FRANCHISE CONTRACTS – SERIOUS CONCERNS FOR FRANCHISE BUYERS
By L. Seth Stadfeld
A franchise contract is a long-term arrangement that sets forth the rights and obligations of franchisee and franchisor in the operation of a franchised business. A prospect need not pay great attention to its terms until proper due diligence investigating an opportunity has been done. At a minimum, this includes studying the Franchise Disclosure Document (FDD) which (hopefully) contains helpful financial performance information, speaking at length with existing and former franchisees and discussing all aspects of the deal with trusted advisors. After that, assuming the prospect wants to proceed with the deal, the next step is to study carefully the offer contained in the franchise agreement with guidance from knowledgeable franchise counsel.
The Franchise Sales Process. Prospects should evaluate franchise offers prudently and wisely. They should not rush to buy or succumb to high pressure sales tactics (which accompany some but not all offers). In the franchise sales process, sellers may emphasize success stories (or the potential for success) while steering clear of negatives (which accompany most franchise offerings). Frequently, they downplay the significance of the so-called “standard” franchise contract. This does a disservice to the prospect. They may tell prospects to put their trust in the franchisor who will be with them “every step of the way, because if you [the franchisee] don’t make money we [the franchisor] don’t make money”. As a result, many prospects believe that all franchise contracts are basically the same (“standard”) and that they are non-negotiable. Both statements are not necessarily true. Indeed, the contract is crucially important in the franchise relationship. Courts pay great attention to them in franchise disputes. Prospective franchisees should do the same. Why? Because if the parties find themselves in a serious dispute (which is not improbable), nothing is more important in the relationship than legal RIGHTS. If a franchisee is not lucky enough to benefit from a state franchise relationship law or franchise registration law (passed in only a small minority of states), s/he must look to the contract to determine the parties’ rights and obligations. And if the franchisee has not negotiated rights to make the contract fairer, the likelihood is that it will be very difficult to prevail in a franchise dispute. Some important areas of concern are discussed below.
Not all franchises are created equal. The two main benefits one looks for in a franchise are a well-known name (brand) and valuable know-how in operating the franchised business. Of the thousands of franchise opportunities in the marketplace, however, few have well-known names; the type that immediately attracts customers once the business first opens. What is more, many franchisors are not adequately capitalized; in some cases less so than prospects to whom their franchises are offered for sale. And yet, typically their lawyers prepare “standard”, long, onerous contracts giving them extensive (sometimes unnecessary) rights and saddling the franchisees with extensive obligations, as if these franchisors were industry giants.
Some important points to take away from this discussion are as follows. Contract language is very important. While there are many similarities in these contracts (such as the franchise grant and necessary franchisor controls over its system, trademarks and confidential information), there are also many differences. These appear in areas such as fees, franchisor services, termination, transferability, source restrictions (such as on inventory and supplies used in the business), remedial restrictions and post-termination controls, to name a few. The point is that there are material differences in these so-called “standard” contracts. Some are more franchisee-friendly than others; some decidedly less. In light of the significant investment to be made in the business, prospects should engage experienced franchise counsel to study the contract and advise on the good, the bad, and what if anything, might be negotiated to level the contractual playing field. There is no substitute for both franchisee and counsel to read and understand the contract fully. Often, this exercise may reveal material discrepancies between what the contract provides and what the franchise seller says about the deal.
Another key point is that more often than people think, franchisors will consider making changes to the contract; not so much to change the basic terms of a deal, but rather, to make the contract a bit fairer for the franchisee while not depriving franchisors of traditional rights in the relationship. A prospect may well be able to negotiate.
Just as a house rests on a concrete foundation, a franchise business rests on a contractual foundation. If the franchisee does not (or cannot because some franchisors do not negotiate) negotiate sufficient rights, the business rests on a shaky foundation (essentially the good graces of a benevolent franchisor) and thus, is more susceptible to loss through termination and post-term exigencies. Therefore, by way of example, consider the following areas of the franchise relationship covered by the contract. These are not set forth in order of importance.
Territory. For most franchises, the franchisee wants an exclusive territory protected from competition from other system outlets. In systems where this is purportedly offered, however, typically franchisors reserve many ways to compete in that territory, whether in other distribution channels (e.g., electronic commerce, department stores or grocery stores), under other marks, in non-traditional settings (e.g., universities, hospitals or hotels), or if a quota is not met. Also, typically exclusivity depends on the franchisee continually being in complete compliance (which is not realistic for the entire contract term) as compared to substantial compliance with material obligations, which is much more reasonable. Franchisees should try to strengthen their rights in this area.
Renewal. Though franchises often are marketed as long-term deals between so-called “partners” or “family members”, usually the contract grants franchise rights for a ten year term and a right of renewal for one more term (e.g., five or ten years). After that, and after the franchisee has built a good business and added substantial good will to the brand, like a landlord who can evict a tenant, the franchisor can take over. And this is wholly aside from the fact that at renewal, typically franchisors reserve the right to change all contract terms (e.g., new fees, new territory if any, etc.) by requiring that franchisees sign their then-current form of agreement. This can be disastrous for the franchisee; who may be left with nothing and in addition, may be bound by a post-term non-compete clause. Accordingly, it is not unreasonable for the franchisee to have a continuing right to renew the franchise so long as reasonable renewal conditions are met and on contract terms consistent with those previously agreed to.
Pricing Freedom. Until a U.S. Supreme Court case re-interpreting federal anti-trust law in 1997, franchisors and suppliers could not enforce restrictions on prices charged by franchisees and dealers. Considered to be anti-competitive for the better part of a century, vertical price restraints were held to be per se illegal. In State Oil Co. v. Kahn, 522 U.S. 3 (1997), however, the Court ruled that each price restraint must be evaluated on a case by case basis as some may be pro-competitive. Under the old law, it was common to notify consumers during promotions that “price and participation may vary” or that a set price was “available at participating dealers”. Since then, however, many franchisors have introduced this right into their contracts. This is bad for franchisees. They need freedom to set their own prices in order to adapt to competitive conditions, to make a reasonable profit or to mitigate losses.
Risky Personal Exposure with Guarantee and Indemnity. This is a crucially important area. Understandably, franchisors want a franchisee’s principals to guarantee franchisee performance under the agreement so that they are assured of collecting sums due. Also, it is reasonable that franchisors be indemnified for some losses to which they may be exposed that may arise out of the operation of the franchisee’s business. Conversely, franchisee principals have no interest in signing personally for obvious reasons. They could be exposed personally to huge liability. They invest substantial amounts in the business and may take on a lease and other significant obligations. What is more, when one combines the guarantee with the typical one-sided franchisee indemnity, there is concern that the principals may be exposed to high liability where a customer suffers a personal injury caused by something that is not the franchisee’s fault and may be the franchisor’s fault. This could derive from a personal injury caused by inventory or another product sold to the franchisee by the franchisor for use or resale in the business. Though this risk may arise from operation of the business, the franchisee and its principals should not have to take on risks that are not their fault. Yet that is what these clauses provide for. Such risks should be excluded from the franchisee indemnity. Further, the franchisor should indemnify the franchisee for acts or omissions that are its fault. In addition, if a personal guarantee must be provided, franchisees should seek to limit its financial exposure (as opposed to personal liability for compliance with confidentiality, non-competition, trademark use and comparable non-financial undertakings which is not unreasonable). Reasonable limits could include a sum certain (e.g., $20,000) and/or an amount equal to royalties owing during the franchisee’s operation of the business (but excluding future fees post-termination). In fact, certainty of collecting royalties is a primary reason why franchisors require these guarantees. In cases where deals would have been lost unless franchisors softened their stance on guarantee language, franchisors have negotiated.
Franchisee Exit Strategy. Under typical contract provisions, if there is a termination without renewal (which often is a matter of dispute between the parties) or expiration, the franchisee could be out of business with no decent options and significant financial obligations. This is because the franchisor reserves an option to take over the lease and purchase certain hard assets of the business on terms that are unattractive to the franchisee (e.g., no compensation for a potentially valuable lease and book value less depreciation for tangible assets). Plus, the franchisee is bound by a non-competition covenant. All of the franchisee’s good will in the business (which would be preserved if the franchisee were to transfer the business) is destroyed. In these cases, if the franchisor wants to take over the business, the franchisee should be paid its fair market value as a going concern. If not and if the franchisee wants to stay in business, s/he should be able to do so by paying a reasonable termination fee to the franchisor in the absence of a better alternative.
Conclusion. The foregoing contract terms represent very important issues for consideration in a franchise purchase. But they are hardly the only ones. In a 40-50 page agreement, there are many more. From arbitrary deadlines to open the business or curing defaults, to obtaining freedom to purchase items used in the business from approved suppliers on the best terms if they meet the franchisor’s quality standards (as opposed to having to buy from designated suppliers at non-competitive prices), to ameliorating unduly harsh termination clauses, to more reasonable conditions precedent to obtaining franchisor consent to a transfer or a renewal, to fairer dispute resolution terms (which can be outcome determinative in a dispute), there is much that franchisees can do to give themselves a modicum of rights in relationships with their franchisors. And believe it or not, even if the franchisor were to agree to changes in some of these areas, it still would hold most of the cards should the parties get into a dispute. What is more, the suggested points for negotiation would not alter material business terms or the way the parties do business with each other during the relationship.
In the ideal situation, the parties will have put the contract in the desk drawer and not looked at it again because both will have experienced success without confrontation. But the value of rights in the relationship cannot be understated. Franchisors know this well. It is reflected in their contracts. Franchisees can help themselves significantly by understanding this and seeking to negotiate accordingly. Should they find the franchisor unwilling to compromise, at least they will fully understand just how adverse their contractual situation is. If they do the deal anyway, they will have done it fully informed and convinced, that despite unattractive contract terms, they cannot think of anything better to do with their time and money.
L. Seth Stadfeld
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