Legal advice on franchise agreements

Vicky Wilkes, senior partner at Squire, Sanders & Dempsey, highlights the legal aspects to consider before signing a franchise agreement

Entering into a franchise agreement usually means a franchisee will make a substantial investment and assume a number of legal obligations. This article highlights some of the issues that should be considered before signing a franchise agreement, though it is no substitute for taking legal advice on the particular franchise agreement that a franchisee may be considering signing.

The first thing to consider is what form of legal structure to use to enter into the franchise agreement. There are a number of ways you can do this, and each has their own pros and cons. For example, you could enter into the franchise in a personal capacity as a sole trader or through a partnership formed with other individuals. Other options include setting up a limited company or a limited liability partnership.

If you trade as a sole trader or partnership, your liability is unlimited. This means the liabilities of your franchise will have to be met out of your personal assets if the business does not have sufficient assets. If you are a partner in a partnership, you could also face liability for the actions of your partners.

In contrast, limited companies and LLPs benefit from limited liability for their owners, although in exceptional circumstances (usually involving some wrongdoing) company and LLP owners can face personal liability. The trade off that comes with limited liability is that companies and LLPs are more heavily regulated and have to submit information to Companies House, which is then made publicly available. However, you should be aware that many franchisors may ask you to personally guarantee the performance of the company or LLP, which in practice puts you in no better position than if you entered into the franchise agreement in your individual capacity.

As well as having different positions in terms of personal liability, there are also differing tax implications, which you should take expert advice on from your accountant.

Premises
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Depending on the nature of the franchise, you may need to acquire dedicated premises from which to run the business. Most franchisors will want to inspect and approve the premises before you start trading from them. Depending on the particular franchise concept, either you or your franchisor will take a lease from the landlord - in many cases, you as the franchisee will take the lease and have to negotiate the terms directly with the landlord. Again, it is advisable to take specialist advice before signing your lease.

Key document
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The franchise agreement is the key document that will govern the relationship between the franchisor and franchisee. As a franchisee, you will almost certainly have no room to negotiate the terms of the franchise agreement, as most are offered on a ‘take it or leave it’ basis. The commercial rationale for this being that the franchisor requires uniformity across its franchisee network to provide brand consistency.

However, that does not mean you should sign it without taking legal advice, as a specialist franchising lawyer will be able to identify the key areas of risk and should be able to advise you on steps you can take to minimise those risks.

Common key areas detailed in the franchise agreement on which a franchisee may require advice include:

* Term of the agreement and rights to renew. It can take a while for any new business to generate profit and for its initial investors to get a return on their investment, particularly if the business has been financed by way of a bank loan. Even though franchises will be businesses based on a proven concept, the same principle applies. The term of the agreement and the rights to renew should therefore allow the franchisee sufficient time to recoup any investment and generate a profit. Rights to renew the franchise agreement should not be too restrictive and ideally the franchisee should not be required to pay a further fee in order to renew.

* Rights to transfer the franchise. The rights of the franchisee to transfer the franchise to someone else (or to transfer ownership of the company or LLP they have formed to enter into the franchise) will be relatively limited, as the franchisor will want complete control over who the franchise business is sold to and who becomes its franchisee. However, the limitations imposed on the franchisee should not be unduly onerous, as the franchisee should also have the ability to make a return on its investment by selling the franchise on.

Usually the franchise agreement prohibits the franchisee from transferring the franchise without the franchisor’s prior consent. The franchisor will invariably require the potential purchaser to satisfy the criteria it uses to evaluate prospective franchisees as a condition of giving its consent. Also, a franchisor often has first option to purchase the franchise business from the franchisee, which is usually on equivalent terms to those offered by a third party purchaser or at market value.

If a franchisee wishes to transfer the franchise, they will usually have to pay some of the franchisor’s administration costs in relation to the transfer. The franchise agreement may also give the franchisor the right to charge a commission for brokering any sale of the franchise, though the amount of the commission should not be so high that a sale is no longer worthwhile for the franchisee.

Termination
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While the franchisor has the power to terminate the franchise agreement for a number of reasons, it is unlikely the franchisee will have the right to do so. However, the franchisor should not have the right to terminate for trivial reasons and the franchisee should have the opportunity to put right any breaches, unless they are material ones. This is reiterated in the British Franchise Association’s code of ethics, which provides that franchisees should be given notice of any breaches as well as a reasonable time to remedy the breach where appropriate.

Usually the events that will give rise to terminating a franchise agreement will include insolvency of the franchisee and a number of specific breaches, such as if the franchisee fails to pay amounts due to the franchisor on time, provide accounting information on time, or operate the franchise in accordance with the franchisor’s systems and manuals. The franchisor may also have general rights to terminate for material breaches of the agreement by the franchisee, and where the franchisee does anything that may bring the name and goodwill of the franchise concept and trade marks into disrepute.

A franchisee should consider seeking specialist legal advice in relation to the proposed franchise agreement so that they can fully assess the risks involved before signing on the dotted line.