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Factors to Consider in a Franchise Agreement

A franchise agreement, which should usually be drafted by a lawyer, sets out all the terms and conditions which govern the relationship between the franchisor, and each franchisee. It is important therefore, that the agreement be comprehensive and carefully prepared. It is recommended that a standard agreement be drafted with suitable provision for future changes in the operation. Consistency and standardization are also key words that should characterize the relationship with each franchisee as it will avoid problems that might result from treating them differently.

The basic goal of a franchise agreement from the franchisor's viewpoint is to protect the proprietary interest, when granting a franchise to the franchisee for the use of the trademark and operations system. It is important that the franchisor maintain control over the franchisee=s operations, however, the control exercised should not limit the franchisee to the extent that the relationship becomes one of master/servant or of agency. The "control" referred to is embodied in the franchise agreement and the actual course of excessive control would mean the franchisor would be exposed to greater third party liability.

Example Problem

Richard and John are considering franchising their exclusive rickshaw business throughout Canada and the United States, together with their registered trademark "Rambling Rickshaws". They are very concerned about the basic issues which should be addressed in their franchise agreement in order to ensure the success of their venture.

Required:

Consider what basic matters should be included in Richard and John's agreement to protect their interests.

Solution:

The agreement should set out the obligations of the franchisor and the franchisee. The following list of obligations of you, the franchisor, should be considered in conjunction with your goals, and you should include only those obligations you intend to provide on a continuing basis:

a)         franchisee and managerial staff training;
b)         franchisee seminars and retraining courses;
c)         site selection and layout assistance or leasing assistance;
d)         building plans and specifications;
e)         provision of an "operations manual";
f)          assistance in the opening period including a standard bookkeeping and reporting system;
g)         specifications of required machinery and equipment purchases;
h)         continuing consultation;
i)          periodic inspections for quality control;
j)          national, regional or local advertising;
k)         continued protection and renewal of trademark;

The cost of providing some of the above services may be shared or carried totally by the franchisee. These fees should be set out clearly in the agreement.

The value of your franchise is affected positively by the fact that you are the sole and exclusive owner in Canada of all proprietary and other property rights in your registered trademark once obtained. This fact should be noted in your agreement. Further, you should consider under what terms the territory will be granted to the franchisee. Each franchisee will desire an exclusive territory in order to protect his long-term investment. This may not be in your best interest. It is conceivable that more than one franchise could operate successfully in certain cities. You might consider including a clause stating the exclusive territory to be a certain limited number of square miles so long as the franchisee faithfully performs all his obligations.

The franchisee's obligations will be concerned with maintaining the success of the operation and prohibiting any deviation from the operations system you have devised. The following obligations are those commonly imposed on franchisees:

a)         financial reporting and timely payments
b)         attendance at various training and retraining programs
c)         insurance requirements and indemnification provisions
d)         provision of adequate working capital
e)         full-time commitment to the business
f)          use of products or equipment specified by the franchisor and purchased from the franchisor or other approved suppliers
g)         strict compliance with the franchisor's operations manual
h)         a covenant to repair and maintain the franchised premises
i)          restriction of other goods and services the franchisee may provide on the franchised premises
j)          a covenant as to proper trademark usage
k)         partaking in advertising and promotional campaigns as required
l)          must enter a registered agreement in respect of the franchisor's trademark
m)        compliance with all federal, provincial and municipal laws and bylaws
n)         carrying on operations in defined business hours

You should consider any further restrictions on what the franchisee may and may not do on the business premises and further obligations as to what he must do.

There are three main types of franchising fees: a lump sum initial fee; a monthly royalty fee based on gross sales of the franchise; and an advertising fee usually based on a percentage of growth.

In setting the fee structure, you should consider those fees which will reflect the value of the operation and maintain the marketability of the franchise units. The agreement should clearly set out the fee structure. The initial fee should be "payable" on signing the agreement and it should be "fully earned" at that point. It should also be non-refundable on termination of the agreement for any reason. Recall that you are prohibited under the Franchises Act from accepting any payments until after your agreement has been registered and the potential franchisee has received a Statement of Material Facts or Prospectus.

In setting the term of the Franchise Agreement, you should consider the amount of the initial investment required by the franchisee so that the term allows amortization of certain capital payments. You may consider granting a right of renewal upon expiration of the term, if the franchisee is not in default of any obligations outlined in the Franchise Agreement. You may charge a "renewal fee" to cover administrative costs and you may charge a further initial franchise fee. These elements should be set out concisely in the Agreement.

The Franchise Agreement should provide for default and termination. In the event the franchisee fails to pay any sums due or fails to meet the material obligation, the franchisor may terminate the Agreement after notice of default has been given. In addition, termination of the Agreement may occur immediately in the event of material breaches of the Agreement such as closure or abandonment of the franchise business premises, bankruptcy, insolvency or liquidation of the franchisee; seizure of the premises or goods by creditors; attempted assignment of the Franchise Agreement by the franchisee without consent; disclosure of confidential information; assignment or improper usage of the franchisor's trademark or improper calculation of the franchise fee payable. You should consider providing means for a franchisee to have a right to terminate the Agreement.

If there are other ancillary Agreements such as a lease or sublease, a debenture or a mortgage back to the franchisor, you should consider cross-default provisions, with the result that a default under one Agreement is a default under all related Agreements between you and the franchisee. Additional consideration should be given to the rights and obligations to the parties following termination. A term in the Agreement should require the franchisee to cease representing himself as a representative of the franchisor and must immediately cease to display the franchisor's trademark for any purpose whatsoever. In addition, all operation manuals and other inventory or assets forming part of your business system should be returned immediately. The Agreement should provide that you own the manual at all times or that it will be returned for nominal considerations.

The Agreement should grant the franchisor an irrevocable appointment of attorney for the franchisee upon termination, so enforcement of the preceding obligations is possible. As well, the franchisor should be able to enforce such obligations as the immediate transfer of the right to all telephone listings, transfer of a lease Agreement and cancellation of the registered user's Agreement. If you wish to have the right to repurchase the franchisee's equipment, fixtures and building upon termination, the cost should be defined in the Agreement. One method of determining the repurchase price is the original cost less depreciation. It should be pointed out to the franchisee that after a number of years such price will be low or nil. In the alternative, the repurchase price may be fair market value, with a method set out by which the value may be determined.

It is suggested that a restrictive covenant be added to prevent the franchisee from entering into a competing business during the term of the Agreement. You should also consider restricting the franchisee=s right to enter a competing business upon termination of the Agreement, for a reasonable time period. In order for the non-competition clause to be valid, it must extend only to those types of business that the parties were carrying on, for a reasonable period of time and area, in order that your interests are protected. This clause should be severable so that if it is found to be invalid, the whole Agreement will not also fail. The franchisee should be precluded from representing himself as a current or past franchisee of the franchisor. These controls are very important for the continued success of your operations.

The Agreement should provide that it constitutes the entire Agreement between the parties and no other oral representations form part of this Agreement.

If you do make statements or representations upon which the franchisee relies, you must ensure that they are true and complete as there are strict disclosure standards you must meet under the Franchises Act. For example, if an earnings clause sets out a schedule of projected earnings, the data base must be disclosed. You should stipulate that the figures given are estimates only and no assurance is given that the franchisee will ever achieve those earnings.

You should consider what terms will operate if you choose to allow the franchisee to sell or assign his interest. The terms should extend to any sale or assignment including a deemed assignment on the transfer of shares of a corporate franchisee or the transfer from an individual to a personally-controlled corporation. The terms may include requiring the franchisee to give written notice of his intentions and the terms of the sale or assignments; further dealings should be contingent upon the franchisor's consent to those terms and conditions; the Assignee or Purchaser must execute a new Franchise Agreement and all ancillary Agreements affecting the Franchise Agreement; the Assignor must terminate the Franchise Agreement and all ancillary agreements; and there should be payment of a transfer fee from the Assignor to the franchisor for administrative costs.

Finally, you should consider a mechanism for settling disputes between the parties.