Whether a franchisee or franchisor, when starting such a partnership both parties are generally committed to a long-term and fruitful business relationship. But while focusing on getting the business up and running, many give little thought to the backbone of the successful partnership: the franchise agreement.
It is important to carefully review and discuss important legal isues up front that will set the tone for the business partnership. For starters, using vague and overly broad terms related to royalties and other fees leave an opening for a disagreement in the future. Royalties and other fees should be tied to narrowly defined revenue sources.
In traditional franchise arrangements, royalty payments and other fees are often based on a percentage of overall sales. Clearly define net sales or gross sales, and understand what sources of revenue are included in or excluded. Pay close attention to the franchise disclosure document and whether other franchisees are working with the same terms.
Does the franchise agreement require a personal guarantee from the franchisee’s principal? If so, for what debts and liabilities?
Establishing a corporate structure will not shield a franchisee from personal liability if there is a signed personal guarantee in place. Importantly, the franchisee can remain personally liable under a guarantee long after selling or leaving the business.
A franchisor’s willingness to negotiate the application and scope of a personal guarantee may differ depending on whether the franchisee is a single- or multi-unit franchisee. Consider discussing whether to limit the duration of personal guarantees so that they expire after a number of years of ongoing operation in good standing. If the franchisee is well-funded or has multiple units, consider whether to waive or release personal guarantees based on the strength of their balance sheet. For the franchisor, review the franchisee’s balance sheet to assess how much the personal guarantee is worth in the event the franchisee defaults under the franchise agreement.
Get everything in writing and be leery if either party says, “Don’t worry about it” or “We can deal with that later.” Most franchise agreements include provisions that only the written terms of the agreement will be binding. To protect oneself in the event of a later dispute, take notes immediately after conversations with the other party particularly after “Discovery Day” or in meetings and phone calls leading up to signing the agreement.
Be sure to communicate an understanding of the agreed upon terms in writing to the other party. Written communications and notes of conversations can have a significant impact if a dispute arises with regard to the meaning or application of a vague or ambiguous term in the franchise agreement.
Rights of First Refusal
A franchisee may be required to offer to sell a franchise to the franchisor before freely selling it to someone else. This obligation may make the franchisee’s business less appealing to a third-party buyer and less valuable. For example, a third-party buyer may have to wait for the franchisor’s right of first refusal period to expire or execute a new franchise agreement that does not include the terms of your more favorable agreement.
For the sake of continuity, the franchisor may consider permitting the franchisee the right to sell to another existing franchisee, to a member of the existing ownership group or to a family member all without triggering the right of first refusal.
Right to Purchase
Agreements may allow the franchisor to purchase the franchise for a stated price based on a multiple of profits or another formula. Make sure that the terms of the purchase are clearly defined with definitive time periods in which the parties may act and close the sale.
A franchisor must protect against a franchisee’s argument that the purchase provision is vague and unenforceable, and a franchisee must protect against building a great business only to be faced with having to “give it away” to the franchisor for less than it’s worth.
It is important to pay attention to these issues on the front-end of the franchise relationship to help ensure success down the road. Consult with legal and financial professionals who have experience with these issues and franchise relationships.