Understanding The Franchise Agreement

If you have never looked at a franchise agreement before, at first glance it may seem that lawyers do all they can to make it as complicated as possible! To the prospective franchisee this will be frustrating because it is essential that they understand what it is that they are required to sign. This article sets out a plain English guide to the commonly used legal terms in franchising so as to make the task less daunting.

Intellectual Property:

The franchise agreement licenses the franchisee to use the intellectual property owned by the franchisor. The franchisor will normally have an established brand, which in an ideal world, will be registered trademark. Intellectual property may also include the franchisor’s copyright in the manual, requirements as to how a franchise outlet should look and feel and other elements such as technical know-how confidential to the franchisor. Intellectual property is important in franchising.

Exclusivity:

Almost all franchise agreements will grant the franchisee rights in a designated territory. Not all franchise agreements grant exclusivity within a particular territory. If the franchisor is providing exclusive rights that means that the franchisor will not appoint anybody else in the territory and will not operate itself in the territory. When sole rights are given all that the franchisor is doing is agreeing not to appoint anybody else in the territory but the franchisor is not excluded from trading in the territory.

Passive Sales:

Competition law does not allow franchisors to prevent franchisees from responding to unsolicited enquiries from outside their territory – even when exclusive territories are granted. This is referred to as passive selling. However, franchisors are able to prevent franchisees from taking steps to obtain customers outside their territory, this is referred to as active selling.

Non-Compete Covenants:

During the term of the franchise agreement the franchisor will usually prohibit the franchisee’s involvement in a competing business. There are instances where a franchisor will agree to relax these terms if the franchisee is already involved in a different business and discloses it before signing the franchise agreement. This is normally recorded in a side letter to the franchise agreement. It is also commonplace for a franchise agreement to include restrictions on the franchisee when the franchise agreement expires or terminates. These normally apply for 12 months. As part of these non-compete covenants there will be non-solicitation obligations, which mean that franchisees are prohibited from encouraging their former customers to patronise their new business.

Management Service Fee:

Almost all franchise agreements require franchisees to pay a continuing fee. It is usually referred to as a management service fee but can be called a service fee or management fee. It is standard for it to be calculated on a franchisee’s gross revenue, which generally includes sums payable by a franchisee’s customers even if those sums were not, in fact, paid.

In addition to the management service fee, franchise agreements will typically require a separate payment for marketing undertaken by the franchisor. This is referred to as a marketing or advertising fee. Again, this payment is calculated as a percentage of gross revenue. As a rule of thumb, management service fees are 8 per cent and marketing fees are 2 per cent of gross revenue.

There are franchises which do not charge a continuing fee. This is usually because the franchisor receives payment by way of a mark-up on products or services that franchisees are required to purchase from the franchisor on a rolling basis. If that is the case you would expect the franchise agreement to provide franchisees with protection from the franchisor unfairly increasing the price of products or services which it provides.

Indemnity:

Increasingly, franchise agreements contain an indemnity whereby the franchisee indemnifies the franchisor for loss the franchisee causes the franchisor. Ideally, these indemnities should not be widely drafted and be limited to loss that a franchisee causes a franchisor as a consequence of being in breach of contract or for the franchisee’s negligence. The precise extent of these indemnity clauses will depend on the language used but, in essence, when a franchisee gives a franchisor an indemnity and the franchisor suffers loss of, say, £2,000, then the franchisee must reimburse the franchisor £2,000.

Guarantee:

If the franchisee is using a company as their trading entity, the franchise agreement will usually incorporate either in the body or in a schedule a guarantee which the individual who operates or who owns the company will be required to sign. The effect of the guarantee will be that the individual agrees that if the company does not comply with the franchise agreement the individual will be personally liable. For example, if the company does not pay its management service fee the guarantee will permit the franchisor to sue the individual personally.

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