What is a Franchise Agreement?
By Michael Seid, Managing Director, MSA Worldwide
A Franchise Agreement is a legal document that binds franchisor and franchisee together. This document explains what the franchisor (the licensor) expects from the franchise (the licensee) in running the business. The Franchise Agreement is designed to ensure that all of the franchisees within an organization are treated equitably.
However, while every franchise is a license, not every license is a franchise.
A. What turns a license into a franchise?
In the United States, this is governed by the definition established by the Federal Trade Commission (“The FTC Rule”) and by the various states that have adopted alternative definitions.
Under the FTC Rule, there are three general requirements for a license to be considered a franchise:
- The franchisee’s business is substantially associated with the franchisor's brand. In franchising, the franchisor and each of its franchisees are sharing a common brand.
- The franchisor exercises controls or provides significant assistance to the franchisee in how they use the franchisor's brand in conducting their business. Since the franchisee is an independent contractor and not a joint employer, generally those controls are over brand standards and do not extend to the human resources of the franchisee, nor do they extend to how the franchisee manages their business – subject to meeting the requirements of the brand standards – on a day-to-day basis.
- The franchisor receives from the franchisee a fee for the right to enter into the relationship and to operate their business using the franchisor’s trademarks. The fee can be an initial fee, or it may be a continuing fee in excess of $500 (adjusted annually) with certain exemptions provided under the law.
Several states have also passed laws defining “what is a franchise,” and those laws can capture into the definition of a franchise some relationships that do not meet the FTC Rule.
B. It's a formal and complex long-term business relationship.
It’s not a partnership, it's not a joint-venture or cooperative (although it could be), and it's not a joint-employer relationship (although it could be that also). It's a license that establishes the rights and obligations of the licensor and the licensee. Regardless of how the parties refer to the relationship, every franchise is governed by the terms of a contract (generally a written agreement) between the licensor (the franchisor) and a licensee (the franchisee), and that document is called a Franchise Agreement.
As in any well-crafted contract, the Franchise Agreement is designed to balance the needs of the franchisor to protect its intellectual property and ensure consistency in how each of its licensees operates under the brand.
- It needs to also ensure that even though the relationship is codified in a written agreement, meant to last sometimes more than 20 years (generally the agreement is ten years), that the franchisor has the ability to evolve the brand and its consumer offering over time.
- It needs to be flexible enough to allow the franchisor to modify the agreement so that when franchisees in different situations have specific needs, the agreement can reflect those decisions.
- It also needs to serve the needs of franchisees to manage their independently-owned businesses on a day-to-day basis governed by a requirement that they continually meet brand standards.
- It's long, detailed, and provided to prospective franchisees as an exhibit to the Franchise Disclosure Document (FDD) well in advance of the franchisee signing it, to ensure they have time to review the agreement and get advice from their lawyers and other advisors.
Franchising is about consistent, sustainable replication of a company’s brand promise and needs to detail the thousand and one business decisions that go into creating any franchise system. It’s complex and in most instances a contract of adhesion (meaning an agreement that is not readily subject to change). Because it is meant to reflect the uniqueness of each franchise offering and needs to also craft the dynamics of the intended franchise relationship, copying another franchise system’s agreements in developing any franchise system is likely the single biggest mistake new franchisors can make. Franchisors who choose to work with lawyers and franchise packaging firms that cut corners and copy others' documents put their franchise systems in peril.
Because of the length and complexity of a Franchise Agreement, most qualified lawyers will not attempt to roll into it all the agreements required by the relationship including personal guarantees, leases, and other requirements of the relationship, and instead have those contained in separate documents.
As with any well-written contract, the Franchise Agreement needs to deal with some basic elements including, but not limited to:
- An Overview of the Relationship. The parties to the contract, the ownership of the intellectual property, the overall obligations of the franchisee to operate their business to brand standards, etc.
- Duration of the Franchise Agreement. The term of the relationship, the franchisee’s successor rights to enter into new agreements, the requirement to upgrade the franchisee’s location, etc.
- Initial and Continuing Fees. Franchisees generally pay an initial and continuing fee to the franchisor for entering into the system and remaining a franchisee. There are also a host of other a la carte fees that are included in most agreements. Most franchise systems also provide for a payment to an Advertising or Brand Fund that is used by the franchisor to market the brand to the public and for other contractually defined purposes.
- Assigned Territory. Not every franchise agreement grants a franchisee an exclusive or even a protected territory, and how a territory is established must be defined. Franchisors also need to deal with reservation of their rights within a franchisee’s territory including alternative distribution sites, sales over the Internet, etc.
- Site Selection and Development. Franchisees generally find their own sites and develop them according to the franchisor’s standards. The role of the franchisor is generally to approve the location found by the franchisee and then approve, prior to opening, that the franchisee has built their location to meet design and other brand standards.
- Initial and Ongoing Training and Support. Franchisors generally provide a host of pre-opening and continuing support including training, field and headquarters support, supply chain, quality control, etc.
- Use of the Intellectual Property including Trademarks, Patents, Manuals. As the IP of every franchise system is its most valuable asset, some of which will change as the system evolves, the agreement defines what is licensed to the franchisee, how the franchisee can use the IP, and the rights of the franchisor to evolve the system through changes to the franchisor’s operating manual.
- Advertising. The franchisor will reveal its advertising commitment and what fees franchisees are required to pay towards those costs.
- Insurance Requirements. Franchise agreements will define the minimum insurance a franchisee is required to have prior to opening and during the term of the agreement.
- Record-Keeping and the Rights to Audit the Franchisee’s Records. The franchisor defines the records that it needs its franchisees to maintain in the agreement and in the operations manual, the software they are allowed to use, its rights to access that information including online through the internet, and its rights to audit that information from time to time.
- All the rest. Some may call it boilerplate, but in well-developed agreements it is not. Among the myriad other issues contained in the Franchise and other agreement are the franchisee's successor rights, default, termination, indemnification, dispute resolution, resale rights, transfer rights, rights of first refusal, sources of supply, local advertising requirements, governing law, general releases, personal guarantees, roll-up provisions, etc.
In developing a proper set of franchise agreements, each of the elements of the franchise need to be evaluated and decisions made. Prior to having the lawyers begin to draft the agreements, it is essential for the franchisor to first develop its business plan, with all the myriad of issues decided on. For most franchisors it is important that in addition to working with qualified franchise lawyers, they first work with experienced and qualified franchise consultants in crafting their franchise offering.