Is It Time to Rethink Those Franchise Agreements?

There was a time when franchisees of McDonald’s took pride in telling people that if McDonald’s told them to jump off a cliff, they would do so, knowing that McDonald’s knew what was best for them. Franchisees did as they were told in most systems, and prospective franchisees for new franchise systems would sign any agreement put in front of them, for fear of missing out on the “next McDonald’s.”

Clearly, times have changed. Declines in same-store sales figures throughout the food and retail industries have taught us that there are no fool-proof businesses. More importantly, as multi-unit franchisees become more plentiful, their experience often surpasses the experience of the small and mid-size franchise systems trying to woo them. While multi-unit operators from one system make very good prospective franchisees for smaller systems trying to expand, these sophisticated franchisees are balking at signing one-sided contracts being presented to them. Rather than eliminating these franchisees as prospects, franchisors need to rethink the restrictive provisions in their franchise agreements.

The foregoing is not to suggest that emerging franchisors must take up the mantra of franchise lawyers who may be proponents of collective bargaining among franchisees, or franchise agreements that move decision-making from franchisor to franchisee. To the contrary, sophisticated franchisees recognize the need for franchisors to control their brand. However, there is a fine line between the need to control the brand, and attempts to control the franchisee. Likewise, there is a difference between protecting a brand, and protecting against any “what if” scenario that might be imagined. While the former is critical, the latter can lead to unnecessary, one-sided provisions that are causing sophisticated franchisees to walk away from otherwise ideal franchise opportunities.

Examples of restrictive provisions abound. It is important that franchisors carefully draft territory provisions so there can be no dispute as to the rights of either the franchisee or the franchisor to expand the brand. However, is it necessary for a full-service restaurant operator to grant a territory to a franchisee, yet reserve the right to place limited service businesses throughout that territory selling similar products under the same brand name? Is it necessary to also reserve the right to place branded foods in other establishments in the territory, when those establishments compete directly with the franchisee? Similar questions must be asked of noncompete provisions in franchise agreements. Franchisors need to restrict franchisees from using information given to them as franchisees to compete with that system. On the other hand, a multi-unit operator of a submarine sandwich franchise is not likely to agree to refrain from selling sandwiches in any business she operates. While there is no question that lessons learned in selling submarine sandwich franchises can be applied to the sale of sandwiches in other food establishments, it is not necessary to preclude the franchisee from owning any restaurant selling sandwiches in order to protect the franchisor’s brand. Franchisees who want to diversify will walk away from franchisors seeking to impose such restrictions.

Franchise agreements also typically include provisions addressing the franchisee’s financing of its business. Provisions restricting the ability of a prospective franchisee to grant security interest in his business to a lender, or imposing conditions on the lender’s exercise of its rights following the franchisee’s default, can impede the franchisee’s ability to obtain financing. Provisions restricting the ability of a prospective franchisee to grant a security interest in his business to a lender, or imposing conditions on the lender’s exercise of its rights following the franchisee’s default, can impede the franchisee’s ability to obtain financing. While a franchisor may not want a bank to ultimately own its franchise, if the restrictions in the agreement effectively prevent franchisees from obtaining financing from many available sources, those restrictions will seriously impede the growth of the system.

Default provisions also should be reasonable. Franchisors must have the right to act quickly when a franchisee defaults, particularly when the default affects the quality of the product, or the integrity of the franchise system. However, sophisticated, experienced operators will not give their franchisor the right to cut off all sources of supply to the franchisee, or to take their units, without notice, based on an allegation of breach.

Franchisors seeking to attract inexperienced franchisees also need to reevaluate the provisions of their agreements. For years, attorneys have recommended to their franchisor clients that they contractually obligate themselves to as little as possible, knowing they can always out-perform the written agreement. While a franchisor may need to be careful not to commit to obligations that must be fulfilled five, 10 or 15 years down the road, perhaps by a different owner, franchisors certainly should know what they will do to initially help franchisees during their first year of operation, and should be willing to commit to such assistance. Clearly, site selection, initial training, and the initial opening of the business are critical to the success of the franchised operations. If that is the case, then why would franchisors not promise to deliver assistance in these areas? (Some attorneys may reply that they want to avoid having their clients liable to franchisees for failing to provide adequate assistance in these areas. However, these concerns can be dealt with by including provisions to the effect that all assistance will be offered based on the ability and knowledge of the franchisor, and not necessarily to meet any particular level of expectation of the franchisee, or requiring any claims to be brought to the franchisor’s attention immediately, so that once the business opens for operation, such claims are waived.)

By their nature, franchise agreements will always be considered one-sided, and contain provisions designed to protect the brand. However, franchisors need to understand these provisions, and question their attorney as to the reason for particular provisions. The provisions mentioned in the article represent only a handful of probably dozens of areas that must be addressed. If a provision is necessary to protect the franchisor or the brand, then it needs to be included. If the provision does not serve that purpose, then it needs to be rewritten or eliminated. Too many agreements erect unnecessary roadblocks to the efforts of franchisors with very viable concepts to grow their system. Franchise agreements can and should be written in a manner designed to help attract, rather than repel, the type of franchisees to whom the concept is being marketed.

This article was originally published in the February 2004 issue of Franchise Times.

Reprinted with the permission of Franchise Times, February 2004 © Franchise Times, 2808 Anthony Lane South, Mpls., MN 55418