Before you sign a franchise agreement, you should have a clear understanding of what it is and what it obligates you and the franchisor to.
- Franchise agreements are important and necessary legal contracts between the franchisor and the person interested in opening a franchise.
- According to federal law, these multiyear arrangements must include key provisions, including a fee schedule and the use of a trademark or trade name, to be considered proper franchise agreements.
- While franchise agreements are relatively standard, with the right legal advice, you can negotiate terms.
- This article is for people who are interested in opening a franchise of an established business.
Whether it's a restaurant, a hardware store or a hair salon, opening a franchise of an existing business cuts out a lot of the groundwork required to successfully launch a new venture. In exchange for a fee, you'll have the rights to use select trademarks of an already-known entity, greatly reducing your efforts to raise brand recognition. You'll also receive marketing material, an operations handbook or both, giving you formulas and processes that have already been proven in the marketplace.
Before you open your doors, though, you'll need a franchise agreement that formalizes your arrangement with the franchisor. Before signing on the dotted line, you should have a clear understanding of what franchise agreements are, what they typically entail and what to look out for before agreeing to anything.
What is a franchise agreement?
A franchise agreement is a binding legal document between a franchisor and a franchisee. This document spells out the expectations, obligations, permissions and restrictions for operating the franchise. A franchise agreement also outlines a fee schedule that the franchisee pays to the franchisor, including amounts or percentages and the frequency of payments.
"Franchise agreements are the Bible of the franchising industry – they are the most vital agreements for governing the relationship between franchisees and franchisors," said Evan Goldman, a partner at the New Jersey-based law firm A.Y. Strauss and chairman of the firm's franchise and hospitality practice group. [Read related article: Ultimate Guide to Business Franchising]
How does a franchise agreement work?
Franchise agreements assign the rights to use a franchisor's intellectual property and resources to a franchisee for a predetermined amount of time. The rights and allowances assigned to a franchisee are very specific and leave little room for expansion or error.
"You are only allowed to use the things you are explicitly given the rights to use," Goldman said. "If your franchise agreement says you can only do three things listed in the agreement, it means you cannot do a fourth thing not mentioned."
These provisions are enforced to ensure brand continuity, and the franchisor's standards are upheld consistently, no matter where in the U.S. or the world the franchise is located, he said.
"You want the franchise to look and feel identical, no matter if you walk into a location in New York, Iowa or Europe," Goldman said.
Key takeaway: Franchise agreements explicitly award franchisees the rights to use certain trademarks, such as logos or slogans, in particular ways. Anything outside those explicit parameters or anything not explicitly mentioned in the agreement are not allowed.
What is a franchise disclosure document?
By law, franchisors must provide franchisees with a franchise disclosure document to review before any money is exchanged. The Federal Trade Commission requires franchisors to disclose 23 points relevant to the franchising opportunity, including the following:
- Information about the franchisor.
- Financing information, including initial investment estimates.
- The items to which a franchisee is entitled.
- The territory given to the franchisee.
- An outline of what will be contained in the franchise agreement.
Key takeaway: Federal law requires the disclosure of 23 key points about a franchise, which are laid out in a franchise disclosure document, before any money is exchanged.
What is typically included in a franchise agreement?
According to Goldman, three elements must be included in a franchise agreement:
- A franchise fee. Some amount of money must be paid by the franchisee to the franchisor.
- A trademark or trade name. The franchisee must be given permission in the agreement to use the franchisor's intellectual property, such as logos and trade names.
- A marketing system or a method of operations. The franchisee must be provided with either a system for marketing and advertising, such as posters and promotions, or with proprietary information on how to run the franchise so it looks and feels like others with the same name. Goldman noted that some franchise agreements provide both, depending on the type of franchise. For example, a restaurant may provide a marketing system and a method of operations, while a janitorial service may provide only a method of operations.
If an agreement includes these three elements, federal law automatically regards it as a franchise agreement, no matter what it may be called.
"A franchisor can call itself a membership or a license, but when these three requirements are met, you are entering a franchise agreement," Goldman said, noting that some franchise agreements may attempt to masquerade as licensing agreements. "A pure licensing agreement gives you permission to use the name and logo, and that's it – you don't get the marketing help or method of operations that you would get from a franchise."
Outside of these three main provisions, Goldman said, the remainder of the agreement can vary depending on the franchise type and size, among other factors.
"Every franchisor is slightly different because every brand will want something different from their franchisee," Goldman said.
Key takeaway: If an agreement has a fee structure, allows the use of trademarks and provides a marketing system and/or method of operations, it is automatically considered a franchise agreement. Other specific provisions may be included depending on the parties' negotiation.
How long do franchise agreements last?
According to Goldman, franchise agreements are generally entered into for multiple years. They typically last between five and 25 years, with 10 years being the average length of a franchise agreement. The agreements also often include renewal terms. Some states, including New Jersey and Wisconsin, recognize perpetual franchise agreements. These are franchise agreements that renew every 10 years, sometimes automatically, indefinitely.
While franchisees cannot terminate a franchise agreement ahead of schedule, they can transfer or sell their interest to another party that wants to fulfill the remainder of the contract.
"If you shut down a franchise agreement early, you may get hit with liquidated damages, which is typically two to three years of royalty payments, and there will be a judgment that will require you to pay it back," Goldman said.
Importantly, Goldman noted that many franchisees are personally liable for paying royalty fees, called a personal guaranty, which can make breaking an agreement a costly and risky endeavor.
Key takeaway: Most (but not all) franchise agreements last 10 years. Make sure you know the penalties for breaking an agreement.
Can you negotiate the terms of a franchise agreement?
Not every franchise agreement is set in stone, but depending on the franchise, there may be room to negotiate certain points. Older, more established franchises are less likely to be flexible, while newer franchises may be willing to be more accommodating on certain points.
"The goal is to get the agreement as balanced as humanly possible between franchisor and franchisee," Goldman said.
Here are some items you may be able to negotiate:
- Territory: Exclusivity within a certain ZIP code, neighborhood or distance from your location may be requested. This can help with reducing competition and increasing the chances of the success of your franchise's location.
- Grand opening assistance: When it comes time for your grand opening, the franchisor may be willing to provide extra help, such as marketing staff or money, to help promote the opening of your new franchise.
- Transfers: You may be able to negotiate the ability to transfer the franchise to an inheritor as part of your estate.
Goldman cautioned that fees are rarely, if ever, up for discussion, especially with established franchises.
"Unless you're the first or second person ever to franchise a particular business, fees are pretty much set in stone," Goldman said.
Key takeaway: Franchisors and franchisees should aim to reach an agreement that's fair to both parties, although certain elements, particularly fee structures, may not be up for debate.
Franchise agreement best practices
Just like any other agreement, franchise agreements should be reviewed carefully before you sign on the dotted line. Keep these items in mind when you're thinking about entering a franchise agreement:
- Get legal advice. According to Goldman, most franchisees don't hire a lawyer when negotiating with a franchisor. Without legal advice, franchisees may end up getting the short end of the stick – a particularly tricky predicament, especially when personal guarantee provisions are involved.
- Know what territory you're being provided. Franchise agreements may or may not offer exclusivity for a certain territory, whether that's a certain block, neighborhood, ZIP code or distance from your location.
- Understand the difference between "may" and "shall." Be clear from the get-go as to what the franchisor must provide and what they can, but don't have to, provide. "May" means that the franchisor could provide something but is under no legal obligation to do so, while "shall" means that the item in question must be honored. According to Goldman, the difference can be exponential and can help you properly manage expectations between you and the franchisor.
- Don't ask to move mountains. While negotiating is part of the franchise agreement process, don't expect drastic changes to your agreement, especially from well-established and globally recognized brands that have been in operation for decades. Seek legal advice for best practices on what you can request to change and what your chances may be for revised provisions.
Key takeaway: Utilize legal help before entering a franchise agreement so you fully understand your obligations, the franchisor's obligations and the rights you're being awarded as a franchisee.