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May, 01 2007

Franchise Agreements

As franchising is fundamentally governed by the terms agreed between the parties, the franchise agreement is the cornerstone of the franchise relationship.

As franchising is fundamentally governed by the terms agreed between the parties, the franchise agreement is the cornerstone of the franchise relationship. The franchise agreement describes the legal relationship between the franchisor and the franchisee and sets out their respective rights and obligations. It contains information relating to the establishment and identification of the franchisor's proprietary interests, nature and extent of the rights provided by the franchisor and the obligations of the franchisee.

A standard franchise agreement is the disclosure document of choice for a majority of franchisors. It is also enormously useful for prospective franchisees as an introduction to a franchise system and should be used as the foundation for inquiries into the system.

It is important to carefully review and understand it before buying a franchise. Depending on the individual franchisor, there are different terms and conditions, but a franchisee should pay attention to the following key elements.

The franchisor- its predecessor and affiliates:

Information about the franchisor, any predecessor and its affiliates, disclosure includes: a description of the business of the franchisor, its predecessors and affiliates; the business to be operated by the franchisees and the general market for products or services offered by franchisees.

Keep in mind that investing in a brand new or inexperienced franchisor may be a greater risk than investing in an established and successful franchise.

Business experience

Information about the past work experience of all executives of the franchise system (i.e. officers, trustees, directors and managers) including their main occupations and past employers.

Consider the executives experience in managing a franchise system as well as their business experience. Also find out for how long these individuals have been with the franchisor. Conduct a study of the franchisor's track records. Interview or visit previous franchisees and determine their level of success.

Litigation

In this clause the disclosure of prior or present litigation of the franchisor and anyone affiliated with the company.i.e. predecessors, executives and franchise brokers is included.

If you find number of actions, particularly if franchisees have sued the franchisor, be sure to bring this matter to your lawyer's attention for investigation.

Bankruptcy

Knowledge of any bankruptcy issues will assist in your assessment of the franchisor's financial stability and strength. You should invest in a franchise that is financially sound and able to deliver the contracted support services.

Initial franchise fee

Franchisees are required to pay an initial franchise fee that grants them the right to use the franchisor's trademark and operating system. Be aware that certain initial fees may be non-refundable.

Other fees

Understand information on other fees that are paid to the franchisor, i.e. ongoing royalty payments and advertising fees. Since you contribute a percentage of your business income to advertising, find out just how and on what these funds will be used. You should be sure that your franchise and territory would benefit. Most franchisors require franchisees to pay an ongoing royalty, usually 4 to 8 per cent of total sales, typically on a monthly basis.

Initial investment

This clause summarizes the franchisor's estimate of the typical investment costs of establishing a new franchise in their system. This key information is enormously helpful to you and your accountant in preparing your business plan or obtaining financing. Be sure to note that this is an estimate of typical investment costs; there may be other undisclosed costs, so read between the lines.

Talk to current franchisees and compare your estimates with their actual initial costs. Also speak with franchisees of competing companies; you may be able to get a better deal with a competing franchisor.

Products and services restrictions

This clause lets you know if you are required to buy or lease products or services from the franchisor or other designated authorized suppliers and provides details of the specific restrictions imposed.

Supply arrangements are a key aspect of running a successful franchise, so review this section carefully. If it looks like a significant portion of the franchisor's revenue comes from franchisee purchases and the franchisor's profit is your unfortunate loss, find out from current franchisees if products are priced fairly and delivered efficiently.

Franchisee's obligations

The franchisee's obligations are in different categories. These include: site selection and acquisition, initial training, opening, compliance with system standards, territorial development, insurance, records and reports and dispute resolution.

Financing

Describes any financing offered to the franchisee by the franchisor or affiliated third party. A small number of sophisticated franchisors do offer in-house financing. A larger percentage has special arrangements for franchisee financing with particular banks or other financial institutions. Study franchisor's financial status and viability, find out the extent or level of support that the franchisor gives to the franchisee.

Franchisor's obligations

The franchisor's principal obligations under the franchise agreement includes a list of services the franchisor is to provide before and after the opening of the franchisee's business. It also includes detailed information on the franchisor's advertising programme, any required computer system or electronic cash registers, the operations manual, site selection criteria and procedures, the franchisor's training and assistance program and the contractual obligations.

Keep in mind that a key reason for investing in a franchise is the training and assistance provided. If you suspect the training is insufficient for your needs, you may consider another franchise opportunity.

Territory

This section lays out your territorial rights and restrictions. It includes disclosure on exclusive territory granted, whether or not the franchisor can open another franchise within your geographical area, conditions for relocating the franchise, and any sales targets imposed on franchisees. Be sure to understand what rights you have both inside and outside of any designated territory.

It is important to note that even the best territorial rights within a franchise system will not completely prevent competition in your territory. For example, a competing business could very well open up its doors right across the street.

Trademarks

This disclosure provides information on who owns the trademarks of the franchise, how each trademark is protected, and how the franchisee will be allowed to use the trademarks.

For each trademark, find out if it is registered or if registration is still pending. Any trademarks listed by the franchisor should be registered to insure your right to continue using them in the future.

Patents, copyrights and proprietary information

The franchisor must disclose in this section information about any patents, copyrights, confidential information, or trade secrets relating to the franchise.

Be sure to take the protection of intellectual property seriously. As a franchisee, you must do your part in ensuring that you do not violate any trusts placed in you.

Obligation to participate in franchise operation

This section provides information on whether or not the franchisee is required to personally participate in the operation of the franchise.

If the franchisee is not required to personally participate in the business operation, be sure to review the information and this should include training requirements and any restrictions the franchisor can place on the manager.

Franchisee sales restrictions

It describes the product line, and discloses any restrictions for other products or services you may be allowed to offer to your customers.

This type of control can diminish your ability to exercise your own business judgement; for example, as a restaurant franchise owner, you may not be able to delete menu items that are unpopular or add items that you feel would be popular.

Renewal or termination

These provisions deal with how the franchise can be renewed or terminated. Some franchisors have an arbitration clause in the franchise agreement, which means that if legal action on either side is warranted, an arbitrator will review the case instead of going to court.

Disclosure of the required conditions for renewal, termination, and transfer of the franchise also provides information on the approved methods for resolving conflicts and disputes with the franchisor.

Earnings claims

If this information is provided, read it carefully and share this information with your accountant for a clearer understanding. If the information is not provided, try to find out why, as it may in fact be that the actual earnings of franchisees are less than desirable. Whether or not the franchisor provides earnings information, be sure to ask existing franchisees about their sales and profits. And most importantly, examine the projected return on investment for the franchisees.

List of outlets

In this section the franchisor must disclose information on the number of franchise units; name, address and telephone numbers of all franchisees, number of new franchisees predicted for the upcoming year and the contact information of franchisees who have ceased to be franchisees. This should give you a sense of the direction of the franchise. Again, talk to as many current franchisees as you can.

Financial statements

Financial statements audited by an independent chartered accountant must be provided. These include: for the last three fiscal years- cash flow statements, statements of operations, and statements of stockholders equity and the profit and loss report of the franchisor.

These statements can be difficult to understand, so it is critically important to have your accountant review these financial statements in order to ascertain the financial strength or weakness of the franchisor.

To recap

Although it may be tempting for both franchisor and franchisee to rely on goodwill, ultimately it is only the contract that matters. Whatever the size or reputation of the franchisor, prospective franchisees should always expect a high-quality franchise agreement. As there is no standard format for a franchise agreement because the terms and conditions and operations vary from franchise to franchise and industry to industry, it must be tailored for specific and distinct requirements of each franchise system and if the franchisor has agreed upon something it should be in written and not in oral form.

This is in fact the crux of the matter. Like it or not, even the fairest of franchise agreements will contain clauses that could severely limit a franchisee's rights. Such clauses are not necessarily bad, but it is essential that you understand their meaning in legal terms. Remember, just because a franchise agreement is valuable to you doesn't mean you should sign it without question. Go over each and every provision carefully and be sure you understand why each section/clause has been included and how it will affect you. Make sure you understand all the stipulations in your agreement before sealing the deal.

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