1 Gurmeet S Jakhu, Partner Hamilton Pratt Solicitors Birmingham United Kingdom Topic 5: Successful Franchising: Key Terms of a Franchising Agreement

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Gurmeet S Jakhu, Partner Hamilton Pratt Solicitors

Birmingham United Kingdom

Topic 5:

Successful Franchising: Key Terms of a Franchising Agreement

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CONTENTS

1. An Introduction into Franchising

2. Pilot Testing

3. Franchise Agreements a. Introduction

b. Guiding Principles

c. Outline Agreement

4. Operations Manuals

5. Property Documents

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1. An Introduction into Franchising

• What is a franchise?

• Types of Franchises

• What are the alternatives to franchising

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What is a franchise?

Business Format Franchising contains 4 essentialelements

– The Fr’sor allows the Fr’ee to use a name which is associated with the Fr’sor

– The Fr’sor exercises continuing control over the Fr’ee

– The Fr’sor provides assistance to the Fr’ee

– The Fr’ee has periodically to make payments to the Fr’sor.

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Types of Franchises

Two main types:

1. Product distribution franchises –licences TM & logo, Fr’ee not provided with entire system for running business.

Product distributionEg: soft drink distributors, car dealers and gas/petrol stations

2. Business format – replicate business format. Most common form of franchise –Fr’ee uses/replicates the complete method to conduct the business.

Business formatEg: fast food, retail, restaurants, business services and lodging

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Alternatives to Franchising1. Distributorships

• D purchases products in his own name

• Has no connection with Supplier/wholesaler

• Familiar with local markets

• Deals with more than one supplier/producer;

• No/limited support, training from the supplier/producer

• D free to operate business, maybe regulation relating to stock levels, turnover & advertising Cf: franchising

• Fr’ee pays an initial fee and continuing fees

• D pays a one off purchase price. Profit element to supplier is difference in manufacture/purchase costs and that which he sells at

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Alternatives to Franchising

2. Agency:1.Agents do not purchase in their own name2.Contracts directly by supplier and customer or agent

on supplier’s behalf3.Few restrictions t - relate to the agent’s powers to

incur liabilities4.Some Franchises have agency-principal relationship

– eg: parcels delivery franchises customers contracts with Fr’sor but delivery/collection by Fr’ees.

3. Licensing

1.IP rights licensed to a manufacturer to enable manufacture to produce/sell

2.Pay for rights to use particular trademark3.Supervise the use of the license - limited4.Most FA contain a licence to use TM & Brand –

however FA more heavily regulated

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Alternatives to Franchising

4. Acquisition/Setting up a Subsidiary;Straight acquisition of an existing business or establish a wholly owned subsidiary - provides maximum control

5. Joint Venture:• 2 or more companies/firms agree establish a

common enterprise in which they intend to participate jointly;

• Frequently international in nature• Advantageous

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(2) Pilot Testing

• Why pilot test - Purpose– prove the financial viability – ensure Fr’sor able to transfer its know how

and – Chance to refine the franchise process itself

• 2 way process for transferring know how and experience

• Enables Fr’sor to develop its Operations Manual

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(3) Franchise Agreement

Introduction• Care and skill required in drafting FA• FA fundamental to success of franchise:

– Negative impact– Reflect current custom and practice– Accurately reflect the way the Fr’sor operates the

business– Protect from Fr’ee claims

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Franchise Agreements – Guiding Principles

– Protect reputation of the Fr’sor; – “tough” – but to strike correct balance

• Achieved by:• Balance• Limit Discretion• Selling Document• No legal terminology and well presented

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Franchise Agreements - Guiding Principles

• Easily understood – otherwise slow down process

• Do not change FA for individual Fr’ees

• Variables – premises, equipment package, minimum performance, key people often set out in Schedule

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Outline Franchise Agreement

• No two FA are the same - are some basic provisions

• ‘Skeleton’ form of FA and notes in Handout

• Parties: Franchisor, Franchisee, Individuals– Natwest/BFA Survey: 36% Sole Traders; 22%

Partnership & 41% Companies

• Corporate Fr’ee – New Co, no assets; desirable to obtain individual guarantee

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• Directors/major Shareholders: – restrictions on transfer of shares & – subject to Restrictive Covenants

• Recitals: – set out the background and could form part of factual

background in which to construe contract

• Definitions: – essential that all terms used in FA are clearly set out.

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• Rights granted

• Exclusive FA: Fr’sor not appoint another Fr’ee in the Fr’ee’s territory; Danger for new Franchises.

• An exclusive/non-exclusive licence to :

• Operate Business within the Territory (from Premises)

• Use of trade names and trade marks

• Use Fr’sors copyright, material, know-how, knowledge

• Benefit from Marketing knowledge & experience of Fr’sor

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Term

– Usual initial term is 5 years

– If less than 5 years unlikely to be a franchise

– BFA’s code of Ethical Conduct: Extension and Interpretation and Art.5.4 of the European Code of Ethics

• term to be sufficiently long to pay back the Fr’ee initial investment

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• Franchise Fee (Initial Fee)

– Fr’ee should not be trained until full fee has been paid off

– Initial fee should not contain a profit element

– Amount will depend on reputation of Fr’sor and profitability of his franchise

– Fr’ee to pay Fr’sors legal costs – discourages attempts by Fr’ee’s legal advisors to negotiate the terms of the FA

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• Rights of Renewal

– Essential to enable a Fr’ee to renew term

– At the end of initial term – optional for Fr’ee

– Renewal should be exercised without further payment

– Not to be lost for trivial/minor breaches of FA

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Renewal (contd)

• Fr’sor may introduce further requirements:• A“re-vamp” clause & relocation clause

– Must be necessary to revamp or move; costs effective – Demonstrate that the revamp resulted in better financial

performance for other Fr’ees– Fr’sor to assist with sourcing finance

• Indiv/Fr’ee to give up all claims against Fr’sor– Enforceability issues in light of UCTA

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Rights of Renewal & Minimum Performance clauses

• Which apply on renewal only are acceptable

• Appropriate if all franchise territories are comparable & some form of exclusivity has been granted

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• Fr’ors initial obligations – to provide advice on:

– Finding premises & alterations to the premises– How to set up the franchise– Such equipment, stock etc as set out in the Schedule– PR launch– Initial training programme

• right not to enter into FA and • reimburse costs

– Operations Manual on loan to Fr’ee

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• Franchisor’s continuing obligations

– Provide Fr’ee with know how, advice & guidance relating to the Business

– Supply products to the Fr’ee– Supply stationery when required– At cost, train Fr’ee’s personnel– Organise an annual conference for Fr’ees– Try and set out Fr’sors obligations extensively

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• Franchisee’s Obligations– Refurbish & equip the Premises as required by Fr’sor– To use Fr’sor supplied stationery, invoices & products – Operate the Business in accordance with Operations

Manual– Use only signs & packaging in connection with the

Business as approved by the Fr’sor– Premises:

• Maintain to the highest standards and • not to carry out any alterations without Fr’sor’s consent

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• Fr’ees Obligations (contd):Use best endeavours to promote & extend Business

– Operate the Business during specified hours– Ensure that staff are well dressed clean and polite– Not employ a manager unless:

• been approved by the Fr’sor and• completed Fr’sor’s training course

– At the request of the Fr’sor provide potential Fr’ees with information as reasonably requested

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• Training– For Individuals – corporate Fr’ee (no charge)– For Fr’ee’s employees and subsequent managers (at

cost)– Initial training often FOC but during term – at cost

• Continuing Fees– Management Fee 6-10% average of Turnover– In high turnover franchises can be paid weekly– Payment by Direct Debit– If Fr’ee purchase goods/services from Fr’sor, Fr’sor

will have a mark up on such gods/services supplied

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• Accounting Records – Fr’ee shall:

– Maintain record of gross turnover & submit to Fr’sor

– Records needed to calculate Management Fee & Marketing Levy as specified in the Operations Manual

– Maintain records to verify gross turnover for 6 years

– Fr’sor’s right to enter the Premises to review

– Supply to the Fr’sor copies of all VAT returns

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• Advertising/Promotions

– Fr’ee to contribute to national advertising and marketing by way of a Marketing Levy (2-4%)

– Marketing Levy received kept in a separate marketing account - audited annually

– All advertising is to be approved by the Fr’sor

– Fr’ee free to advertise on internet – as long as not active selling

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• Insurance

– Uncertainty - Fr’sors liability for act of Fr’ee

– Relate to conduct of the Business & as Fr’sor shall reasonably require (Ops Manual)

– Fr’sor’s interest to be noted on policies &/or

– Provide Fr’sor with copies of policies and evidence of payment of premiums

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• Trade Marks

– Fr’sor has to warrant that it is able to licence the use the Trade Marks?

• If it has Registered TM – no problem• If not no warranty should be contemplated

– To bring a passing off action in relation to unregistered trade marks, the Fr’sor must be able to show that it has retained goodwill in them

– Fr’ee to notify Fr’sor if it becomes of any unauthorised use

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• Improvements

– Right during term to introduce amendments and improvements

– Who is to pay for the new technology

– Ensure not impose too high a financial burden on Fr’ee

– Not require Fr’ee to make extensive improvements just before expiry of the initial term of FA

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• Manual– Deals with day to day operations

– Power to amend the Manual during term • If not, will be unable to introduce modifications or

amendments to the system

– Definitive copy of Manual to be retained

– In event of conflict between the FA and the amended Manual, the FA would prevail

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• Telephones, fax & domain names

– Main source of advertising will be directories hence control of numbers is important esp. on termination

– Fr’ee only to use the telephone numbers which have been notified to the Fr’sor for the Business

– Consider: • Fr’sor to subscribe to the number or• Request Fr’ee to sign undated mandate which is exercisable

on termination (transferring numbers/names to Fr’sor)

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• Sale of Business

– Fr’ee’s right to transfer subject to Fr’sor’s consent

– The Fr’sor shall consent to a transfer provided that:• The purchaser meets Fr’sor’s min. standards

– To include business experience and financial resources

• Payment of investigation and training cost• There are no subsisting breaches of the FA

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• Sale of Business (contd.)

– Option to match offer made to the Fr’ee

– Fr’sor may require payment of a “finder’s fee”

– Other matters may be taken into consideration such as aptitude for the business, references, etc

• Must ensure that tests are not too subjective otherwise the Fr’sor would effectively have a right of veto

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• Non-Competition

During the term of the franchise neither Fr’ee nor the Individuals will:

• Carry on any other business• Entice employees from the Fr’sor or other Fr’ees• Use or disclose confidential information for any purpose other than a

purpose set out in FA

• Staffing

– Senior employees of Fr’ee not to make use of Fr’sor’s confidential information

– Consider use of Side Letter/Deed of Confidentiality hence will be subject to restrictive covenants and obligations of confidentiality

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Outline Franchise Agreement• Death of Individual

– FA does not bind the Individual’s personal representatives

– A manager for a period of 3 months, on payment of the Fr’sor’s then current costs and expenses

– Within the 3 months period the Individual’s personal representatives or beneficiaries must either:-

• Qualify as a Fr’ee by training (same a for new incoming Fr’ee) or• Notify the Fr’sor of their desire to sell the franchise

failing which the Fr’sor may terminate the FA

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• Termination (1)

– It is unusual for Fr’ees to be given an express right to terminate

– If Fr’sor wishes to terminate because of Fr’ee’s breach, the Fr’ee should be given notice of any breach and reasonable time to remedy a default

– The Fr’sor may terminate the FA if the Fr’ee:• Fails to commence business within 3 months of execution of

the FA

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Termination (contd) 2:• Breach of specific terms of the FA – list out those

terms which amount to fundamental terms

• Persistently defaults in payment of any amounts due to Fr’sor

• Is found to have supplied materially false or misleading information in or supporting the franchise application

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Terminations (contd) 3

• Failure to rectify in specified period – breaches which can be remedied

• Goes into liquidation/bankruptcy or is insolvent• Abandonment of business• Serious criminal convictions

• Note: Consider inserting a liquidated Dm clause for sums payable by Fr’ee on termination – issues of enforceability.

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• Consequences of TerminationFollowing termination of the FA the Fr’ee:

• Must cease use of the Fr’sor’s trade name and trade marks• Not hold itself out as being a Fr’ee of the Fr’sor• Pay all sums due• Return all manuals, literature, promotional material etc• Provide the Fr’sor with a list of all customers and potential

customers of which it is aware – problematic due to ownership issues

• Not make use of or disclose confidential information relating to the system of the franchised business

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Restrictive Covenants:

• Drafting Note:

– Will only be enforceable if it is reasonable to protect legitimate interest of Fr’sor – ‘blue pencil’ test.

– Make sure that RC does not simply prevent Fr’ee from carrying on business as Fr’sor

– Need to ensure that Fr’ee does not compete with Fr’ee business and that of the Fr’sor

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Outline Franchise AgreementFr’ee & Individual shall NOT:

• Compete with the former Fr’ee’s business/Fr’sor:

– Expressed by reference to geographical limit and temporal (time) restrictions eg:

• 1 mile or 700 yards of the former premises or any other franchised or corporate owned premises

• For 6 or 12 months

• Solicit or entice customers of the former business – Actual or those who had expressed an interest

• Recruit former employees

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• Individual’s Guarantee– The Individuals shall indemnify the Fr’sor against any

breaches of the FA by the Fr’ee

• Representations– the Fr’ee and the Individuals confirm that they have not

relied on any representations or warranties from the Fr’sor in entering into this Agreement

– Must be drafted with great care to ensure effectiveness of the clause in order to protect the Fr’sor from misrepresentation claims

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• Acknowledgement & Non Reliance Clause

• Not exclude liability for fraudulent misrepresentation eg: where Fr’sor made wholly unrealistic forecasts and representations

• Acknowledge that Fr’ee has not relied on any statements made by Fr’sor

• Remember UCTA and any similar legislation.

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4. Operations Manual

1. Introduction • Brief summary of the franchise business• What the franchisee will have to do • What the franchisor will provide• Details of the existing franchise network - The

franchisor’s business philosophy

2. System• A detailed description of the system and each of its

elements

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Operations Manual

3. Operating Methods

A list of what is required in the business should be

set out and should include:-

Equipment• How the equipment is to be operated

• Equipment problems• Stock requirements• IT requirements (hardware and

software)• Vehicle requirements

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Operations Manual

4. Operation Instructions

All matters relating to the operation of the business

should be set out in detail and will include:-

• Standard procedures• Financial records• Financial reporting• Payment of franchise fees

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Operations Manual• General accounting, (VAT, PAYE and

Income/Corporation tax) information on how to complete necessary forms

• Cash control and banking procedures

• How to deal with cheques, debit cards and credit cards

• Staff requirements

• Staff uniforms

• Advertising

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Operations Manual

• Staff training• Procedure for disciplining staff• Summary of employment legislation• Breakdown of job description for staff• Opening times• Trading patterns• Purchasing requirements and stock levels• Pricing policies• Insurance

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Operations Manual

5. Outlet

• Suggested location of store• Store layout• Display and merchandising techniques• Cleanliness• Complaints procedure

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Operations Manual

6. Standard Forms• All standard documentation and forms required to be

used in the business should be set out.

This may include:-• Business Names Act notices• Accounting and financial forms• Ordering forms• Stationery• Data Protection Act forms • Contracts of employment

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Operations Manual

7. Legal Issues• A summary of relevant legislation should be provided.

8. Franchisor's Directory• A list of the franchisor's employees with their job

descriptions and reporting structure• Useful telephone numbers and contact details

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5. Property

These could include:

• Lease (if the Fr’sor is the immediate LL – on termination just take over the premises)

• Deed of Option – upon termination, the Fr’sor has the option to take over occupation of the premises subject to LL consent