4 Essential Rules for a Trouble-free Franchise Agreement

4 Essential Rules for a  Trouble-free Franchise Agreement

With legal contracts, the devil is in the detail. Karen Marchiano guides you through what can be dispute-infested waters

Rule 1: Start – but do not end - with a solid template from an experienced franchise lawyer. Wheels were invented in approximately 3500 B.C. Franchise agreements were invented later. No need to reinvent either. On the flipside, do not assume a template, even an excellent one for another situation, is perfect for your needs.

Rule 2: Learn from others. Focus your attention on frequently litigated areas.
Read the entire agreement, cover to cover. However, recognize that some provisions lead to litigation more frequently than others, and that some provisions lead to particularly expensive, protracted litigation if not drafted properly. The following provisions merit particular focus:

 Deadlines for commencing operations. Specify the consequences of failure to begin operation of the franchised business by a date certain, and the conditions under which extensions will be granted. For example, delays in obtaining permits are common and foreseeable and should be addressed.

 Territory. Specify whether the franchisee has a territory, and if so, what rights are exclusive to that territory. Any rights not expressly given to the franchisee should be expressly reserved for the franchisor. This should resolve common disputes over whether the franchisor, an affiliate of the franchisor, or another franchisee can sell products or services into that territory via the internet, non-traditional locations (such as airports, college campuses, and stadiums), or other brands (including competing brands).

 System changes. Reserve the right for the franchisor to change the system – even fundamental aspects like the system’s trademarks - over time. Franchise systems need the flexibility to respond dynamically to changing customer preferences, technology, competition, and regulation.

 Advertising fund. Broadly describe how the advertising fund can be spent and whether required advertising fund contributions can increase over time. State whether the advertising fund spending must benefit the franchisee’s market in proportion to the franchisee’s contribution. Explain who determines how the advertising fund will be spent. Explain the circumstances when the advertising fund can be used to pay expenses incurred by the franchisor. State whether the franchisor can defer or reduce contributions of other franchisees.

 Remodel requirements, software/IT upgrades, and other capital expenditures. Outline areas of significant capital expenditure that franchisees can expect to incur.

 Renewal rights: Identify the conditions for allowing renewal. State whether one condition is execution of the then-current form of franchise agreement that may be materially different from the current form.

 Termination rights. Franchise terminations are one of the most frequently litigated aspects of the franchise relationship, if not the most frequently litigated aspect, so clear drafting in this section of the agreement is absolutely critical. Identify the circumstances when the agreement can be terminated with and without an opportunity to cure.

 Holdover franchisee. Specify that the agreement goes month-to-month if neither party terminates the agreement at the end of its term.

 Effectiveness. Expressly state that the agreement is not effective until signed by the franchisor.

 Nature of relationship. To mitigate the risk of joint employer liability, specify that the franchisee is an independent contractor with sole responsibility for hiring, supervising, and terminating its own employees, and for the day-to-day operation of the franchised business.

 Transfer rights. Identify the conditions under which transfer is prohibited and the conditions under which it would be approved. Carefully define transfer. State whether the franchisor has a right of first refusal.

Rule 3:
Fill your toolbox. You’ll want options if a dispute arises.

Even with a well-drafted agreement, disputes can arise. When they do, franchisors will want the following tools in their toolbox to facilitate resolution of the disputes:

 Personal guaranties from principals, guaranties from related entities, letters of credit, and/or escrow accounts. These, and similar options, provide options for a franchisor to recover when a franchisee financially defaults.

 Agreements for principals to be personally bound. If the franchisee’s principals are in a jurisdiction that permits post-termination non-competes, consider expressly calling out the obligation to be bound to the non-compete, in addition to being bound to all the other financial and non-financial obligations in the franchise agreement.

 Lease assignments. Particularly in jurisdictions where non-competes are unenforceable, the franchisor should consider requiring lease addendums and contractual provisions that give the franchisor the option of taking over the franchisee’s lease.

 Post-termination obligations. Require payment of amounts owed. Prohibit further use of the franchisor’s marks, trade dress, and confidential information. Prohibit identification as a former franchisee. Require changes to physical premises. Provide for transfer of phone numbers and internet directory listings. If the franchisee is in a jurisdiction that permits post-termination non-competes, consider including one.

 Indemnification provisions. These are critical to protect the franchisor against third party claims against the franchisor caused by the franchisee’s conduct.

 Insurance requirements. Either the franchise agreement or the operations manual should specify minimum limits and types of insurance for the franchisees to maintain, and should require that the franchisor be named as an additional insured. Equally critically, the franchisor should periodically monitor the franchisee’s compliance with the insurance requirements.

 Liquidated damages or other remedies upon breach. The franchisor should consider whether to include a liquidated damages provision that is a reasonable estimate of damages, at least for some types of breaches.

 Non-reliance and related acknowledgments. The franchisor should seek to include in the agreement itself, as well as in a separate questionnaire, language stating that the franchisee has independently investigated the franchise opportunity, understands the risks that could result in losses, and has not received and is not relying upon any representations or guarantees outside of the franchise disclosure document.

 Dispute resolution. The agreement should include a robust dispute resolution section, that addresses choice of law, choice of forum, and any mandatory alternative dispute resolution mechanisms (mediation or arbitration). The franchisor should consider language limiting class actions and imposing reasonable contractual limitations periods.

Rule 4: Choose the right counter-party to your franchise agreement.
This final tip is the most important. Disputes arise most commonly when the franchisee is struggling financially. Thus, before moving forward with a prospective franchisee, the franchisor should screen the prospect very carefully on financial, operational, organisational fit, and other metrics. Similarly, the prospective franchisee should fully investigate the franchise opportunity before moving forward. Read about other important franchise legal documents here.

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