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Jan, 16 2010

Legal considerations while signing

The market outreach of McDonald’s or CCD is amazing. It is present in almost all the metros, tier one cities and moving on to tier two cities. The reason behind this market penetration is the franchise business model adopted by McDonald’s and CCD.

The market outreach of McDonald’s or CCD is amazing. It is present in almost all the metros, tier one cities and moving on to tier two cities. The reason behind this market penetration is the franchise business model adopted by McDonald’s and CCD. Franchising is fast catching up in India with more and more business houses adopting the model for expansion and it is increasingly being preferred over the distribution, agency and licensing methods as it helps the businesses to access the unexplored market at a lower-cost but with the same brand recognition.

For a franchisee, the right to use the brand name of the franchisor is an advantage as it provides swift market recognition. Franchising also helps franchisees in reaching economies of scale and in procuring goods from the franchisor at less than the market rates. The franchisee also gets help in advertising and benefits from the latest research and development undertaken by the franchisor.

Depending upon the nature of the business and the commercial understanding of the parties, different franchise business models are being adopted. The models that exist are basically classified on the basis of the ownership or functionality. On the basis of ownership, franchising is classified into:

  • Single Unit franchise where the franchisor provides to the franchisee the right of running a single unit
  • Area Development franchise, where the franchisor provides to the franchisee the right of developing franchisee in a specific area, and
  • Master franchise, where the franchisor provides to the franchisee the right to sub-franchise in a particular region.

On the basis of functionality, the franchise could be divided into:

  • Product Distribution franchise, where franchisee has to market the products manufactured by the franchisor
  • Business Format franchise, where franchisor agrees to provide the license to use its brand together with the business format, and
  • Affiliation franchise, where the franchisor enters into franchise with franchisees that are already operating in the same or similar business.

In India, the franchise is still being governed by the agreement executed between the franchisor and franchisee pursuant to entering into the franchise, since there is no specific legislation pertaining to franchisee. Therefore, it is of utmost importance, from legal point of view, both for the franchisor and franchisee, to clearly define the rights liabilities and other conditions governing their relationship. This is well documented in the franchisee agreement. Franchising in simple terms is essentially an agreement by which the franchisor provides license to use brand name, product, or system of a business to the franchisee in consideration of fees and/or royalties.

Since the franchise agreement is a contractual agreement entered into between the franchisor and franchisee, the agreement will be governed by the Indian Contract Act, 1872. Further, depending upon the various conditions governing the relationship between the franchisor and franchisee documented in the franchise agreement, the Trade Marks, 1999, other Intellectual Property Right legislations like Copyright Act, 1957, Patent Act, 1970 and Designs Act, 2000 may also come into application. Limited application of Sale of Goods Act, 1930, Transfer of Properties Act, 1882, the tax legislations need to be taken into consideration. In the event of the franchisor being a foreign entity, the Foreign Exchange Management Act, 1999, also comes into play. Implications of Specific Relief Act, 1963, Code of Civil Procedure, 1908 and Arbitration Act, 1996, need to be conceived for the purpose of the dispute resolution aspect, in case of difference of opinion between franchisor and the franchisee. With the advent of the Competition Act, 2002, the restrictive covenants provided for in the franchise agreement, will also come under the scrutiny of the Competition Commission of India.

Legal aspects to be kept in mind

The franchisors before venturing into franchising need to first register all the intellectual property held by them. This is important since a significant consideration involved in the franchise is licensing of the brand name and in most of the cases the technical know-how also. Franchisor should ideally do a brand valuation and determine whether their business model is ideal for franchise.

When entering into a franchise agreement the franchisor should take special care of confidentiality and/or non-compete clause. While the confidential information needs to be well-defined, the confidentiality clause also needs to be extended to the employees of the franchisee. Extra care needs to be taken if the franchise involves high-valued trade secrets. Non-compete clause needs to be incorporated in the franchise agreement to protect the rights of the franchisor. This restricts the franchisee from engaging in a similar or same business after the term or termination of the franchisee agreement, generally for a specific period of time. The non-compete clause needs to be conceived in such a way that, it could be well enforced in the courts of law.

The importance of exclusivity and restricting the franchisee from dealing in competitive products is an important aspect of the product distribution franchise model. In a affiliation model of franchising, the franchisee cannot be bound down by an exhaustive exclusivity clause, since most of the times the franchisee are effectively functioning in the same or similar business. When it comes to the business format franchising other than the exclusive dealing provision, the need of strapping provisions, that could bind the franchisee, its affiliates and  even its employees from  exploiting the technical know-how of the franchisor needs to be enshrined in the franchise agreement.

In the event of the location of the business being an important consideration, there should be clauses restricting the franchisee from re-locating the franchise or re-locating only to a specified area mentioned in the franchise agreement. In case of the service industry, the franchise needs to be in a prime location having easy accessibility and visibility. These commercial aspects also need to be made part of the franchise agreement. If the franchisee is geographically restricted, as in the Area Development franchise, the same needs to be specifically mentioned in the franchise agreement.

To protect the quality and good-will associated with its business the franchisor should include clauses in the franchise agreement stipulating quality standards, observing the code of customer grievances and other conditions which may cause material breach of the franchise agreement. Indemnity clause for the damage caused in the franchise agreement would also help protect the rights of the franchisor. The conditions leading to material breach of the contract needs to well defined in order to avoid unnecessary disputes on the premature termination of the franchise agreement.

The franchisee should conduct an independent due diligence of the franchisor to know whether their brand value is worth the fees and/or royalty being paid. Franchisees should avoid entering into ‘take it or leave it’ franchise agreements, since such agreements may have one sided clauses in favour of franchisor.

Franchisees should be careful of the licensing clause in the franchise agreement. The licensing clause, which provides for the right to use the trade mark of the franchisor, needs to stipulate the extent of the license. License to use the trade mark may vary from right of non-exclusive use, exclusive use limited to a geographical territory, and exclusive use. Franchisees should make sure that the licensing clause is in consonance with his business plan since the rights accrued by the licensing is the most important consideration flowing to the franchisee.

In the case of business format of franchise model, the obligation upon the franchisor to provide the technical know-how, training of the franchisee’s employees and other agreed assistance in operation of business needs to be reflected in the franchise agreement being entered into. Also, the party that shall bear the financial burden of training and other agreed assistance needs to be well defined in the agreement.

The term of the franchise agreement, also needs to be well defined. Generally franchise agreements have a clause which specifies the term of agreement as a very short time span, which could be extended based on the performance of the franchisee. But to balance the rights of the franchisee, it is also important to stipulate minimum performance on the basis of which the franchise agreement shall be renewed. Franchisees should be careful of the conditions relating to renewal of the franchise, such as; the maximum cap on the renewals may be stipulated in the franchise agreement.

The financial considerations that need to be paid to the franchisor as fee and/or royalty forms a standard part of the franchise agreement. The schedule of payment needs to be well defined and also needs to contemplate situations of market fluctuations depending upon the nature of the business. It is ideal to prescribe royalty payment on a progressive basis, as this provides enough room for the franchisee to establish the business. The existing Foreign Exchange Management Act, 1999 and other applicable laws need to be taken into consideration while stipulating the royalty obligations, in the case of franchisor being a foreign entity.

Another very important area is the rights provided to the franchisee to exit. The franchisee agreement should also include the rights of the franchisee to sell the franchise held by it. Franchise agreement may stipulate a preemptive right in favour of the franchisor, but the franchisee should ensure that such rights provided in the franchise agreement are in accordance with the business understanding.

Future growth of franchise

Growth options of franchise as a business model in India are immense. Businesses in the sectors such as food chains, bookstores, play schools, retail, educational ventures, and travel have adopted the franchise model in such a way that it has almost become an industry example. Many more sectors in which generic services are being dolled out, can use the franchise model. With the proposal of removing the cap on foreign remittance as royalty is in the pipeline, India is definitely a place for foreign business houses to explore franchise opportunity, especially in the retail sector in which multi-brand retailing is not allowed by FDI. Also, with the IPL franchise team model becoming popular, the franchise model is all set to capture the sports and entertainment sector.

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