LEGAL CONSIDERATIONS OF FRANCHISE AGREEMENTS

By Lee Shy Tsong

Senior Partner

Donaldson and Burkinshaw

 

There are many reasons that motivate a franchisor and franchisee to formalize their agreement with a Franchise contract. Benefits of a Franchise agreement are listed below.

  • Allows greater flexibility since parties are free to negotiate terms of the FA and determine scope of agreement
  • May attach ancillary documents, refer to the applicable legislation, provide for alternative dispute resolution through arbitration and mediation clause
  • Allows parties to frame relationship between franchisor, sub-franchisors and franchisees
  • Parties are at liberty to craft the contractual relationship as desired. E.g. Franchisor may choose to deal only with sub-franchisor and transfer certain risks associated with managing the franchisee to the sub-franchisor
  • Allows parties to make provisions for all contemplated circumstances
  • Provide for termination, or restrict/ impose conditions on transfer of interests or rights under the FA
  • No restriction on financial returns to be agreed from the franchising scheme
  • Allows parties to negotiate for the proportioned amount
  • Supplemental terms may be added through addenda, supplemental agreements and side letters
  • Protection of the know-how
  • Can include non-competition clauses or covenants not to compete. May not be entirely effective because of the general public interest for competition. Therefore these clauses will be limited in their scope and duration.

Why Franchisors and franchisees fight

By Hsien Naidu

Buying a franchise can provide you with instant customer recognition, a well-designed business model, marketing and operational support, and volume purchasing, but it can also bring you the potential for disputes with your franchisor.

The relatively high level of litigation in franchising has little to do with the people involved – in general, franchisors and franchisees are no more litigious than anyone else in business. Rather, the conflict emerges because the two parties make money in different ways.

Understanding these differences helps franchisors and franchisees avoid escalating disagreements to the level of litigation.

At its heart, franchising is a business arrangement in which one party (the franchisor) rents a business model and brand name to another party (the franchisee), who uses it to sell products or services to end users. The “rent” that the franchisee pays is usually calculated as a percentage of the his or her gross sales. That means franchisor profits increase with franchisee sales, leading franchisors to adopt policies to maximize sales at franchisee locations.

Franchisees, however, make money by generating revenues that exceed their costs. Therefore, they seek policies that maximize profits at their locations.

The policies that maximize outlet-level sales aren’t the ones that maximize outlet-level profits, causing conflict between franchisors and franchisees. A good example is the use of buy-one-get-one-free discounts, which are common in retail businesses. Done right, a buy-one-get-one-free discount will bring more customers to a retail outlet, boosting sales. That’s clearly beneficial to the franchisor whose earnings are linked to outlet-level sales.

But the discounting strategy might not boost the franchisee’s profits. If it doesn’t boost the size of the average customer purchase, the franchisee could be worse off. The buy-one-get-one-free promotion could raise the franchisee’s costs (by the amount of the free item) but not boost its revenues.

The conflict between the franchisor and franchisee is rooted in the economics of franchising, not in the two parties having “bad” attitudes. The franchisor wants the couponing strategy because it will make more money, while the franchisor doesn’t want it because it will not be made better off. If enough money is at stake, the end result could be a lawsuit between the two parties.

Disagreements over discounting strategies aren’t the only disputes driven by franchisor and franchisee goal divergence that result in litigation. A couple of years ago Burger King and its franchisees ended up in court over a disagreement about late night hours. Burger King wanted its franchisees to stay open late to sell more fast food to those seeking it at off hours.

To the franchisor, the strategy made perfect sense. If franchisees sold a few more burgers and fries to midnight diners, Burger King would bring in more royalties, which would boost its bottom line. But staying open late caused the franchisees to lose money. They had to pay employees for the additional hours even though their late-hour revenues were less than those wages.

The difference between maximizing sales and profits also leads causes franchisors and franchisees to fight about adding locations. Even when an additional location cannibalizes sales at an existing outlet, franchisors are better off because the new establishment boosts system-wide sales. But it does necessarily benefit the initial franchisee, who might have the same cost of operations, but lower sales.