Franchise agreements explained

John Pratt, senior partner at franchise firm Hamilton Pratt, highlights the key terms used in franchising

There are a number of important terms that are used in pretty much all franchise agreements - the system that is the franchisor’s method of doing business. Often these terms are defined in the agreement because they are used several times.

The purpose of this article is to look at the likely meaning of these terms although, in all cases, you should look at the definitions in your particular franchise agreement to ensure the standard meanings set out below have, in fact, been adopted. If they have not, you need to know why.

Fees
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In franchising there are usually three sets of fees. An initial fee is aimed at reimbursing the franchisor for the cost of recruiting you and providing the initial obligations, including training. This fee should be clearly set out and, generally speaking, should not contain a profit element for the franchisor.

Then there is a continuing fee. The great majority of continuing fees in franchise agreements are described as management service fees, service fees or management fees and are calculated as a percentage of turnover (including bad debts). Most management service fees are set at about eight per cent. Sometimes the fee is a fixed amount, but this will only be the case if it is a cash business or a part-time/home-based business.

In addition, there will be a marketing levy or advertising levy of usually two per cent of turnover. The purpose of this payment is to ring fence marketing contributions to ensure they can only be used by the franchisor to build up the brand’s reputation. Usually this fee is paid into a separate marketing fund and franchisees receive annual certificates indicating what payments have been made in and out of the fund.

Territories
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You will be granted either a non-exclusive or an exclusive territory. Sometimes you can be granted a sole territory, which means the franchisor will not appoint any other franchisees in your territory, but is not prevented from operating in your territory itself. If an exclusive territory is granted, you also have protection from the franchisor.

By no means do all franchise agreements grant any form of exclusivity and you need to be clear about what is being offered, because in the internet age the exclusivity franchisees receive does not usually relate to customers in your territory. Even if no exclusive territory is granted, often territories are set out - usually by reference to postcodes - so as to limit your marketing activities to customers in a particular area.

Obligations
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Most franchise agreements impose obligations on franchisees to use their best efforts to promote and extend their franchise business, but some impose minimum performance obligations. Care needs to be taken with such an obligation.

The British Franchise Association is keen to ensure that if minimum performance obligations are set, they are set at a level that is reasonably easily achieved - it believes that 70 per cent of the average performance of franchisees is appropriate. You should ensure that that is indeed the minimum performance obligation in your proposed franchise agreement. You should also ensure the agreement does not contain an obligation to pay a minimum continuing fee or that the failure to achieve a minimum performance entitles the franchisor to claim the difference between the minimum fee and the amount actually paid.

All the franchisor should be allowed to do if you fail to achieve the minimum performance level is to provide assistance in order for you to achieve the full potential of the franchise and then perhaps make your territory non-exclusive or reduce its size. Only if things do not improve or as a last resort should the franchisor terminate the franchise agreement.

Intellectual property
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Most franchise agreements refer to intellectual property, which is licensed to franchisees and includes trade marks - you would expect the franchisor to have a registered trade mark - copyright of the manual, know-how and, if the franchise operates a retail business, trade dress - the appearance of the retail premises.

Operations manual
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The manual is a fundamentally important document. The franchise agreement deals with the ‘big issues’ and cannot be changed for the duration of the term of the agreement - most last for five years and can be renewed twice. You would expect the renewal right to be automatic in favour of the franchisee, provided the franchisee has not breached the franchise agreement and has performed reasonably well. The manual, on the other hand, sets out the day-to-day operational issues and can be changed by the franchisor to reflect new or different ways of conducting the franchise business. Indeed, the franchisor should change the manual regularly to reflect changes.

National accounts
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Some franchise agreements refer to national accounts - those accounts that are obtained by the franchisor and in respect of which the franchisor has a direct contractual relationship with the customer, either because the customer wants services or goods supplied in more than one franchisee’s territory or because the franchisor is of such a size that the account is too big for one franchisee to handle.

Deed of option
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If the franchise is a retail operation, sometimes franchisors require franchisees to enter into a deed of option, which seeks to ensure (when the franchisor does not take a head lease or own the freehold in the property) the franchisor can retain the property at the end of the franchise. Franchisors do not want franchisees simply taking the signs down and operating independently, although that would in any event be prohibited by non-compete obligations.

Guarantee
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Finally, if a franchisee operates the franchise business through a limited company, there will be a guarantee so that the individual who has set up the company must guarantee the obligations of the franchisee company. This does of course mean that at least in relation to liability to the franchisor, setting up a company does not offer limited liability.