In this uncertain climate in corporate America, owning one’s own business can appear very attractive. Many middle managers who lost their jobs with large companies and are having trouble finding new jobs are now considering going into business for themselves. Often, owning a franchise business is an attractive option. A franchise is typically a form of business that already has an established product or service – such as Dunkin’ Donuts, McDonald’s, and many, many other businesses. With a franchise, the owner (franchisor) enters into a contract with another, known as the franchisee, who acquires the right to operate the franchised business with the benefit of the franchisor’s operating history, reputation and trademarks. As such, franchises provide a number of advantages over starting a business from scratch – but include certain things about which the future franchisee should be careful.
A good franchisor typically has invested a great deal of time and money developing a proven operating system for its particular type of business. Franchisors often provide detailed policy and procedure manuals that address many of the day-to-day problems associated with owning a business. Moreover, franchisors often (and should) provide training in these policies and procedures, enabling the franchise owner to quickly get up to speed on business operations and the actual processes by which the franchise and franchisee will conduct day-to-day operations.
In addition to a proven business operating system, many franchisors have developed strong trademarks and service marks, such as business names, catch phrases, and logos that are associated with their businesses and that are recognizable in the marketplace. These marks are the embodiment of the franchisor’s goodwill and name recognition in the given field of operations, and the franchisee is intended to acquire, in signing the franchise agreement, the benefits of the franchisor’s branding investment and efforts. In the franchise agreement, the franchisor licenses these trademarks to its franchisees, allowing franchisees to use these recognizable names or phrases in their own businesses – imparting to them immediate name recognition and legitimacy. The franchise agreement invariably will contain provisions protecting these trademarks from misuse and maintaining their value to the franchisor and its system. It should be no surprise that franchisors – such as Dunkin’ Donuts and others – are vigilant about protecting the value of their trademarks against shoddy practices by franchisees.
Investigating the Franchise Opportunity
The franchisee is often making a very significant investment in his or her franchise. That investment should not be made without a thorough investigation of the franchisor and an understanding of the strength or weakness of the particular franchise opportunity. A weak franchise – one in which the trademarks are not particularly strong or well-known, or in which the franchisor does not have the financial resources to support its franchisees – can be a very poor investment.
There are significant legal documents that are provided to a prospective franchisee, including the franchise disclosure document (“FDD”) and the franchise agreement. One of the most important things a prospective franchisee can do is to thoroughly read the FDD. The contents of the FDD are to a high degree dictated by the federal franchise regulations and it is a rich source of information – and potential questions – about the franchisor and the strength (or weakness) of the franchise. The FDD and its associated tables, charts and appendices can tell the prospective franchisee a great deal about the background and financial strength of the franchisor. The FDD always contains the identity and contact information of other franchisees in the system. The prospective franchisee should contact several current and former franchisees, who are in the best position to provide inside knowledge about the pros and cons of the system. Questions should include the following:
– Whether the franchisor’s estimate of the working capital requirements to get up to speed were accurate;
– Whether, in addition to the franchise fee rendered as part of the franchise agreement, there are any other ongoing service or other fees payable to the franchisor;
– Whether the franchisor provided adequate training in the business system;
– Whether the operations manuals are helpful and easy to follow;
– Whether the franchisor provided meaningful ongoing assistance in getting the franchisee’s business or site up and running; and
– Whether the franchisees think that the system added value that would not be available to a similar business operating outside such a system.
The FDD, along with its exhibits and tables, can be somewhat daunting to review. It is advisable for the prospective franchisee to engage the services of an attorney knowledgeable about franchise law to review the documents and provide guidance to the client. The attorney will not render purely business advice (e.g., whether or not the acquisition is a good deal), but will consider the business issues in the context of providing legal advice. Also, if the potential franchisee does not understand the financial information provided in the FDD, it is a good idea to consult with an experienced CPA.
Finally, because much of the value of a franchise often is associated with the strength of the franchisor’s trademarks/service marks or trade names, it is important to know whether the trademarks have been registered with the United States Patent and Trademark Office (“USPTO”). While unregistered trademarks may be strong, federally-registered trademarks bestow important benefits to both franchisor and franchisee. An attorney can conduct a search on the USPTO website to confirm that the franchisor’s trademarks are properly registered. If the franchise is not particularly well-known or well-established, the attorney can analyze the strength or weakness of a franchisor’s trademarks and advise the prospective franchisee accordingly.
The Legal Relationship Between Franchisee & Franchisor: The Franchise Agreement
The prospective franchisee must have a full understanding of the legal relationship between the franchisor and the franchisee, which is embodied in the franchise agreement. Franchisors typically tell prospective franchisees that the franchise agreement is non-negotiable. Even if that is true, it is still important for the franchisee to understand what is contained in the agreement. A lawyer can interpret and explain to the prospective franchisee in plain English the more complex provisions of the document.
Of course, in many cases, the franchise agreement is negotiable, or at least significant portions of it are negotiable. As with most any contract, the degree to which the franchise agreement is negotiable is related to the relative bargaining power of the parties involved. A general rule of thumb is that the more well-known and well-established the franchise, the less likely the franchisor will be willing to make any changes to the franchise agreement.
Even assuming a relatively strong and well-established franchisor, there are certain provisions that an experienced attorney may be able to negotiate.
Notice Provisions. There are many places in a franchise agreement where the franchisor has the right to exercise certain remedies upon a default by the franchisee. The franchisee’s attorney can usually insert provisions requiring advance notice and an opportunity to cure such defaults before the franchisor may exercise its remedies.
Limiting the Franchisor’s Discretion. Franchise agreements often contain provisions requiring a franchisee to obtain the franchisor’s consent to do certain things. The attorney for the franchisee can try to ensure that the franchisor does not have absolute, unfettered discretion to deny its consent when giving such consent would be reasonable based upon verifiable facts.
Trademark Protections. Again, much of the value in the franchise system is attributed to the trademarks that the franchisor licenses to the franchisee. The franchisor should be willing to stand behind its trademarks and defend them in the event they are challenged by third parties. Consequently, the franchisee’s attorney can request that the franchisor indemnify the franchisee in the event the franchisee is sued on the basis of trademark infringement.
Adjoining Territories. Sometimes the franchisor is willing to grant a strong franchisee, (generally that means well-financed and/or purchasers or owners of multiple franchises), a right of first refusal to purchase the territories that are contiguous with his or her own and which have not yet been assigned to other franchisees. The franchisee’s attorney might even be able to negotiate a reduced price for such additional territories.
Indemnification Provisions. Franchise agreements sometimes contain unreasonable indemnification provisions. It certainly makes sense for the franchisee to indemnify the franchisor for losses or damages that the franchisor suffers as a direct result of the wrongful acts of the franchisee or its employees. But occasionally the indemnification provisions are written much more broadly to favor the franchisor and the franchisee’s attorney can make every effort to cut back such unreasonable indemnification rights.
Advertising Requirements. A franchisee may want to request that the franchisor loosen the requirements that the franchisee spend a certain dollar amount or percent of gross sales on advertising, particularly during the first several months of operation. Some franchisors will lower these requirements during the first six months to a year, in recognition that revenue is usually very tight during the start-up stage of the business.
Forum Selection and Governing Law Clauses. Although it will rarely come to pass, the franchisee should also request that the judicial or arbitration forum for future disputes concerning the operation of the franchise or the meaning and construction of the franchise agreement be in the franchisee’s location and governed by the franchisee’s local law. Owning a franchise in the State of Washington, while having to manage a dispute with the franchisor in Florida, places a potentially significant burden on the franchisee to inexpensively and expeditiously resolve disputes with the franchisor.
Sale of the Franchise. All franchise agreements set conditions on a franchisee’s ability to sell or transfer the franchise. These provisions are sometimes negotiable with respect to the assignment of the franchise to family members and with respect to the franchisor’s ability to exercise a right of first refusal. Since most franchise agreements typically have a term of 10 to 20 years (during which the franchisee develops its own goodwill, reputation and business), it is imperative that the franchisee understands the restrictions on his or her ability to sell the franchise.
Investing in a franchise can be a very rewarding decision for a client. It can also be an unmitigated disaster if the prospective franchisee does not understand what he or she is getting into. The prospective franchisee’s attorney can guide his or her client in the investigation of the franchisor and can often negotiate more franchisee-friendly terms in the franchise agreement. Whether the client fails or succeeds will depend upon a variety of factors, but with good legal representation going into the deal, the client will at least be cognizant of his rights and responsibilities.