When starting a franchised business, you are no doubt ready to invest personal capital and sweat equity on the road to success, but you also likely have faith in yourself and your new franchisor, or “business partner.”
While focusing on the nuts and bolts of the products or services your business will offer, also pay close attention to the franchise agreement to ensure a smoother ride and harmonious relationship with your franchisor.
Here are five critical legal issues for franchisees to consider when negotiating the terms of a new or renewed franchise agreement. A franchisor’s willingness to negotiate varies, but be sure to keep a close eye on these issues.
Defined Terms Related to Royalties and Other Fees
These terms can be vague or overly broad, leaving an opening for the franchisor to charge additional fees in the future – fees not contemplated when the agreement was executed. This is particularly relevant when franchise business models and sources of revenue mature and change over time.
Royalties and other fees should be tied to certain revenue sources, which are, if possible, narrowly defined. For example, royalty payments and other fees are often based on a percentage of overall sales. Clearly define “net sales” or “gross sales,” and understand what sources of revenue are included in – or excluded from – “sales.”
Pay close attention to the Franchise Disclosure Document and whether other franchisees pay different royalties or other fees. Try to determine whether your proposed agreement contains the same terms as other franchisees.
Some franchisors negotiate to attract or retain certain franchisees, which can be beneficial for the franchisees who successfully negotiate, but a problem for those who don’t and are forced to bear the burden of the franchisor trying to recoup what was negotiated away.
Does the franchise agreement require a personal guarantee from the franchisee’s principal, and if so, for what debts and liabilities?
Establishing a corporate structure like a corporation or a limited liability company to operate a franchise will not shield you from personal liability if you sign a personal guarantee. Importantly, you can remain personally liable under a guarantee long after you sell or quit the business.
Your ability to negotiate the application and scope of a personal guarantee may differ depending on whether you are a single-unit or a multi-unit franchisee. Consider asking the franchisor to limit the duration of personal guarantees so they expire after a number of years of ongoing operation in good standing.
Also, if you are a multi-unit franchisee, consider asking the franchisor to waive or release personal guarantees based on the strength of your company’s balance sheet.
Integration or Merger Clauses
Get everything in writing and be leery when the franchisor says, “Don’t worry about…” or “We can deal with that later.”
Most franchise agreements include provisions stating that only the written terms of the agreement will be binding, and that nothing previously discussed or promised will be enforced unless expressly contained in the franchise agreement. To protect yourself in the event of a later dispute, take notes immediately after conversations you have with the franchisor during “Discovery Day,” or in meetings and phone calls leading up to signing the franchise agreement, and communicate your understanding of the agreed upon terms in writing to the franchisor.
Your written communications and notes of conversations with the franchisor can have a significant impact if a dispute arises with regard to the meaning or application of a term in the franchise agreement.
Rights of First Refusal and Other Conditions for Sale or Assignment
You may be required to offer to sell your franchise to the franchisor before you can freely sell it to someone else. This obligation may make your business less appealing to a third-party buyer and less valuable. For example, a third-party buyer may have to wait for the franchisor’s right of first refusal period to expire, or execute a new franchise agreement that includes less favorable terms than your franchise agreement.
Consider negotiating the unrestricted right to sell to another existing franchisee, or to a member of your existing ownership group, or to a family member. Maintaining maximum flexibility is key.
Franchisor’s Right to Purchase
Your franchise agreement may allow the franchisor to purchase your franchise at a time in the future for some stated price, or based upon a multiple of your profits or another formula.
Therefore, you may succeed in building a great business only to be faced with having to “give it away” to your franchisor for less than it’s worth. Give careful thought to your longer term business plan and then negotiate for the maximum purchase price or profit multiple, as well as a long period of time before the right to purchase can be exercised.
It is important to pay attention to these issues on the front end of the franchise relationship to help ensure success down the road. There is no need to go it alone: consult with legal and financial professionals who have experience with these issues and franchise relationships.
Scott M. Ratchick and Scott A. Augustine are attorneys with Chamberlain, Hrdlicka, White, Williams & Aughtry. Ratchick is a commercial trial attorney and represents franchisees in disputes with franchisors, landlords and employees. Augustine is a business attorney and represents franchisees in franchise agreements, purchase agreements, finance agreements and real estate matters.
For more information visit: www.chamberlainlaw.com