What Does Your Franchise Lawyer Really Do For You? And How Much Will It Cost?
One of the most enjoyable parts of being a franchise lawyer is that every day is different. Being a lawyer who specialises in franchising means that I get to meet a large number of interesting people who operate in businesses across many sectors.
As anyone can see from the listing of different franchise organisations in New Zealand, there are a huge number of different franchise systems that are available for people to join. Each system brings with it its own subtleties. No two franchise agreements are the same. Therefore, when the phone rings and a new client is on the end of the line asking to come and see me about a franchise system that they are interested in buying into, it is very hard to answer the question “How much will it cost me to do this?”.
Unlike a house purchase transaction which has largely standard procedures to follow so that a relatively accurate price range can be given at the start of a transaction, the same cannot be said for a franchise. During the course of this article, I will attempt to set out different levels of work involved in different types of franchise transactions to illustrate why this is the case.
1. An Owner Operated Franchise System with no Employees and no Premises
As one might imagine, from a legal perspective a franchise transaction is generally at its most basic when the person buying a franchise does not intend employing other people and they do not intend leasing premises to operate from. Often a “one man band” type franchise like this occurs for a service based franchise, such as home services and cleaning franchises. In that case, when a client comes to see a lawyer, there are three main things that need to be reviewed and discussed.
The first of these is the Franchise Agreement. In every transaction, a Franchise Agreement will need to be reviewed and explained to a client. Further, the Franchise Agreement for every system is different. Franchise Agreements are tailored to fit each franchise and there is no “one size fits all” Franchise Agreement. The reason for this is that franchisors and franchisees have different needs and obligations in every franchise system. Franchise Agreements can vary in length from 30 odd pages through to 200 pages. It is a generalisation, but in many instances franchise systems that have come to New Zealand from Australia will have more complicated documentation to review, as often such Franchise Agreements are largely taken from the highly regulated Australian system and are just converted to fit New Zealand’s laws. By and large, Franchise Agreements that come from Australia are considerably longer because of the Australian obligations that they must comply with.
Therefore, if a client rings up to have a Franchise Agreement reviewed, it is very difficult to give them an estimate of what it will cost to do this until the Franchise Agreement has been sighted. At the very least, the range would be quite large.
Secondly, regardless of whether a franchisee is going to be a one man band or not, a lawyer should talk to their client about the business structure that they wish to operate under. Often, when a franchise system has a sole operator with no employees, the structure can be kept simpler than a structure that would be required for larger operations that have more people involved and higher turnovers. However, there still needs to be a decision made as to whether a franchisee wishes to operate as a sole trader, or in a partnership or as a limited liability company. If the partnership option or the company option is chosen, this will involve further work for the lawyer in either preparing a Partnership Agreement, or helping to form the company. Each option has its pros and cons.
The third item that a lawyer often has involvement with in most franchise transactions is the finance. Unless a franchisee is paying cash to finance their purchase and working capital, there will often be a need for a loan to be raised. At that time loan agreements will be prepared and executed and, in many cases, the loan will be secured against the family home. In all likelihood a lawyer will be required by the bank to be involved to put the appropriate mortgage in place and to provide advice to the franchisee about the loan agreements and guarantees that they are signing.
2. An Owner Operated Franchise System with Employees but without Premises
The second scenario is not much different from the first one, but it involves an extra layer of complexity and this brings with it more complications. One could reasonably assume that because employees are involved, the turnover of the franchise will be higher and therefore the return to the franchisee will be higher. Therefore, in addition to the comments made under scenario 1 above, there may well be reason for the lawyer to undertake the following tasks. First, they should take a more in-depth review of the business structure. Whereas under scenario 1 a franchisee may have been quite comfortable trading as a sole trader or in a partnership, it is more likely that when employees are involved that the benefits of using a company will outweigh the compliance costs of having one. There may well also be good reason to review the way a franchisee owns their own personal lifestyle assets, such as their family home and other investments. A lawyer will often talk to the franchisee about the benefits of a Family Trust.
Secondly, the other obvious implication of involving employees is the impact of the employment legislation in New Zealand. There is now a need to have a written Employment Contract in place with every employee of a business. There are also subtleties involved if an employer wishes to obtain the benefit of the 90 day trial period when hiring new employees. If the correct procedures are not followed, then you can lose the benefit of that trial period. Finally, for the franchisees that have never been employers before, there will be a steep learning curve to come to grips with things like pay roll systems, tax payments, holiday entitlements and so on. A prospective franchisee should never be concerned about taking advice from the lawyer on such matters, as the costs of getting something wrong can be disastrous for a business.
3. An owner operated franchise with employees and premises
Just as when employees are introduced into the mix, the introduction of premises into the mix adds a further layer of complexity. It would be fair to say that when a franchise system involves a retail operation, the employment of people and the leasing of premises, that it can end up being a reasonable sized operation. Franchise Agreements for such operations tend to involve more content and therefore are longer and take more time to review. Again, it will be important to review the matters discussed earlier. In particular, it is more likely in such scenarios that financing will be required. Also, the structuring of the business becomes a very important matter.
In addition to all of this there is also the need to put in place a lease for premises that the franchisee wishes to operate from. Some franchise systems will have the franchisor taking the Head Lease of the premises and then subleasing them to a franchisee. However, most franchisees will negotiate directly with a landlord. Many Franchise Agreements contain certain specific terms relating to Leases and clauses that they require to be inserted into those Leases. Therefore, a Franchise Agreement should always be reviewed before a lease is signed. Further, there are always methods a lawyer can use to try and minimise a tenant’s liability in a Lease. Such areas include limiting the ongoing liability of guarantors and, where appropriate, trying to ensure that the landlord does not undermine the franchisee’s business by leasing other premises they own to competitors of the franchisee.
Commercial lawyers review a lot of leases and have significant knowledge and skills that should be harnessed before an Agreement to Lease is signed. All too often an Agreement to Lease is signed before a lawyer is asked to have input, and at that stage it can be too late to insert clauses which would have been of real benefit to a tenant. The most effective time to negotiate with a landlord is before the Agreement to Lease is signed. It should also be noted that not all leases are the same. A lot of leases for stand alone premises use a relatively standard form Deed of Lease, but whenever the premises being leased are in a mall or other large complex then different forms of Lease will often be used that are again more complex and involve more time for a lawyer than the simple standard form.
4. Summary
As can be seen from the different scenarios above, a lawyer’s involvement can vary to a great extent, depending not only on the complexity of the Franchise Agreement, which they will have to review in every case, but also on the nature of the transaction and the other legal elements involved.
Franchisees only get one chance to set things up the right way at the outset. Taking proper advice from an experienced franchise lawyer is an integral part of this as the input they can give will be invaluable. Equally however, a client should never be afraid to ask a lawyer what a transaction may cost. At the very least, a lawyer should give a client an estimate for reviewing the Franchise Agreement and reporting back on it once they have had an opportunity to view the agreement. After that has occurred and the contents of the Franchise Agreement are known (whether good or not so good), then the extent that a lawyer will need to be involved in the balance of a transaction will become clearer. That will enable the lawyer to give a clearer estimate of what the legal fees will be for the balance of the transaction. Start up costs, including legal costs, are often higher in the more complex franchise transactions. Provided that they do not come as a surprise, then they should be seen by a franchisee as an investment in the business and a necessary part of joining the franchise system.
This article was written by Mark Sherry and first published in Business Franchise New Zealand magazine (Vol 02 Issue 02).
June 2011 - When Disaster Strikes - Maintaining business continuity in the face of uncertainty
The following article was written by Mark Sherry and first published in Business Franchise New Zealand magazine (Vol 02 Issue 01/2011)
In the past twelve months both New Zealand and Australia have suffered from numerous significant natural disasters. There have been two major earthquakes in Canterbury, extreme flooding in Brisbane and a category five storm in northern Queensland. Having had an office situated in central Christchurch, I have experienced first-hand the devastation and disruption that the two earthquakes have caused.
In September 2010, the first earthquake struck in the early hours of a Saturday morning. We had a week of uncertainty before being allowed back to our premises. However, by the middle of that week, we did have power on in our building. This enabled us to get remote access to our servers and largely get back to business as usual.
The earthquake on February 22, 2011 had a much more catastrophic affect on businesses in Christchurch. For my company, even three weeks after the initial earthquake, we were severely affected and hampered by the aftermath of the disaster. Based on first-hand experience, this article will discuss important crisis management issues that all businesses should address. It will also look at some of the natural advantages that franchise systems may have to help franchisees re-establish themselves in a time of crisis.
Communication
After the first earthquake, we discovered the importance of keeping in touch with our employees, key suppliers and clients. Crisis creates uncertainty. That uncertainty can compound when people you depend on to keep your business going don’t know what is happening or when you can’t contact the people that you need. It is vital to have contact details for all your team, along with your key suppliers and clients. This will allow you to find out how they are faring and what you can do to assist. It is also essential to have these contact details when you need assistance. Sometimes timing is crucial and you must be able to immediately contact the right people. It is also important to keep a constant flow of information going to the right people. This ensures that as progress is made and things stabilise that news is then communicated to those that matter. Use of websites, email and even social networking groups have been valuable tools of late in keeping lines of communication open.
Franchise systems can provide a natural advantage in unfortunate circumstances, particularly in dealing with key suppliers. The relationship is often fostered by franchisors and they can take the lead in getting assistance for franchisees. Further, part of a franchisor’s role is to provide assistance to franchisees when the need arises. So at a time of sudden and unexpected crisis, the franchisor should be able to provide other forms of invaluable assistance too. Given that franchisees operate in different geographical areas, and provided the franchisor does not operate in the area that has been affected by a disaster, they should be immediately available to assist affected franchisees.
Data Protection
Like it or not, most businesses rely on technology these days. Having access to that technology is crucial and often, to quote the song, “You don’t know what you’ve got till it’s gone.” For my company, being without our data for two to three days after the first earthquake made us feel vulnerable. For many other companies, the second earthquake destroyed much of central Christchurch and caused people to be locked out of their premises for what could turn out to be months, if indeed their premises even survived at all. There are tales of woe where businesses have had no offsite backup available to them to help when setting up elsewhere. Others were in the rather unfortunate position of having backups that were locked in safety deposit boxes inside the cordon. Therefore they were inaccessible.
A critical question that every business needs to be able to answer in a satisfactory way is, “If we had to walk out of our premises right now with no notice and not come back - do we have systems in place to be able to start up again elsewhere with minimal disruption?”
In many cases this is where franchise systems can have a competitive advantage. Many franchisors have central computer systems that upload data from individual franchisees to the franchisor. Such systems can capture sales data, client lists, invoicing and all other forms of information normally stored on hard drives and servers. Provided such information is hosted securely by the franchisor, it would be easy for a franchisee to gain access to it in the event of a disaster. It is incumbent on franchisors that run systems in this way to ensure that data is secure and perhaps kept at a mirror site too, in case the primary site is affected by some form of disaster itself.
If a franchise system does not have this type of data recovery system, it will be necessary for the franchisee to look at what they need to protect their own information. This may range from the creation of regular backup tapes stored off-site through to the franchisee arranging the secure hosting of its own data elsewhere.
Insurance
Most franchise systems do require franchisees to keep minimum levels of insurance for various purposes. There is often a requirement for a franchisee to keep certain types of business interruption insurance in the event that something happens to prevent a franchisee from trading. This insurance will keep income streams flowing to both the franchisor and franchisee. Even if a franchise system does not provide for this, it is imperative that a franchisee considers taking such insurance voluntarily. This protection provides considerable peace of mind if disaster strikes.
It should be noted that not all policies are created equal. Therefore it is important to have a knowledgeable insurance broker to assist in deciding what policies are best in each circumstance and what levels of cover should be held. Some policies only provide cover for the costs of relocating premises. Others can provide a subsidy for the income you would have earned had the business interruption not occurred. Deciding what policy is best will depend on the type of business you have, the ease that it can be set up elsewhere (mobile type franchises have an advantage here) and how strategic your site is to your business. If the premises are crucial and they are destroyed, having a higher level of cover is more important than if the business can be relocated with relative ease.
Premises
If a franchise operates from premises and those premises are destroyed or become inaccessible, the franchisee’s business may be prejudiced in circumstances where the franchise has been granted for that site only. The franchisor may have a right to cancel that franchise. In addition, if the premises are leased and are no longer able to be used for trading purposes, a business owner will normally want to act in haste to find an alternative site. This can raise issues and questions that are difficult to answer. Such questions include:
- What is the status of my existing lease?
- How can I sign a lease for new premises if my old lease is not necessarily at an end?
- What do I do when the premises I operate from are fine but there is a cordon in place stopping me from accessing them?
If anyone faces such issues, they should seek legal advice as to whether they have a right to cancel their lease or not. In some circumstances there may be an argument that a lease has been frustrated and this may allow the owner to bring the terms of the lease to an end. Such issues were at the forefront of business owners’ minds in Christchurch in light of the damage to buildings caused by the earthquake and the cordons which remain in place in parts of the city months after the actual quake.
Disaster Plan
In conclusion, the alternative to having a robust and comprehensive disaster plan to deal with issues that may arise in a time of crisis, is to risk total business failure. At the very least, not having such a plan will provide a real advantage to competitors in the market place who have taken steps to prepare themselves for unexpected eventualities that may arise. Business owners need a plan that will enable them to reconstitute as soon as possible. It is also essential to ensure that your business can and does communicate with customers as soon as the doors are again open for business. Surrounding yourself with the right types of support mechanisms will help, and franchise systems that are properly run will no doubt provide great assistance in these scenarios.
October 2010 - Five important questions to ask your Franchisor before you sign anything
The following article was written by Mark Sherry and first published in Business Franchise New Zealand magazine (Vol 01 Issue 03).
1 Do you have a disclosure document?
Reputable franchisors take a lot of time setting up their franchise systems. One of the most important documents that a franchisor can provide is a disclosure document. A disclosure document is a document that explains in layman’s terms the most important aspects of the franchise system. The sorts of questions that a disclosure document might answer include:
- the payments that must be made by a franchisee
- the expectations a franchisor may have of a franchisee
- what ongoing assistance a franchisor will deliver
- the background of the franchise system
- how many franchises are in operation already
- the franchisor's financial details
- what plant and equipment will be required to run the business along with the approximate costs of such items
In New Zealand a disclosure document is not compulsory for many franchise systems. However, if a franchisor has voluntarily become a member of the Franchise Association of New Zealand then a disclosure document is mandatory. That is because best practice suggests that a disclosure document should be provided to prospective franchisees.
2 Can I speak to existing franchisees?
A disclosure document only tells a buyer so much about a franchise system and there are a lot of intangibles within a franchise system that cannot be stated within a disclosure document. One of the best ways to assess the effectiveness of a franchise system is to talk to existing franchisees. From discussions with existing franchisees a person will soon be able to establish whether a franchisor is providing the services that it is obliged to under the franchise agreement and whether the franchise system runs smoothly or has issues.
Every franchisor will potentially have favourite franchisees that they may try to convince a purchaser to contact. It is highly preferable to contact as many franchisees as possible to try and establish just how widely the levels of satisfaction with the franchisor run and to see whether some franchisees are content with the system while others have gripes. One of the indicators of a good franchise system is that a franchisor is responsive to issues when they arise. If a franchisor only allows a buyer to speak with one or two specified franchisees then this should certainly raise an antenna for prospective franchisees.
3 What are your expectations of me as a franchisee?
Every franchise system has expectations of behaviours that franchisees must adhere to. Ideally, when a franchisor is asked this question the response will be very detailed and the franchisor should be quite animated. The response may even lead the prospective franchisee to question whether they can meet the expectations. This is because one of the main signs of a well run franchise system is that franchisors have high expectations of franchisees and they want to ensure that they comply with the terms of the franchise agreement and the franchise manual. It is a good sign when a franchisor has high expectations as it means that not only will they ensure that you as a franchisee behave properly but that other franchisees within the system also must comply with their obligations so as to ensure a strong brand.
The alternative to a franchisor that cares about their brand and their franchisee’s behaviour is a franchisor who is not that interested in the way that a franchisee behaves once the franchise agreement has been signed and the initial franchise fee has been paid. Where a franchisor relies on the self motivation of franchisees for the growth of a business and will tolerate mediocre behaviour and performances by franchisees without having minimum key performance indicators in place then a buyer should question the system they are looking to buy into. If a buyer is looking to enter a high performing franchise system they need to look for franchisors that keep their fingers on the pulse and have systems in place to foster productivity and service.
4 What will be my costs under your franchise system?
This question can be difficult for a franchisor to answer. It depends on the way the financial aspects of the franchise system have been set up. Where a new franchise is being purchased then invariably costs will include an initial franchisee fee. There will also normally be plant and equipment purchases and in some cases the cost of premises rental and fitout costs. Where an existing franchise is being purchased then there would not normally be an initial franchise fee but instead there would be the price paid for the existing franchisee’s business. This will no doubt include a goodwill payment for the outgoing franchisee. Generally however the initial payment to get into the franchise is just one payment consideration for a franchisee. In many cases franchisees focus too much on the initial costs and not enough on the ongoing costs of belonging to the franchise system. Most franchise systems have ongoing royalties based on turnover and many have items of stock and/or plant which must be purchased through the franchisor that contain a franchisor’s mark-up. Also, there are often contributions to franchise system advertising which are based on turnover.
It is important to take professional advice when assessing the costs of a system and most specialist franchise accountants will be able to complete projected accounts and cash flow statements for a business that factor in all the payments that need to be made in the course of running the business. At the same time the lawyer involved will advise on contingent liabilities and payments that might have to be made if the franchise business fails. Such payments might include ongoing payments under the franchise agreement, ongoing obligations on the lease arrangements and obligations to repay banks and other lending institutions for money being borrowed. It is very wise to look beyond the initial advertised purchase price as the costs involved go well beyond the scope of those.
5 How do I exit my business?
This is a question that many people fail to ask themselves at the time of purchasing the franchise as it can be forgotten in the excitement and stress involved in sorting out all the purchase related issues. However, many people enter into start-up businesses with a view to building them up and selling them on for a profit. Others that have a long term perspective may face changes in circumstance due to things such as health or family issues that cause them to have to sell. When selling the franchise it is not simply a matter of engaging a business broker to list the business on the market and selling it to the purchaser that offers the highest price. Most franchise systems require prospective franchisees to be vetted by the franchisor and the fact that a purchaser has the money to pay the asking price does not mean they fit with the vision that a franchisor has of the appropriate franchisee. The franchisor will look at matters such as industry experience, personality types, financial stability and many other factors. Therefore, the prospective purchaser will need to jump through hoops with the franchisor. They may also, where a business occupies premises, have to jump through similar hoops with the landlord.
Once a purchaser has been found, the franchise agreement may still impose significant obligations on the existing franchisee. There may be obligations to train the incoming franchisee. There may be payments to be made by an outgoing franchisee as a transfer fee to the franchisor. Some franchise systems even require the franchisee to pay a proportion of the sale price to the franchisor in recognition of the fact that part of the goodwill of the business is due to the branding and efforts of the franchisor.
In limited life franchise systems (e.g. a system that may run for an initial term of five years with a right of renewal for a further five years) a franchisee needs to confirm what it is that they are selling to a prospective buyer. Some franchise systems effectively allow an outgoing franchisee to sell a whole new franchise by restarting the time frames for an incoming franchisee whereas other systems only allow a franchisee to sell the equivalent of the remaining years in their franchise system. In the latter case, the shorter the time remaining until the franchise expires then the less the sale price will be. Many franchise agreements are silent on how this issue is treated and it is very important to try and get some agreed parameters around it at the outset. It would be fair to say that the more one pays to enter a franchise the more one would be seeking to be able to exit the franchise and recoup initial investments and goodwill. Where small purchase prices are paid to enter franchise systems then ability to be able to sell a full franchise term becomes less of an issue.
It is always important to remember that when you are in doubt about any issue you should take advice from appropriately qualified franchise advisors before signing anything.
July 2010 - Franchising "Lingo" - what does it really mean?
The following articles were written by Mark Sherry and first published in Business Franchise New Zealand magazine (Vol 1 Issues 01 and 02 respectively):
When someone purchases a franchise it can be a very confusing time. Often it is the first time that they will be self employed and have had contact with a lawyer for business matters.
Starting a franchise business can be a huge learning curve as it involves meetings with lawyers, accountants, the franchisor, potential landlords and bankers. During that period you need to take in information relating to leases, the franchise system, employer responsibilities and a myriad of other issues as well as understanding the risk you are taking on. It is an exciting but stressful period and it can be made all the more difficult by the fact that many of the documents and terms within those documents are foreign to you. One of the most important documents is the Franchise Agreement (agreement) that you will have to enter into. This is the legal agreement that sets out all the rights and obligations you will have and it will be full of jargon and defined terms that you will need to familiarise yourself with very quickly. Hopefully this article will help de-mystify the meaning behind commonly used terms.
Scattered throughout a franchise agreement are the terms franchisor and franchisee. The franchisor is the person that has established the franchise and is selling rights to use it. The franchisee is you - the person who has bought the rights to use the franchise system for a limited period of time. Generally the first part of an agreement sets out the names of the parties signing it. These names will include the franchisor and the franchisee but they may also include the details of a guarantor, especially where the franchisee is a company. A guarantor is generally the individual or individuals behind a company and they sign the agreement in their personal capacity guaranteeing the obligations of their company as franchisee. If, for any reason their company fails, then they will be personally required to make good any losses that the franchisor faces.
The franchise fees payable to the franchisor are amongst the most important things for many franchisees. If a franchisee is to be the initial franchisee for a franchise being established in a certain area, then there is normally an initial franchise fee. This is a payment to the franchisor for the right to have a franchise. However, where a franchise is being purchased from an existing franchisee, then often the incoming franchisee pays a purchase price to the outgoing franchisee for their business and no initial fee is payable. Where an existing franchisee sells their business, this is referred to as an assignment. Generally, a franchisee will only have the right to do this in consultation with the franchisor and if they have complied with all the terms of the agreement. In the case of an assignment many agreements do provide that the outgoing franchisee must pay a portion of the sale price received by it to the franchisor.
A franchisee that is new to the franchise system will often have to pay a training fee to the franchisor for compulsory courses and training that must be undertaken. Sometimes, however, this can be avoided if “on the job” training is provided by an outgoing franchisee. This would only happen if the franchisor is confident that this level of training would suffice.
Ongoing royalties will generally be payable by a franchisee to a franchisor. Such payments can be calculated in many different ways, with the most common way being a percentage of the turnover of the franchisee’s business. However, in a franchise system where the franchisor provides the products being sold by a franchisee, these fees are often paid to the franchisor by way of an additional margin added to the costs of goods supplied.
In addition to franchise fees, it is very common for the franchisor to charge a marketing levy or advertising levy to franchisees. This is generally also calculated on the turnover of the franchisee’s business, although sometimes it is a fixed annual amount. The agreement normally dictates how the advertising levy can be used by the franchisor, and it is generally kept in a separate account to pay for the advertising and marketing of the franchise system only.
As alluded to above, an agreement normally only runs for a certain period of time. This is called a term. Many agreements give the franchisee a right of renewal to a further term. This means that the franchisee, if they have complied with all their obligations under the agreement during the initial period, will have a right to renew the agreement for a further period. Often, a renewal fee will be payable by a franchisee if it exercises its right of renewal. Many reputable systems only have renewal fees that are sufficient to cover the actual costs incurred by a franchisor when granting the renewal but some systems charge a significant fee often similar to the level of the initial franchise fee.
Many agreements give the franchisee a right to run their franchise within a territory. The agreement will define how the territory is made up and, in many cases, this is done by attaching a map to the agreement. An exclusive territory gives a franchisee the sole right to operate a franchise within that territory, whereas a non-exclusive territory allows a franchisee a right to operate a franchise within the territory but gives the franchisor the right to allow other franchisees to operate within that territory also.
The reason an agreement contains so many restrictions and conditions that the franchisee must comply with is so that the franchisor protects its intellectual property. Intellectual property describes the branding, trade secrets, patents, trademarks and ideas that the franchisor owns and has developed over time. This represents a large part of the value of the franchise system. A franchisee is authorised by the agreement to use that intellectual property, but only in such a way that protects it and does not abuse it, as the intellectual property is the prime asset that the franchisor owns. One of the main pieces of intellectual property that a franchisor has is an operations manual. The manual details a lot of the day to day procedures that must be followed by franchisees and will also provide detail on issues such as store setups, sign writing, vehicle requirements, technology requirements and the like. These are matters which are of extreme importance within the franchise system but are at a more operational level than a strategic level. Often, a franchisor reserves an absolute right to change the terms of the manual at any time and a franchisee would then have to observe such changes.
If a franchisee fails to comply with the agreement, this is referred to as a breach or a default. The consequences of breaches will depend on the severity of them. A minor breach may bring about a verbal or written warning with a requirement to rectify matters whilst a more severe breach could involve the charging of penalty interest or even cancellation of the agreement.
Where a breach is challenged or where some other form of dispute arises between the franchisor and franchisee, then this will invoke the dispute resolution procedure. Many agreements set out detailed processes to be followed in the event of a dispute. Often, there will be a requirement to try and resolve matters privately in the first instance, but where that fails the parties can then refer it to mediation, which is a process where the parties meet with a facilitator in an attempt to reach a negotiated settlement of matters. Where that process is unsuccessful, the dispute may then be referred either to arbitration which is a process where the parties agree on an arbitrator (often an expert in the area where the dispute has occurred) to resolve the issue after hearing arguments from both sides. An alternative to arbitration is litigation where the parties would refer to the matter to the Courts where it will be decided by a Judge.
Many reputable franchise systems have voluntarily signed up to the Franchise Association of New Zealand (FANZ). Members of FANZ must subscribe to a detailed disputes resolution procedure which is fair to both parties and where the parties will genuinely attempt to resolve any dispute in good faith. Members of FANZ are also required to have a cooling off period in their agreements. This enables a new franchisee to cancel the Franchise agreement for any reason within 7 days of signing it. In those circumstances, they would normally receive most of the money they have paid back, except for an amount which would cover an administration fee incurred by the franchisor. A cooling off period is designed to stop franchisees being coerced into a system and then later regretting their decision.
Finally, as many franchise systems get larger, individual franchisees can feel that they do not have a voice or way of dealing with issues that may arise within the system. Often it is the case where one franchisee is facing an issue in a certain area that other franchisees will be facing that same issue too. Therefore, many reputable franchise systems provide for a franchisee committee or franchise council where all of the franchisees in the system get to elect some members to a committee that will be their voice with the franchisor. This committee would raise concerns that franchisees have and would also put forward new ideas that franchises may have that would enhance the franchise system.
Every franchise system has different ways of doing things and every agreement will be different. Prospective franchisees need to take the time to understand the obligations that they are taking on when entering into an agreement even if they have been franchisees in other franchise systems before, as rights and obligations will differ markedly between franchise agreements. A franchisee should note that when a franchise is being renewed at the end of its term, the franchisor may have the right to substitute the agreement with its then current version of the franchise agreement. Therefore, rights and obligations can change if the franchise agreement has been updated. A franchisee should always take professional advice from a knowledgeable franchise lawyer prior to signing the agreement.
April 2010 - The Franchise Territory - what does it mean?
When a prospective franchisee is looking at purchasing a franchise operation, they are buying various rights. These include the intellectual property behind the franchise system, the support of the franchisor on an ongoing basis to assist in a successful business and, more often that not, the right to sell the goods or services that are the subject of the franchise within a specified territory.
Just what may define a territory differs from franchise system to franchise system. Territories come in many shapes, sizes and styles. The most common of these are set out as follows:
Exclusive territories
When a franchise is being sold with an exclusive territory this means that the franchise agreement will contain details of an exclusive area in which the franchisor will not set up another franchise to compete with the franchisee that holds that territory. In many cases a map is attached to the franchise agreement to highlight the exclusive area of the franchisee. Depending on the type of franchise this could be anywhere from a specific address or premises, such as a certain shopping mall or defined suburbs, through to cities or even wider geographical areas. The theory behind such territories is that a franchisee can establish their business without the threat of someone else within the same franchise system setting up in competition with them. Of course, this does not prohibit competitors from outside the franchise system competing with their business.
Non exclusive territories
Non exclusive territories often define the area that franchisees are allowed to trade within, but they allow the franchisor to sell franchises to other prospective franchisees within that territory also. Such systems effectively allow franchisees to sell their products or services within that territory but they have restrictions on them trading outside of it. The freedom of the franchisor to sell other franchises within that area is retained in the belief over time that the territory could sustain an increase in the number of franchisees. The franchisor reserves the right to sell additional franchises at the appropriate times.
In such circumstances the franchisee must trust the franchisor not to over-saturate the market with franchises so that their franchise business will become diluted to the extent that it does not provide an appropriate return. An astute franchisor will not over-saturate the market because such action will lead to dissatisfied franchisees, which in turn leads to major disputes within the franchise system. Disharmony in a franchise system causes a loss of focus for all concerned and can lead to a loss in profitability.
A prospective franchisee needs to be wary of a franchisor that is looking for a quick profit by way of the sale of new franchises into non exclusive territories, especially if that market already has a number of participants. Meeting as many existing franchisees as possible and discussing the system with them is advisable to ensure that not only are they comfortable with the franchise system generally but that they are comfortable that the market can sustain another franchisee. The better franchisors focus on earning income through the operation of the franchise and the royalties generated through franchisee sales rather than cannabalising franchise territories by selling new franchises into them for an upfront fee, when the addition of a new franchisee will not increase the level of franchisee sales at all.
Changes to territories
Many franchise agreements, even those that provide for exclusive territories, give the franchisor the right to change the territory or alternatively start up a new franchise within the territory should circumstances arise that will allow the territory to sustain another franchise operation. Such circumstances may include a change of demographics within the franchise territory or a development in the technology used by the franchise system that makes it a market leader and in turn results in a much greater demand for the product or service being offered within the franchise system. It is not uncommon to see a right given to the franchisee which requires the franchisor to offer the franchisee the first right of refusal to purchase the new franchise operation commencing within the territory. That way the franchisee would have the opportunity to expand its business and keep the territory exclusively for itself. In successful franchise systems franchisees often tend to exercise such rights when expansion opportunities come along, and where franchisees take the opportunity to invest further in a system this can often be taken as a strong sign of a successful and well run franchise.
Franchisors often also reserve the right to sell a new franchise into a franchisee’s territory where the franchisee is under performing or failing to meet preset minimum key performance indicators. This is understandable from a franchisor’s perspective as it cannot afford to have what could otherwise be a high performing territory failing to produce appropriate levels of income because of the lack of franchisee achievement. In such circumstances a franchisee would normally have received feedback and warnings from a franchisor that it’s performance is not up to the required standard. It should also have been given training, assistance and/or advice from the franchisor to try to turn the direction of the business around and it will be aware that the introduction of a new franchisee to the territory is one of a number of possible consequences that may be faced if performance does not improve.
Types of territories
When people think of territories they tend to think of geographical areas. In the majority of cases that is how territories are derived. However, depending on the type of franchise system and how business is attracted, territories can be split up using a variety of methods. A good example of this is where business is derived via the telephone, for example pizza franchises that provide home delivery. In such cases territories may literally be divided up between franchisees by allocating different telephone exchanges between them, with calls routed through the different telephone exchanges going directly to the franchisee concerned.
Problems with territories
One of the major problems that can occur with exclusive territories is when a franchisee attracts business from outside of its allocated territory. Some franchise agreements recognise that this may occur and they attempt to deal with this issue in advance. Solutions range from an absolute prohibition on trading with a customer from outside the territory, to allowing such a transaction to occur but requiring the franchisee to make a payment to the franchisee of the territory that the customer came from.
Such problems often occur in franchise systems where there is a service being offered to customers on a mobile basis, for example gardening and lawn mowing services where a franchisee receives a referral and attracts business from outside of its agreed territory. The problem can also arise when a franchisee has an existing client within its territory and that customer moves premises outside of the territory but wishes to continue using the services of their existing provider rather than contracting the franchisee for the territory that they have moved to.
A good franchise agreement will have clear guidelines to deal with such issues and rules dealing with the allocation of work. It is not uncommon to see a provision in franchise agreements where customers contact a franchise system through a toll free number so that the work is always referred to the franchisee that has control of the territory, but they can be referred to other franchisees if the franchisee for the territory is too busy to meet the service guidelines of the franchise or that particular customers requirements. Such situations must be clearly defined and consistently adhered to so as to avoid disputes between franchisees.
In scenarios where issues can arise between neighbouring territories there are often strict controls on how advertising can be carried out so that one franchisee is not seen to be attempting to attract business from the territory of another franchisee. There are often controls on whether an individual franchisee can have its own website. It is more normal for there to be one website for the whole franchise system that is controlled by the franchisor.
Issues have also arisen with the recent growth of internet sales. This has caused disputes within franchise systems as this source of sales has opened up opportunities for franchisors that may not have been originally contemplated. Whilst many franchise agreements may provide an exclusive geographical or other type of territory for a franchisee, older franchise agreements may never have even contemplated online sales. Many franchise agreements that do provide for online sales actually reserve the right for the franchisor to sell products or services online. An ideal scenario from a franchisee’s perspective would be for some type of payment to be made to the franchisee of a territory if the franchisor makes a sale by internet to a potential customer within that territory. This however can be difficult for a franchisee to monitor.
The writer has recently been involved in a franchise system that was able to revolutionise the way a service was delivered through the use of the internet but, unfortunately for the franchisees, the delivery of online seminars and advice to customers by the franchisor caused the loss of a significant revenue stream for them, which affected the viability of their businesses. The franchise agreement allowed the franchisor to use the internet, but as the agreement had been prepared ten years ago, the use of the internet by the franchisor in the manner that caused the issue had not been contemplated by any of the parties as it was only the recent expansion of broadband capability throughout New Zealand that enabled them to offer the online services that saw the franchisor competing with its franchisees. Whilst many franchise agreements contain a disputes resolution procedure, it relies on the goodwill of the parties concerned to try and reach an amicable solution. There is currently no general duty in New Zealand for franchisors and franchisees to act in good faith towards each other so such disputes often result in one party being detrimentally affected whilst the other receives a windfall.
Summary
Every franchise agreement is different, and the rights and privileges obtained under the agreement will differ in each case too. It is extremely important to minimise unpleasant surprises and to properly understand exactly what rights a prospective franchisee is purchasing when buying into a franchise system, including knowing the issues surrounding the territory being purchased. Taking advice from a specialist franchise lawyer and liaising with as many existing franchisees as possible are the best ways to understand your rights and to gauge the robustness of the franchise system and the behaviours of the franchisor. They will also give you an indication of the general satisfaction of franchisees with the franchise system. Remember though that having an exclusive territory does not prevent the franchisee from facing competition from any person in the same line of business who is not part of the franchise system.
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