Common Legal Protections for Franchisees

Franchising is a business model in which one business (franchisor) grants the rights to another business (franchisees) to use the franchisor's established business model. Here are some ways for small businesses to optimize their advantages and minimize risks.

1. Diligently Research the Franchise.

The franchisor has already invested time and resources into building brand recognition, custom00er loyalty, and efficient operational systems. However, before committing to a particular franchise, it is important to diligently research the business, its history of demonstrated success, revenues, approach to marketing, customer service, reviews of other franchisees, and many other aspects. Franchisees should carefully read the franchisor’s disclosures and financial information, and request all necessary additional information to make their informed decision. Potential "due diligence" information may include (this is not a full list) basic corporate documents, financial documents, sales and marketing activities and materials, a list of franchisees (current and past), a list of all locations, reasons for termination of former franchisees, all pending litigations and claims, documents regarding intellectual property, a list of distributors and suppliers, and other information, depending on the business, industry, and specific dealing.

2. Calculate and Negotiate the Fees.

Franchisees are typically required to pay one upfront franchise fee and ongoing (usually monthly) royalties to the franchisor. Marketing fees are also not unusual. The upfront franchise fee depends on the franchise’s value and can be $20,000 or more. Monthly royalties and marketing fees are usually calculated by a percentage of gross sales. These costs can impact your bottom line and reduce your overall profitability. Carefully negotiating the fee provisions in the franchise agreement can establish transparency and allocate the risks. Things to pay attention to include the calculation methods, frequency and methods of payment, the amount for fixed fees, penalties and late fees, grace period, waiver of fees, and the definition of the default, among others. A franchisee should understand what all the fees include (for example, the use of trademarks, trade dress, training of employees, supply of products, a website, weekly newsletters, and other types of marketing). In sum, a franchisee should quantify the benefit of using the franchisor’s model and compare it with the fees he/she will have to pay.

3. Negotiate Your Freedom and Take Advantage of Franchisor’s Resources.

As a franchisee, you can benefit from operating under an established brand with an established business model. However, you also agree to operate within the guidelines set by the franchisor. This means you may have limited control over certain aspects of your business, such as location choice, pricing, menu, restrictions on goods sold, dress code, hours of operation, sales area, or marketing strategies. It is crucial to carefully read the franchisor’s guidelines and agreement. Franchisees can negotiate the scope of freedom and limit franchisors’ access to certain information or frequency of reports and audits, among other things.

Franchisees also may want to specify the franchisor’s responsibilities regarding other franchises' proximity to your location, franchisee support, and its terms, duration, and conditions, the marketing minimum scope, frequency, and budget, the supply of products and its terms, and other resources.

4. Allocate the Risks of Franchisor’s Failures.

Though franchisors presumably have established their business models, they are also not immune to business risks, mistakes, and fraud. To protect you from some of the risks, state and federal laws require franchisors to make disclosures to you in a Franchise Disclosure Document (“FDD”). Franchisees should at a minimum carefully read the documents and ask all possible follow-up questions. But FDD does not contain everything.

As a franchisee, you should define in the agreement your remedies for situations when, for example, the franchisor misrepresented the value of the franchise, violated the franchisor's duties regarding marketing, did not support or train, or allowed other franchisees to compete with you. The remedies may include a decrease or waiver of fees, monetary damages, the ability to ask the court to stop the franchisor's actions (injunction), termination of the agreement, indemnification, or other remedies.

5. Outline Smooth Transition and Termination Rules.

A franchise agreement usually has a term. Franchisees can negotiate the duration of the term and the option of renewal, automatic or not. Franchisors generally want to retain as much power to terminate the agreement as possible. For example, franchisors usually want to be able to terminate the agreement if the franchisee violates certain standards or does not pay the fees. If this happens, the franchisee will lose the whole business. Therefore, the more you can limit termination reasons, the better. Franchisees may want to include a cure period for violations or narrow the definition of default.

If you want to sell your business, franchisors typically want to retain the right of first refusal and the discretion to approve the transfer of business and/or appoint a manager. For the right of first refusal, franchisees should seek to clarify the limits of the right (or even remove it) and detail the process of determining the price. Franchisees also prefer to limit the franchisor’s discretion in approving the successor-franchisee. That would give franchisees more flexibility in selling their business. Other important terms that franchisees should pay attention to are the payments upon termination, distribution of inventory and materials, confidentiality, non-compete, and non-solicitation. Those terms may affect franchisees’ ability to open other businesses, compete with the franchisor, or solicit customers.

In sum, franchising can be a powerful tool for business growth if used properly. Franchisees can benefit from an established business model and brand recognition, but they have to be willing to pay franchise fees and royalties and accept associated risks.

This blog is not legal advice. All information here is general in nature and does not contain all possible legal protections. Anyone seeking legal advice should retain an attorney.

Federal Trade Commission's Guide to Buying a Franchise
SBA: Franchise Fees: Why Do You Pay Them And How Much Are They?
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