The franchise agreement is the basis of the ongoing relationship between the franchisor and the franchisee. The franchise disclosure document includes a copy of all agreements that comprise the franchise offering. There are single-unit and multi-unit franchising agreements. Here is an overview of various types of franchise agreements:
Unit franchise agreement
The basic agreement that is included in almost all franchise disclosure documents is the single unit franchise agreement. What types of provisions do single unit franchise agreements typically include?
In determining the amount of the initial fee, a new franchisor might look at two factors:
- First, the initial fee should cover the franchisor’s initial costs of selling the franchise, providing initial training and assisting the franchisee in the launch of the business. Don’t view initial fees as a profit center. The system will be much healthier if it profits from ongoing royalties.
- Aside from looking at your own costs, look at what the competition is charging. How does your offering compare? Where do you want your pricing to fit in the marketplace?
- Royalties – The level of ongoing royalties will require a similar analysis, both of estimated internal costs, franchisee costs and the competition.
- Marketing Fees – Franchisors frequently handle regional and national advertising, and they commonly collect marketing fees from franchisees to cover some or all of the costs. Even if you are a new franchisor, you will probably want the franchise agreement to say that you have the right to establish a marketing fund at any time. You will need to indicate either a fixed or a maximum marketing fee in the agreement.
- Services – You may also want to include fees for onsite assistance or training requested by the franchisee. And you may want to charge for web services or any software you provide.
Will the franchise agreement grant an exclusive territory to the franchisee? Many franchisors grant the franchisee the right to open and operate a business at a specific location and offer no territorial protection at all.
If the franchisee will have an exclusive territory, how will the territory be determined? In what ways can this exclusivity limited? The franchisor may reserve the right, for example, to service national accounts that have locations within the territory. Or the franchisor might reserve the right to sell branded products in specified types of outlets in the territory. How does the system handle Internet sales or Internet advertising? Will the franchisor refer customers in the territory to the franchisee? Will the franchisor give the franchisee a commission on its own sales to customers in the territory?
The subject of territory raises other questions as well. What are the franchisee’s rights to advertise or sell outside of the defined territory? Does continuation of territorial exclusivity depend on the franchisee achieving a certain sales volume? What happens if the franchisor acquires or is acquired by a competing system that has one or more locations in the franchisee’s territory?
Does the franchise agreement require the franchisee to sell only those goods and services that the franchisor approves? Must the franchisee sell all of those goods or services?
Term and renewal
Many franchise agreements have a 10 year term with one 10 year renewal, or for 10 years with two renewals of five or ten years each.
Franchisees typically want the right to renew as long as they are in compliance with the franchise agreement. Most franchisors don’t want to give franchisees a contractual right to continuing renewals. But in practice, a franchisor is likely to renew unless the franchisee is underperforming. A simple solution is to say that the when the franchisee renews, the franchisee will have the further renewal rights that are contained in the renewal franchise agreement.
Franchisor’s typically require the franchisee, at the time of renewal, to sign the form of agreement that the franchisor is using for new franchisees. That agreement may be very different than the one that the franchisee signed at the outset of the relationship. This allows a franchise system to change over time.
Some franchisors charge a renewal fee, which may be 50% or 25% of the initial fee of a new franchise or some lower amount. Other franchisors don’t require any renewal fee at all.
Franchisees must be in compliance with their franchise agreement in order to renew. Many franchise agreements require the franchisee to bring the franchised location up to the current standards at the time of renewal. Franchisors also commonly require the franchisee to sign a general release as a condition of renewal.
Transfer restrictions are also common in franchise agreements. The franchisor wants to know that the owners of the franchise are of good character, that they have the requisite business experience, that they are adequately financed, and that they are not affiliated with a competing business. This means that any sale of a franchise is a three-way transaction, involving the buyer the seller and the franchisor. Where there is a lease, transfer of the franchise also involves the landlord.
Multi-unit franchise agreements
Many franchisors offer both unit franchises and multi-unit franchises. Multi-unit franchises come in a few basic varieties. While the names are sometimes used interchangeably, the basic concepts are described below. Each type of agreement will contain a development schedule that will contain the number of units that the franchisee is required to open or sell over a specified period of time. Multi-unit agreements help a franchisor grow a franchise system more quickly and with less effort than selling individual unit franchises.
Basic multi-unit development agreements
The most basic multi-unit area development agreement requires the developer to open an agreed number of franchises in a defined territory over a specified period of time. The developer commonly pays for this right, which makes this a franchise offering, even if a new unit agreement must be signed for each location that the franchisee opens. By working with multi-unit franchise owners, a franchisor can simplify its business by reducing the number of franchisees it needs to support, but not the number of units.
Area representative agreements
Area representatives (often called area developers) commonly act as sales representatives for the franchisor in its sale of franchises within a defined territory. The area representative acts as a finder of prospective franchisees. The unit agreement is signed by the franchisee and the franchisor. The area representative will typically receive a portion of the initial franchise fee and the ongoing royalty from the franchisor. Area representatives commonly perform services for unit franchisees on behalf of the franchisor within the territory. For example, the area rep may assist unit franchisees in finding and developing appropriate sites for the franchise units. The area rep may also train unit franchisees and provide ongoing support. In many systems, the area representative must own at least one unit franchise.
The master franchise approach is commonly used in international franchising. The U.S. franchisor grants master franchise rights to a company in the destination country, and that company grants subfranchises to unit franchisees in the country. Master franchising is far less common in the U.S. One reason is that the master franchisee and the franchisor are jointly liable for compliance with the franchise laws. The unit franchise disclosure document must include disclosures about both the franchisor and the master franchisee, including the audited financials of both the franchisor and the master franchisee. Master franchising can also lead to quality control problems with subfranchisees because the franchisor does not have a direct contractual relationship with the subfranchisees.