02
May

Buying a Franchise? Read This First.

buying a franchiseTo a middle manager in corporate America, owning one’s own business can appear very attractive. Often, buying a franchise business is a more attractive option than simply starting your own business from scratch. A franchise is a form of business that already has an established product or service in which the owner (the “franchisor”) enters into a contract with another, separately-owned business (the “franchisee”), which operates the business within a certain defined territory or from a specific location.

A good franchisor has invested a great deal of time and money developing a proven operating system for its particular type of business. Franchisors often provide detailed policy and procedure manuals that address many of the day-to-day problems associated with owning a business. Moreover, franchisors often (and should) provide training in these policies and procedures, enabling the franchise owner to quickly get up to speed on business operations and the actual processes by which the franchise and franchisee will conduct day-to-day operations.

In addition to a proven business operating system, many franchisors have developed strong trademarks and service marks, such as business names, catch phrases, and logos that are associated with their businesses and that are recognizable in the marketplace. These marks are the embodiment of the franchisor’s goodwill and name recognition in the given field of operations, and the franchisee is intended to acquire the benefits of the franchisor’s branding investment and efforts. In the franchise agreement, the franchisor licenses these trademarks and other intellectual property to its franchisees, allowing franchisees to use these recognizable names or phrases in their own businesses – imparting to them immediate name recognition and legitimacy.

Investigating the Franchise Opportunity

The franchisee is often making a very significant investment in his or her franchise. That investment should not be made without a thorough investigation of the franchisor and an understanding of the strength or weakness of the particular franchise opportunity. A weak franchise – one in which the trademarks are not particularly strong or well-known, or in which the franchisor does not have adequate financial resources to support its franchisees – can be a very poor investment.

Every franchisor must provide a prospective franchisee with a franchise disclosure document (the “FDD”). The contents of the FDD are to a high degree dictated by the federal franchise regulations and it is a rich source of information – and potential questions – about the franchisor and the strength (or weakness) of the franchise. The FDD and its associated tables, charts and appendices can tell the prospective franchisee a great deal about the background and financial strength of the franchisor. The prospective franchisee MUST read the FDD and should seek a lawyer’s assistance with anything in the FDD that he or she does not understand.

The FDD always contains the identity and contact information of other franchisees in the system. The prospective franchisee should contact several current and former franchisees, who are in the best position to provide inside knowledge about the pros and cons of the system. Questions should include the following:

  • Were the franchisor’s estimate of the working capital requirements to get up to speed accurate?
  • In addition to the franchise fee rendered as part of the franchise agreement, are there any other ongoing service fees or other fees payable to the franchisor?
  • Did the franchisor provide adequate training in the business system?
  • Were the operations manuals helpful and easy to follow?
  • Did the franchisor provide meaningful ongoing assistance in getting the franchisee’s business or site up and running?
  • Do the franchisees think that the system added value that would not be available to a similar business operating outside a franchise system?

Finally, because much of the value of a franchise is associated with the strength of the franchisor’s trademarks and other intellectual property, the prospective franchisee or his or her attorney should conduct a search on the US Patent and Trademark Office website to confirm that the franchisor’s trademarks are properly registered. If the franchise is not particularly well-known or well-established, an attorney can (and should) analyze the strength or weakness of a franchisor’s trademarks and discuss those strengths or weaknesses with the potential franchisee.

The Legal Relationship Between Franchisee & Franchisor: The Franchise Agreement.

Franchisors regularly tell prospective franchisees that the franchise agreement is non-negotiable. Even if that is true, it is still important for the prospective franchisee to understand what is contained in the agreement, and it is up to his or her lawyer to interpret and explain to the prospective franchisee in plain English the more complex provisions of the document.

Of course, in many cases, the franchise agreement is negotiable, or at least significant portions of it are negotiable. As with most any contract, the degree to which the franchise agreement is negotiable is related to the relative bargaining power of the parties involved. A general rule of thumb is that the more well-known and well-established the franchise, the less likely the franchisor will be willing to make any changes to the franchise agreement.

With the exception of the very strongest franchises (e.g., McDonald’s, Domino’s Pizza, 7-Eleven), there are certain provisions in the franchise agreement that an experienced attorney should be able to negotiate so that they are more franchisee-friendly.

Notice Provisions. There are many places in a franchise agreement where the franchisor has the right to exercise certain remedies upon a default by the franchisee. The franchisee’s attorney can usually insert provisions requiring advance notice and an opportunity to cure such defaults before the franchisor may exercise its remedies.

Limiting the Franchisor’s Discretion. Franchise agreements often contain provisions requiring a franchisee to obtain the franchisor’s consent to do certain things. The attorney for the franchisee should try to ensure that the franchisor does not have absolute, unfettered discretion to deny its consent when giving such consent would be reasonable based upon verifiable facts.

Trademark Protections. As discussed above, much of the value in the franchise system is attributed to the trademarks that the franchisor licenses to the franchisee. The franchisor should be willing to stand behind its trademarks and defend them in the event they are challenged by third parties. Consequently, the franchisor should be willing to indemnify the franchisee in the event the franchisee is sued on the basis of trademark infringement.

Adjoining Territories. Sometimes the franchisor is willing to grant a strong (generally that means well-financed) franchisee a right of first refusal to purchase the territories that are contiguous with his or her own and which have not yet been assigned to other franchisees. The franchisee’s attorney might even be able to negotiate a reduced price for such additional territories.

Indemnification Provisions. Franchise agreements sometimes contain unreasonable indemnification provisions. It certainly makes sense for the franchisee to indemnify the franchisor for losses or damages that the franchisor suffers as a direct result of the wrongful acts of the franchisee or its employees. But often the indemnification provisions are written much more broadly to favor the franchisor and the franchisee’s attorney should make every effort to cut back such unreasonable indemnification rights.

Advertising Requirements. A franchisee may want to request that the franchisor loosen the requirements that the franchisee spend a certain dollar amount or percent of gross sales on advertising, particularly during the first several months of operation. Some franchisors will lower these requirements during the first six months to a year, in recognition that revenue is usually very tight during the start-up stage of the business.

Forum Selection and Governing Law Clauses. Although it will rarely come to pass, the franchisee should also request that the judicial or arbitration forum for future disputes concerning the operation of the franchise or the meaning and construction of the franchise agreement be in the franchisee’s location and governed by the franchisee’s local law. Owning a franchise in Florida, while having to manage a dispute with the franchisor in Washington state, places a potentially significant burden on the franchisee to inexpensively and expeditiously resolve disputes with the franchisor.

Sale of the Franchise. All franchise agreements set conditions on a franchisee’s ability to sell or transfer the franchise. These provisions are sometimes negotiable with respect to the assignment of the franchise to family members and with respect to the franchisor’s ability to exercise a right of first refusal. Since most franchise agreements have a term of 10 to 20 years (during which the franchisee develops its own goodwill, reputation and business), it is imperative that the franchisee understands the restrictions on his or her ability to sell the franchise.

Conclusion.

Buying a franchise can be a very rewarding decision. It can also be an unmitigated disaster if the prospective franchisee does not understand what he or she is getting into. An experienced attorney can guide his or her client in the investigation of the franchise and can usually negotiate more franchisee-friendly terms in the franchise agreement. Whether the franchisee fails or succeeds will depend upon a variety of factors, but with good legal representation going into the deal, the franchisee will at least be cognizant of the legal and business risks and of her own contractual rights and responsibilities. The attorneys at Wetherington Hamilton have experience representing franchisees in many different industries, from lawn care to sandwiches. We stand ready to help. Please contact the author for more information.

Matthew J. Lapointe, Esq.

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