be a recipe for the franchisee’s success. If, however, the franchise agreement is comprehensive, well-drafted and reflects significant investment of time and money by the franchisor, it is usually indicative of a desire to do things properly.
A franchisee should not be discouraged by what, at first sight, appears to be a very one-sided arrangement which seems designed to protect the franchisor rather than the franchisee. It is this level of control by the franchisor, however, which is at the core of any successful franchise operation and which ensures a uniform quality of services,
which ultimately benefits all franchisees.
Key provisions in the franchise agreement
Territory: Will the rights granted to the franchisee be exclusive, perhaps for a particular county, town or series of postcodes? The franchisor may be reticent to grant exclusive territories, especially where a franchise concept is still developing and the franchisor wants to reserve the right to open up additional outlets in a particular city if the concept proves to be particularly successful.
Conversely, the franchisee will seek to be protected from competition, both from the franchisor and its other franchisees.
Lease: Will the franchisee be required to take a lease of premises from the franchisor or from a third party landlord? If the latter, the franchisor may wish to approve the site and the lease and may require a separate option agreement to enable the franchisor to take over the premises at the end of the franchise term. Who bears the costs of refurbishment and fit out are important considerations.
If it will take some time to identify suitable premises, the franchisor may require the franchisee to enter into a separate franchise purchase agreement prior to a formal franchise agreement being signed, as a sign of the prospective franchisee’s commitment to the relationship. Typically such a franchise purchase agreement requires the franchisee to pay an initial deposit (often non-returnable), to agree to look for suitable premises and to enter into the franchise agreement once the franchisor is satisfied of the suitability of a selected property.
Term of the agreement: Most franchises are for an initial term of five years, to allow individual franchisees to recoup their initial investments. The franchisee will want the right to renew the franchise agreement at the end of the initial term. The agreement should contain an appropriate timetable for relevant notices to be served. Renewal may be conditional upon the payment of a renewal fee and no breaches having been committed by the franchisee (ideally, from the franchisee’s perspective, any minor breaches would be disregarded). Usually the franchisor will require signature of a new franchise agreement, sometimes there will be refresher training and the franchisee may be obliged to pay the franchisor’s legal costs.
Management Fee: This is calculated at a percentage of the franchisee’s takings and usually is based upon a percentage of gross monthly receipts. A typical percentage is 5-10%. A separate advertising levy may be payable, usually around 2.5% of gross monthly receipts. Some agreements may require the payment of a minimum fee, regardless of the level of income.
Supply of equipment: Equipment to be supplied by the franchisor could include vehicles (perhaps a liveried van), machinery, furniture, signage, stationery, uniforms, IT equipment and software. The franchise agreement must state the terms of supply and whether title will pass to the franchisee or whether the franchisor is simply loaning the items.
Franchisor’s obligations: There must be an on-going obligation for the franchisor to provide support, training and advertising in return for the management fee. It is also essential for the franchisor to continue to protect the brand name. The franchisee will want to be sure that the franchisor is entitled to license any trade marks to the franchisee without infringing the rights of any third parties and that all appropriate steps have been taken to register relevant trademarks.
Franchisee’s obligations: It is crucial to maintaining the uniform quality standards of the franchisor’s brand that there are comprehensive restrictions and obligations which bind all franchisees, including the need for strict compliance with a detailed operating manual. An errant franchisee who does not comply may prejudice severely the reputation of the entire franchise network.
Termination: The agreement usually provides for the franchisor to terminate the agreement for breach of contract, mental incapacity or insolvency of the franchisee.
Franchisee’s death or incapacity: Where the franchise is operated by an individual who dies, the franchisor will not want an individual’s share in the business to automatically transfer to beneficiaries who may not prove to be suitable franchisees. Sometimes the agreement will be terminated by the franchisor on the death of an individual, perhaps with the repayment of the initial fee and the franchisor will seek to find a suitable buyer or buy the business itself. If, on the other hand, an individual becomes incapacitated, sometimes there are provisions for the franchisor’s appointment of a temporary manager.
Sale of the franchisee’s business: The franchisor will want to protect its goodwill in the brand by ensuring that individual franchisees cannot readily transfer their businesses to third parties without some input by the franchisor. The franchisee, on the other hand, will want suitable flexibility to allow the sale of a successful business he has developed to a suitable buyer. Once a purchaser has been identified, there is usually an option for the franchisor to buy the business from the franchisee on the same terms. If the franchisor decides not to exercise the option, it will still want to exert some control over the appointment of a new franchisee.
Restrictions: Once the franchisee has sold his business, there are usually restrictions upon future activities to prevent the use of confidential information and know-how gleaned during the franchise relationship being used by the franchisee to operate in competition with the franchisor and other franchisees. Such clauses must, however, be reasonable in geographical extent and duration in order to be legally enforceable.
Is the franchise agreement really so important?
Whilst a prospective franchisee may find the franchise agreement to be overly-complicated and restrictive, it is important to bear in mind that such a document is necessary to protect a proven business formula and an established brand, to the advantage of all franchisees. Each franchisee benefits from the franchisor’s name and reputation, advertising, training and support, which can significantly reduce the risk of failure of the franchisee’s fledgling business.
Unlike a number of other countries, including the United States, the United Kingdom does not have franchise-specific laws. Instead, franchises are governed by the same laws which regulate other businesses. At the core of the business relationship between the franchisor and the franchisee is contract law and the franchise agreement encapsulates that contractual arrangement. The franchise agreement must be carefully crafted to define the respective obligations of the parties and any verbal promises made must be confirmed in the franchise agreement in order to be legally enforceable.
Franchising as a business model is not a soft option for self-employment. The back-up of a reputable franchisor with a proven franchise network is paramount to success, but the importance of taking sound legal advice before entering into this significant and legally-binding relationship cannot be understated. There is no guarantee of business success from a franchise. As with any new business, planning is of critical importance. A diligent prospective franchisee will obtain a thorough review of the franchise agreement by a specialist solicitor experienced in the franchise sector to ensure that the legal framework follows a typical format and is compliant with relevant laws. There is no shortcut to success and doing adequate homework is key to forming and building an effective business with a financially viable exit-route within the franchise sector.