Kerry Ryan and Maija Kerry outline crucial legal issues involved in establishing a franchising agreement, and making the business work for all parties.
Australia is often referred to as the franchise capital of the world, with an estimated three times more franchised units per capita than the United States.
The results of the Franchising Australia 2004 survey conducted by Griffith University revealed that there were approximately 850 business format franchise systems in Australia in 2004. The majority of franchise systems are small to medium-sized with 60 percent involving fewer than 30 franchised units. The Franchise Council of Australia has estimated that the Australian small business franchise sector comprises around 12 percent of the national GDP of Australia. These figures reveal that franchising is a method of business expansion that has been used successfully in Australia.
Many business owners will reach a point in the business lifecycle when they begin to consider methods of expansion. But franchising is not a ‘sure fire’ method of expansion. Business owners who decide to franchise their businesses are still subject to all of the risks associated with business expansion and investment. However, if the business has the right fundamentals—a proven concept, systems and procedures that can be replicated and a distinctive brand and image—there is potential for the business format to be successfully expanded by franchising the concept.
The Agreement
The franchise agreement is the cornerstone of the franchise relationship and is integral to the success of the franchise. It reflects the rights and obligations of each party and compliance with the franchising regime in Australia enshrined in the Franchising Code of Conduct 1998.
The obligations of each party should be clearly delineated so there will be no scope for a court to imply more onerous obligations in a franchise agreement. A balance needs to be found between providing security to franchisees and reducing the exposure of the franchisor to unnecessary liability.
The rights and obligations of the franchisee need to be clearly reflected so the franchisee is aware from the outset of all their obligations. Often the franchise agreement records only the key obligations, and the franchisee is required to comply with the specifics of the franchisor’s systems and procedures that are contained in the franchisor’s operations manual.
The franchise agreement must be tailored to reflect the requirements of the particular franchised business. Although each agreement will vary depending on the nature of the franchise, the following are some of the key issues that need to be addressed:
• Parties—the parties to the franchise agreement need to be correctly identified. If the franchisee is a company, it is common practise to require the directors of the company to be guarantors to the agreement. The franchisee principal is often joined to the agreement so that the franchisor can seek a competition restraint after the expiry or termination of the agreement.
• Nature and extent of the franchise grant—the franchisor must carefully consider exactly what they are granting to the franchisee, including the duration of the franchise, whether it is an exclusive grant or the grant of a territory, and what rights the franchisor wishes to reserve for itself. The grant should emphasise the importance of the branding and the systems, as this is generally the essence of the agreement between the franchisor and franchisee.
• Term—the term of the agreement is often much longer than the term for other commercial agreements that a small business owner might enter into. Therefore, it is important that the franchise agreement accurately represents the franchise relationship during the establishment phase, and that it will also reflect the many changes and developments that will occur in the business throughout the term of the franchise agreement. A common mistake made by franchisors when establishing a franchise network is to frame the franchise agreement on the current franchise situation, without taking into consideration the longer-term objectives of the business.
• Payment obligations—these cover initial fees, ongoing royalties and fees such as marketing fund levies and renewal fees. The payment obligations will be of considerable importance as this will determine whether a franchise will be financially viable and sustainable. The franchise agreement should specify how the franchisee makes payments, the frequency of payments, and whether interest will be payable on overdue payments.
• Performance criteria—often a franchise agreement will require the franchisee to comply with minimum performance requirements. The minimum performance criteria might be a minimum sales level, minimum number of customers/clients, or a minimum level of customer service. The performance criteria can also include consequences for non-performance, which may include a loss of exclusivity or a requirement for the franchisee to undertake additional training.
• Supply arrangements—if the franchise system is based in retail trade, the supply arrangements will be of considerable importance to the franchise network. The supply arrangements need to be accurately recorded in the franchise agreement to ensure the franchisee is supplied with the necessary products and services to enable them to operate their franchise. The pricing structure, minimum amount of stock to be held by the franchisee, and the franchisee’s relationships with suppliers, will generally be prescribed in the franchise agreement. The drafting of the supply arrangements in the franchise agreement will have trade practices consequences and these need to be considered carefully.
• System and image compliance—for premises-based franchises, the franchisor will generally prescribe the image, brand, colours, layout and signage of the business premises of each franchisee. The franchisor will need to create an obligation in the franchise agreement for franchisees to comply with the standards and specify the means of enforcing the standards. Given the importance of uniformity and consistency in a business format franchise, breach or non-compliance with the standards should ultimately enable the franchisor to terminate the franchise agreement.
• Intellectual property—the intellectual property of a franchisor is normally its most valuable business asset. The respective rights and obligations of the franchisor and franchisee in relation to the franchisor’s intellectual property must be clearly specified in the franchise agreement. It should include provisions in relation to ownership, what is being licensed, terms of the licence, a description of the intellectual property, the franchisee’s obligations in relation to the use of the intellectual property, and maintaining confidentiality of the intellectual property.
• Termination—the franchise agreement must contain provisions dealing with the right of the franchisor and franchisee to terminate the franchise agreement. The Franchising Code of Conduct prescribes the circumstances and manner in which franchise agreements can be terminated by franchisors, and the dispute resolution provisions of the agreement.
• Consequences of termination—the ability of the franchisor to buy the assets of the franchisee, or to take over operating the franchise, need to be specified in the franchise agreement. It is also important to protect the franchisor’s intellectual property and confidential information by specifying that the franchisee’s rights to use the trade mark and other identifying signs, business names and confidential information, cease on termination of the franchise agreement.
A prospective franchisor will ne
ed to carefully plan any prospective expansion of its business through franchising. It is not simply a matter of drafting a franchise agreement and giving the franchisee a disclosure document. Overly optimistic expectations of franchise network roll-out or expansion on too many fronts simultaneously, can add unnecessary costs and complications to the process.
Getting Help
The Franchise Agreement and Disclosure Documents are basic to the franchise relationship, but will regulate the obligations of franchisors and franchisees in relation to various aspects of the law, including the Trade Practices Act, employment, property and tax laws. It is imperative that legal advisers specialising in franchising are consulted when establishing a franchise and entering into new franchise agreements. Appropriately experienced advisers will be able to create a franchise agreement that accurately reflects the legal and commercial aspects of the franchised business.
In many cases, a franchise consultant, business adviser or accountant can also add value to the process of negotiating and drafting the franchise agreement. Franchising law and practice is intertwined. Most of the legal issues involved in establishing a franchise will have a commercial aspect, whether they relate to the negotiation of the terms of the agreement or the practical implementation of obligations into the business.
The Franchise Council of Australia (FCA) is the representative organisation for franchisors, franchisees and service providers in the franchising sector, and is a useful resource for both franchisors and franchisees.
Franchising is an on-going process that involves continual reinvention and improvements by both the franchisor and franchisees. If both the franchisor and franchisee are continually looking for ways to achieve best practice in the franchise network, it will remain competitive in the marketplace. An appropriately planned and drafted franchise agreement will reflect the commercial and legal aspects of successful franchise relationships and, hopefully, a successful franchise network.
* Kerry Ryan is a partner in Deacons’ Retail, Franchising and Distribution group, based in Sydney. She can be contacted on (02) 9330 8327 or by email at kerry.ryan@deacons.com.au.
Maija Kerry is a lawyer in Deacons’ Retail Franchising and Distribution Group.
