NEGOTIATING YOUR FRANCHISE AGREEMENT

Date: JUL 5th, 2007

Topic: Industry Experts

picturePeter Macrae Dillon
Telephone: 800-816-9596 ext. 7818
E-mail: peter.dillon@siskinds.com

Admitted to the Ontario Bar in 1988
Admitted to the New York Bar in 2005
Peter is the only lawyer in Ontario outside of Toronto recognized in L'Expert, the leading Canadian legal peer review journal, as an expert in franchise and distribution law. Ranked in the top 100 franchise attorneys in North America by Franchise Times.

You are just about to purchase your very own business. It's an exciting, nerve-racking time. You receive a 75 page agreement to sign. What should you do? What's negotiable? In this article, our franchise expert Peter Dillon explores what you need to know to properly protect your interests while recognizing some of the unique aspects of franchising. For more information on the legal aspects of franchising, visit www.FranchiseLaw.ca

Limitations on Negotiation

Franchising is a unique way of doing business. Unlike the "buyer beware," "winner take all" atmosphere of some business negotiations, franchising takes place in a very different framework. There are two components that most significantly set franchising apart from the one-off transaction. First, the franchisee is joining a system that may have dozens, hundreds or even thousands of other locations. As such, he is constrained in his dealings both by what has proceeded his deal, and what the franchisor reasonably expects will follow in the future. Second, he's entering into a long-term marriage-like relationship that requires a win-win attitude if the relationship is to succeed and be a happy one.

Lawyers representing parties in a transaction will often scramble for the opportunity to prepare the first draft of the deal documentation. In franchising, it is highly unusual for a franchisee's lawyer to prepare the documentation. In fact, in provinces where presale disclosure is required (currently Ontario, Alberta and PEI), such a scenario verges on the impossible, since the franchisor is required to present the franchise documentation as part of its disclosure document. In addition, the franchise agreement and related documents can not be overly slanted in the franchisee's favour. They must create an environment in which the entire multiunit system can function and grow. This usually requires the knowledge, planning and foresight of the franchisor in the preparation of the initial draft of the document.

Unlike the United States, where some states have legislation limiting the ability of a franchisor to negotiate different deals with its franchisees, there is little, if any, constraint on the scope of what a franchisee in Canada can negotiate. That is, having been presented with the franchisor's form of franchise agreement, everything is on the table.

Many franchisees and prospective franchisees will be aware that existing franchise disclosure laws in Canada require that a franchisor deal fairly with their franchisees. However, this fair dealing obligation is limited to the performance and enforcement of the franchise agreement. It is widely accepted that the fair dealing obligation does not apply to the negotiation of the agreement itself. As a result, you probably can not require or insist that the franchisor provide you with any or all of the same benefits that previous franchisees have negotiated, merely on the basis that failing to do so would be unfair.

Achieving Balance

The ability of a prospective franchisee to negotiate changes to an agreement will, to some extent, be a function of how many franchisees are already in the system (in theory, the earlier in, the more room for negotiation), and how much muscle the prospect has (a well-financed individual looking for multiple locations will usually have more negotiating muscle). However, even if the prospect finds himself with the ability to throw his weight around, he needs to ask themselves if that's the right thing to do. Consider a couple of examples.

First, many franchisees will want to negotiate as wide an exclusive territory as possible. Certainly, having an adequate base from which to draw your sales is important and needs to be considered carefully. However, there may be a point beyond which it becomes detrimental to seek exclusivity. Too large a territory means that your location may not gain adequate market penetration, leaving room for the competition to come in and eat your lunch. Similarly, your single unit will not be generating enough revenues to support a robust advertising and marketing program within your territory, also contributing to underachievement.

A second instance of short-term gain for long-term pain is negotiating too hard on the fees to be paid to the franchisor. This seems counterintuitive, because we're all raised to think that if we can negotiate a deal where we get everything and pay nothing, we've done very well. However, if it means that you have starved the franchisor into extinction because he's not generating enough royalty income to support the structure and to grow the system, then your approach has been shortsighted.

We need to get back to basic principles for a moment. Why are you considering buying a franchise? The answer needs to be something along these lines: "to be part of something bigger than I can start myself, using an already developed concept and brand." The more mature the franchise system you are considering, the more developed the concept and brand. In newer systems, the concept and brand are less developed.

I'm going to depart from the theme of this article for a minute to suggest that, at this point, rather than launching into a prolonged and possibly expensive negotiation with your franchisor, that you step back and do some homework. This homework consists of finding out as much about the system you are considering buying into as you possibly can. The Internet is a good place to start. You need to understand the concept and the market in which the franchisor operates. Read the franchisor's disclosure document thoroughly. Armed with this information, speak to as many existing and former franchisees as you possibly can. You need to know two things: are they happy, and are they making money?

If the answers to both of those questions are "yes," then I think your requirement to negotiate the agreement may be less. Of course, you can also ask them if they have negotiated any changes to the agreement, so that you can seek the same benefits that they have obtained. If existing franchisees tell you of some specific issues they've had with the franchisor, then you need to address those in your face-to-face discussions with the franchisor, and seek to negotiate specific changes to remedy those concerns.


What Provisions Are Negotiable?

At this point, it's probably worth considering who should be on your negotiating team. All successful businesses have trusted advisers. The team usually consists of your spouse, a lawyer, an accountant, a banker, and perhaps a close friend or business associate experienced with small businesses. Notice that your spouse comes first on the list. Unless you have an open and honest arrangement for dealing with business issues in the context of your relationship, your business, your relationship, or both will both suffer and the prospect for failure is greatly increased. In some cases, your business may succeed at the expense of your relationship, which for some may prove too high a price to pay.

As mentioned above, larger, more experienced franchisors are less inclined to tinker with their agreements. Consistency is a hallmark of franchising and the willingness of a franchisor to negotiate everything with you may in fact be a danger sign. One aspect of the negotiation is simply the process of examining the document to ensure that it accurately reflects your understanding -- and the franchisor’s -- of how the relationship works. An agreement that does not reflect the deal must be amended so that it reflects the deal accurately. If the franchisor refuses to make this kind of change, move on to the next franchise system on your list of possible investments.

Another general category of modifications that a franchisor should be willing to entertain concerns any aspects of the agreement that imposes unrealistic or impractical standards. For example, if the agreement requires you to provide audited financial statements within 30 days of your year end, you will be severely challenged to find an accountant willing or able to comply with that kind of timeline. Even stringent standards need to be fair and reasonable.

Here are some specific topics to be considered for negotiation.

Amount and Financing of Initial Franchise Fee

An obvious starting point for negotiations is the amount of the franchise fee payable. A sophisticated franchisor will have calculated its franchise fee on the basis of the amount required to repay the capital invested in establishing the existing franchise system structure, developing that structure according to its existing plans, and there may be a profit component to the fee.

One argument for reduction of the fee is the purchase of multiple locations by the franchisee. This will result in savings to the franchisor in such upfront costs as training. Another good justification for a reduction will be the purchase of an underperforming or failed location. If the franchisee brings something special to the table in terms of skills, contacts, locations or something else of value to the franchisor, it may also provide good reasons for negotiating a reduction in the fee.

Franchisees may also request terms for payment of the initial fee. This will almost always occur in situations where multiple locations are being developed over a staggered period of time. It may also be justified where the performance of some of the franchisor's obligations, such as transitional assistance or training, will occur over an extended period of time.

Royalties and Advertising Fees

Royalties are the lifeblood of a sustainable franchise system. A system that requires the continued sale of units to generate franchise fees is something of a Ponzi scheme, since a leveling of growth is inevitable for most systems. Again, a sophisticated franchisor will have established royalties at the level needed to sustain the system and provide an acceptable profit margin.

Some of the grounds for negotiating a reduction in royalty and ad fund contributions are the same as those for negotiating a reduction in the initial franchise fee. For example, the purchase of an underperforming location provides very good grounds for a reduction in royalties for at least some period of time. It's questionable whether a reduction in the ad fund contribution is in the franchisee's best interests. Instead, a savvy franchisee may instead request an increased dedication of marketing resources to his territory, in order to bring it up to an acceptable sales level.

You can expect that any request that your contributions to the ad fund be spent dollar for dollar within your territory will be strongly resisted by the franchisor. Not only is such a request difficult to administer, but it may hinder the franchisor's ability to tailor the marketing program in a way that benefits the system as a whole. This issue requires careful examination. Instead, consider negotiating a compromise. For instance, if the franchisor devotes a lot of marketing money to radio, but your territory is underserviced by that media, then try to negotiate an increase in the direct mailings that the franchisor will carry out within your territory.

Term of the Franchise

Virtually all franchise agreements will provide an initial term of a fixed number of years. The initial term must be long enough to permit the franchisee to obtain a return of all capital invested, and to generate some kind of acceptable return on his investment. Discussions with your accountant will provide the basis for this negotiation, and it's obviously extremely important.

Many, if not most, franchise agreements will also provide for some right of renewal, usually one or two renewal terms for a period of years that are each equal to the initial term. You can expect to be faced with the requirement to reinvest in your franchise during the term of the agreement, and often as a condition of exercising any right of renewal. This ensures that your location keeps up with the developing look, feel and function of the system as a whole. You should welcome this opportunity to "stay in the game," but consider negotiating some kind of cap on the amount required to be reinvested.

As an aside, if you operate from leased premises, you need to ensure that your lease provides you with the right to remain at that location for the same period of time as your franchise agreement, including any renewals.

Using Nonapproved Products or Service Suppliers

This can be a touchy topic. Many franchisors promote their system on the basis that franchisees enjoy the benefits of bulk purchasing. You should confirm that this is actually occurring with some of the existing franchisees.

Again, we need to return to first principles for a moment. You are buying into a franchise system because you want to enjoy the benefits of being part of a larger organization. One of those benefits is typically centralized ordering, warehousing, delivery and billing. Why then, would you want to spend your time and resources duplicating a system that is already available?

There are usually a number of key products, ingredients or services that are essential to the franchisor's concept. It simply not realistic -- or good business -- to expect that you can go out and substitute generic or lower quality products for these key goods and services simply because you think it will save you money. That kind of conduct will directly harm the franchisor's brand and you can expect a harsh response.

The issue is somewhat less clear when it comes to purchasing generic supplies and services. In this case, it seems like a reasonable expectation that a franchisee should receive those goods and services at or below the current market price, considering the quantity and terms of his purchases. In the case that there is some value-added to generic goods and services by the franchisor, such as centralized ordering, warehousing and credit, you can and should expect to pay something for that value. If there is no value-added and the franchisor uses franchisee purchasing merely as a source of income, that in itself is not reprehensible or illegal (it does need to be disclosed in the franchisor's disclosure document), but at a minimum, the franchisee still needs to be receiving these goods and services at or below the market price.

Conclusion

These are just some of the items that need to be considered when negotiating your franchise agreement. Remember, this is a business deal: treat it that way. You need to have a firm and realistic sense of the existing or projected sales, what it will cost to generate those sales, who is going to operate the business, and what support you need from the franchisor. Make sure that the agreement covers these areas, be prepared for some hard work, and happy franchising!