Franchise agreements – take it or leave it?

Franchises are a popular way of doing business in New Zealand – we are in fact, per capita, the most franchised country in the world.

You also don’t have to look that hard to find franchising opportunities; at any time there will be a number of franchisors across various industries in New Zealand looking for franchisees to set up new branches or operate in new territories.  An opportunity might also arise where a business operator of an existing franchise is looking to sell.

Franchised businesses can be an appealing opportunity for those looking to own and operate a business, without having to start from scratch.  In purchasing a franchise, franchisees get the benefit of operating under an established brand (typically), a ready to use business model, and essentially a manual on how to operate the business.  The ease of slotting into a ready-made business, and the thought of being your own boss makes franchises common place in New Zealand.

Sounds easy, right?  Well, one of the trade-offs of buying into a franchise system is that a franchisee will typically enjoy less autonomy that it would owning and operating its own business.  From the franchisor’s perspective, this ensures continuity across the brand and means that franchisors can take a uniform approach to all franchisees.  Ancillary to this is the perception that franchise agreements tend to be non-negotiable, and to favour the franchisor.  While often not enough to deter people from owning a franchise, it is important that anyone contemplating a franchise agreement understands the terms of the agreement, and doesn’t simply take it ‘as is’, without looking into the nuts and bolts.

Below is high level overview of just some of the common terms you will find in a franchise agreement, and some things to think about when considering purchasing a franchise.

Fees

One of the biggest considerations for most will be the cost of buying and operating a franchise.  In addition to the ‘upfront’ fees (such as an initial fee to buy the right to operate the franchise, and any ongoing royalty and/or management fees), there may be a number of other fees that are not immediately apparent.  These include:

  • Transfer fees (payable on the sale of the franchise to another person).
  • Marketing fees (sometimes payable as a percentage of turnover or a nominal amount).
  • Training fees (often payable in addition to the initial fee) for initial training and sometimes ongoing training. This might also include covering incidental expenses (such as travel and accommodation).
  • Association memberships, depending on the industry of the franchise.
  • Penalties (for non-performance, for example).
  • Minimum staffing requirements.
  • Cost of collateral (e.g. branding, uniforms and advertisements).

It’s important to have a clear picture of a franchise’s ongoing costs; while a lot are profit-based, ongoing costs might also be fixed amounts, irrespective of how well the business is doing.

Territories

Most franchises will be accompanied by some concept of territory, and often exclusivity.  While some franchise agreements set out an ‘exclusive territory’ in which a franchisee can market and operate exclusively, other franchise agreements provide no such exclusivity, and might even allow the franchisor to set up shop next door.

Irrespective of which applies, it is crucial that the terms of the franchise agreement reflect the franchisee’s understanding of how the territory is to operate.  The territory (or lack thereof) can have a significant impact on the franchisee’s ability to carry out the business as intended.

Restraint of trade

It is relatively standard practice for the director(s) and/or shareholder(s) of a franchisee company to give personal guarantees to a franchisor, of all of the franchisee’s obligations under a franchise agreement.  This extends the liability of the franchisee to the guarantors

If included as guarantors in a franchise agreement, the guarantor(s) will normally be required to enter into a restraint of trade with the franchisor.  It is important that these are considered in detail (and sometimes amended to carve out any other business activities that a franchisee might carry on outside of the franchise business).  While onerous restraint of trade clauses are often unenforceable, prevention is better than cure, and clearly setting out the parties’ intentions early on can save costly disputes down the track.

Termination

Franchise Agreements typically contain detailed termination clauses. These termination clauses usually provide for a number of onerous outcomes for franchisees in the event of termination which include any of the following:

  • Payment of a sum of money equivalent to the amount of all royalty fees which would have otherwise been due up to the date when the franchise agreement would have terminated, if not brought to an end earlier;
  • Early termination fees;
  • An obligation on franchisees to sell all assets of the franchised business to the franchisor at either book or market value; and
  • No compulsion on the franchisor to pay any sum by way of good will to the franchisee on termination.

Most franchise agreements will provide that these consequences (or others) apply to any type of termination (or expiry), regardless of how the agreement has come to an end.  Where the underlying breach is minor, such clauses can be heavily penal in their effect, and out of proportion to the breach itself.

Rights of first refusal

A common provision in franchise agreements, upon termination, is that the franchisor has a first right of refusal is respect of the business, and the premises themselves.  If the premises are leased, then this will be a requirement to assign the lease to the franchisor, or if the premises are owned by the franchisee, a requirement that the underlying property be sold.

Conditions

We often see conditions in franchise agreements that must be met before a franchise will be granted.  These will not come into effect until after a franchise agreement has been signed, but must be met within a requisite period after signing.  As most franchise agreements require an upfront ‘initial fee’ to be paid on signing, a franchisee can be caught in a position where conditions aren’t satisfied, the agreement is cancelled, but the franchisor is entitled to retain all (or some) of the initial fee, before trading has even commenced.

It is a good idea to work through the conditions with the franchisor before signing, to make sure that they are achievable.  This can often arise in relation to premises, whereby a franchisor’s consent to use certain premises is required before the franchise will be granted – try and get confirmation from the franchisor in advance that the premises are approved.

Franchisee protections

It’s true that you don’t know what you don’t know.  In addition to terms in franchise agreements that might trip a franchisee up, there are also a number of basic protections that franchisees should ensure are included in a franchise agreement to ensure the franchisee’s liability isn’t disproportionate.

Conclusion

While franchisors tend to take a consistent approach across all franchisees, it is important to understand all obligations and potential liabilities under a franchise agreement.  Unforeseen liabilities don’t only arise on termination, but can also appear in the form of unexpected fees and further incidental costs.  Before getting too far into your research on a franchised business, it is advisable to have an upfront conversation with the franchisor to lock down agreed terms when it comes to preparing the franchise agreement.

If you are considering opening a franchise business, or purchasing an existing business that is operating as a franchise, it is critical that you seek legal advice on the franchise documents to make sure that your expectations match the commercial terms of the documents.  Please contact a member of Lane Neave’s Business Law team for further information.

Business Law team

If you need any assistance with the sale or purchase of your business, do not hesitate to get in touch with the Business Law team at Lane Neave.

Gerard DaleClaire EvansGraeme CrombieEvelyn JonesAnna RyanJoelle Grace,  Peter OrpinEllen SewellMatt TolanCarlo WanKristina SutherlandJacob NuttWhitney MooreAlex StoneBen Cooper, Lisa Catto

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