New York Franchise Law Blog : Franchise Lawyer & Attorney Charles N. Internicola, Providing National Representation of Franchisees and Franchisors

When a franchise agreement expires, franchisors and franchisees, many times, enter a decision making period to determine, discuss and negotiate whether or not the the franchise agreement will be renewed.  Although not preferred, this post-termination negotiating period is sometimes necessitated by on-going negotiations and delayed decisions.  During this critical negotiating period - one where the franchisee is, most likely, operating the franchised business without a franchise agreement - franchisors, many times, unnecessarily jeopardize the protection of their trademarks and trade dress by failing to require the Franchisee sign what should be a mandatory acknowledgment.

• The Scenario - Franchise agreement expires and franchisor and franchisee negotiate the potential renewal.  During the "post-termination negotiations" the franchisee continues to operate the franchised business and continues to utilize the franchisor's trademarks and trade dress.  Although the Franchisor does not expressly acknowledge the franchisees continued operation, the franchisor does not continue with the enforcement of the franchise agreement's post-termination restrictive covenants. 

• The Problem that Arises - By permitting the franchisee to continue operations - without the benefit of an on-going franchise agreement - the franchisor is legally acquiescing to the franchisees technical infringement of the franchise systems trademarks and trade dress.  In doing so, the franchisor weakens its marks and makes later enforcement of the franchisee's post termination restrictive covenants more difficult.  While this "problem" is, typically, not fatal, it is nevertheless costly. Especially where negotiations break down and the franchisee continues to violate the restrictive covenants.

• The Solution - During this gap negotiating period, insist that the franchisee sign an agreement whereby the franchisee acknowledges that the franchisor is withholding enforcement of the post-termination restrictive covenants for a limited period of time, i.e., two weeks

The foregoing "problem" is not that great but it is an issue that "muddies the water" in franchisor and franchisee litigation and results in unnecessary legal fees and time.  That is, rather than advancing the franchisors right to restrict the former franchisees future business operations, the franchisor is exposed to the frivolous defense that, somehow, the franchisor acquiesced and waived its right to enforce the post-termination covenants.

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When it comes to identifying the "governing documents" that serve as the the infrastructure for a franchise system, it is extremely difficult to overstate the significance of a franchisor's "operations manual" and the critical role that it serves.  Designed to inject a form of flexibility into the franchisor - franchisee relationship (compared to the static terms contained in the franchise agreement) the operations manual (if properly referenced and identified in the franchise agreement)  the operations manual should serve as a critical vehicle to enable you to consistently refine, further develop and modify (within reason) the components of the franchise system and the day-to-day obligations of franchisees. 

Considering the interdependent relationship between the "franchise agreement" and the "operations manual", it is critical that franchisors constantly refine, update and supplement the operations manual to insure that the operations manual accurately identifies and reflects:

• Current franchisee training obligations.
• Current Area Developer and Area Representative training obligations.  Keep in mind that if you offer multiple franchise opportunities that go beyond a "single unit franchise" you must maintain separate operations manuals.  That is, if you offer area development or area representative rights, you must prepare and maintain a separate operations manual for area developers and area representatives;
• Current approved suppliers and vendors;
• Current architectural plans and specifications;
• Current rules and restrictions respecting the utilization of trademarks and trade dress; and
• Current procedures respecting the reporting of gross sales and reporting information;

There are many other topics that must be maintained and continuously updated in the operations manual.  However, the key is to consistently implement a franchise compliance program that is focused not only on the annual renewal of your franchise registrations but also the overall composition and accuracy of the operations manual.  Otherwise, should franchisee litigation arise, you may be exposing your franchise system to unnecessary "legal headaches" and potentially frivolous claims. 

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I am a firm believer in the efficiencies and economies of scale that may result from operating multiple franchise units.  Provided that you are a dedicated business person and that you are operating within a solid franchise system, the advantage and benefit of operating multiple franchise locations may be substantial.  Of course, if things are not going well, owning and operating "multiple units" may serve to double or triple your difficulties.  If you are a prospective franchisee considering the potential investment in a multi-unit franchise opportunity (i.e., where you obtain the "right and obligation" to develop more than one franchise unit with a proscribed geographic territory) you must carefully consider and evaluate the advantages, if any, that will result from any potential “mult-unit opportunity”.

When evaluating a multi-unit franchise opportunity your starting point must involve a thorough analysis of the franchisors FDD and a clear analysis as to the substantive rights that you will be acquiring as compared to the additional "legal obligations" and expenses that you will be assuming. Factors that should be evaluated include:

• What is the amount of the development fee that you must pay to acquire the multi-unit development rights?

• Will you be afforded a discount to the franchisor’s fixed ”initial franchise fee”; If a discount exists will the discount allow you to recoup the additional initial development fees that you will be required to pay to the franchisor?

• Will you be afforded a protected territory that possesses sufficient demographics and territory size to permit your "profitable" development of the franchise units that you will be required to develop?

• Will you receive a reduced royalty structure as you develop additional franchise units, or, will you be paying the same royalty rates as single-unit franchisees?

• What are the minimum number of franchise units that you must develop?

• Is the development time-table sufficient for your development of the required number of franchised units;

I am a strong proponent of multi-unit franchising and believe that for the right franchisee, multi-unit franchising presents a significant opportunity. However, much will depend on the franchisor, the franchise opportunity and your ability to develop and manage multiple franchise units. If multi-unit franchising is something that you are considering, you must also recognize that there may be additional opportunities (when compared to the negotiation of a single unit franchise) to negotiate and refine the terms of your franchise agreements.

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Many times, "start-up" franchisors (and, too often, some established franchisors) overlook the necessity of maintaining a thorough operations manual that is both "current and relevant" to the particular franchise system. That is, many times operations manuals are viewed as an "afterthought" or a"generic" obligation to be sourced out to third party vendors.

Much more than a "generic resource", your operations manual must be drafted, updated and maintained as an integrated extension of your franchise agreement and FDD disclosures. Recognizing the critical importance of a properly prepared and integrated operations manual, startup and established franchisors should consider the following:

• Franchise agreements are typically drafted and structured to integrate and obligate franchisees to abide by both current "and future" operational requirements set forth in the operations manual. If the franchise agreement is drafted properly, the operations manual should create "contractual flexability", allowing the franchisor to modify elements of the franchise system through amendments and supplements to the operations manual.

• Your operations manual must serve as a thorough blueprint to provide franchisees with detailed "how to" information respecting each and every administrative and operational element of the franchise system.  

Examples of "administrative obligations" include (a) the franchisees royalty and financial reporting obligations, (b) franchisees financial record retention obligations, and (c) system requirements for point of sale systems. 

Examples of "operational obligations" include (a) franchisees obligations respecting the management of the franchise business, (b) requirements for management and control of inventory and supplies, (c) building and construction plans and specifications, (d) training programs and obligations, and (e) operational elements respecting the day-today management and operation of the franchised business.

• The preparation of your operations manual cannot be a task that you simply "outsource". While it is prudent to obtain the advice and input of a qualified consultant (including your franchise attorney), the operations manual must directly reflect and embody "your" direct understanding and knowledge about the franchised business. "You" must be the primary contributor and driving force behind the preparation and development of your operations manual.

• Your operations manual must be consistent with your franchise agreement and FDD. Review with your franchise lawyer the content of your operations manual to ensure that there is consistency with your franchise agreement. Ensure that your training programs are extensively identified in the operations manual and properly disclosed.

• Your operations manual should be constantly updated, refined and clarified to reflect the constant and continuous evolution and growth of your franchise system. 

Your operations manual is critically important to the long-term success of your franchise - treat it as such.
 

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For the start-up and established franchisor alike, as your franchise system evolves continuous consideration must be given to your franchise agreement and "the legal rights that you reserve for your franchise system".  That is, basic to every franchise agreement are the "reservation clauses" identifying and  establishing alternative channels of distribution and legal rights  that are not granted, conveyed or licensed to your franchisees.  These reserved rights typically address alternative channels of  distribution and markets that are expressly reserved to the  franchisor.  Examples include internet sales, mail order sales, captive market accounts and licensed products sold through alternative sales channels.

Chances are that your "existing franchise agreement" contains reservation clauses.  However, have you recently reviewed these legal provisions?  Are the reservation clauses contained in your franchise agreement generic, or do they account for your future plans for expansion? When evaluating your franchise agreements and future plans for expansion, discuss with your franchise attorney and staff:

• Potential distribution and sale of private label products;
• Potential expansion and development of alternative franchise systems;
• Licensed distribution and sale of signature products and services through non-franchised outlets; and
• Your current and future plans for internet and/or mail order based sales.

There are other points but they are all based on the fundamental fact that you must be constantly evaluating your franchise agreement to ensure that it matches where your franchise is today and where it may be ten years from now.  Avoid the generic.

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In a comment to a recent post - "5 Things to Know before Buying a Franchise" - the Franchise King, Joel Libava, raises the critical issue of maintaining "uniformity" in franchise agreements.  That is, the insightful Mr. Libava, challenges the propriety of promoting negotiated modifications to franchise agreements.  The point raised by Mr. Libava is a legitimate and genuine issue that must be evaluated by both franchisors and prospective franchisees.  

From a franchisors perspective uniformity is a critical factor that must underly the franchisors  legal relationship with its franchisees.  Similar to the uniform standards and procedures inherent in franchise systems, franchise agreements must also maintain consistent levels of uniformity.  Such uniformity will, at a minimum, serve to reduce litigation exposure and foster a consistent platform for the management and growth of the overall franchise system.  

From a franchisee's perspective, uniformity in franchise agreements may be a positive factor (i.e., a franchisor committed to its franchise agreement and systems) if the proposed franchise agreement is "balanced" and the franchisor possesses a substantive track record.  So how do you determine if the franchise agreement is "balanced" ?  You do your research, review the franchise agreement and FDD with a qualified franchise lawyer, speak to qualified franchise consultants and conduct the necessary due diligence.  Chances are that there will be "imbalances" in your proposed franchise agreement - there always will - but you must honestly evaluate the impact of this relationship.

So how do I put all this together, i.e., "franchisors perspective", "franchisees perspective", "balance", "imbalance"? Here are my thoughts:

1.  If you are a franchisor, focus on the development of a balanced franchise agreement that fosters the maintenance, protection and growth of, both, your franchise system and business interests of your franchisees.  Once this is achieved - really achieved - then stick to your franchise agreement and be prepared to "walk-away" from potential franchise sales;

2. If you are a prospective franchisee and you have viable questions or concerns about a potential franchise investment (after you have conducted the necessary due-diligence and evaluated the legal implications of the franchise agreement) then be prepared to "walk away" . 

The real issue comes down to a "third scenario" involving  a "franchisor not prepared to walk-away" or a "franchisee not prepared to walk away".  These are the situations where negotiations and targeted franchise agreement modifications come in.  For that prospective franchisee I would much rather obtain targeted franchise agreement modifications that I know will have a substantive impact on the prospective franchisees rights.   I think that Mr. Libava's position would be that  there should not be a third scenario?

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Below are five steps / factors / issues that you should be considering and evaluating before investing in a franchise.  There are many more than five, but the following is a start.

(1) Due Diligence is Critical – If you are considering the purchase of a franchise it is critical that you conduct an in depth evaluation of both the franchisor and the potential franchise opportunity. Far too many franchisees just assume that if a franchise system has multiple franchisees, good looking stores and trade dress, that the franchise opportunity must be profitable. However “profitability” is not guaranteed and all franchises are not created equal. You must research and evaluate the franchisor, the franchise system and whether or not the franchise opportunity is a good fit for you.

(2) Thoroughly Examine the Franchisor’s FDD with a Qualified Professional – If you have already contacted a franchise company to inquire about your potential purchase of a franchise opportunity, chances are that you have been handed, mailed or emailed an extensive document referred to as an “FDD”. FDD stands for “franchise disclosure document” and is the legally mandated disclosure document that a franchisor must provide to you at least 14 days prior to your execution of any agreements or your payment of any money. The FDD is an important document that will serve as a significant resource to enable you to more thoroughly examine the franchise opportunity that you may be considering. The FDD will contain information about the franchisors management team, the franchisors “estimate” of the start-up costs that you should expect to incur and the royalties and on-going fees that you will be required to pay. FDD’s are important and before investing in a franchise you should hire an experienced franchise lawyer to review this document.

(3) Contact Existing Franchisees – One of the biggest resources that a prospective franchisee should consider is the opinion and experiences of existing franchisees. When evaluating a franchise opportunity, take some time to politely contact existing franchisees (choose a franchisee in another state or someone that you will not be in competition with), let the existing franchisee know that you are considering the purchase of a franchise and that you would appreciate it if they would speak with you about their experiences and satisfaction with the franchisor and the franchise system. Don’t just contact franchisees recommended by the franchisor – seek out the advice of as many independent franchisees as possible. Item “20” of the FDD titled “Outlets and Franchisee Information” should include a list of the existing franchisees and their contact information, so use the FDD as your starting point to identify franchisees that you should contact.

(4) Understand that Franchise Agreements are Negotiable – When a franchise opportunity is presented to a prospective franchisee, many times, the prospective franchisee is advised that the franchise agreement is “not negotiable”. Some franchisors and their sales staff may even take this approach a step further and advise that even if they wanted to change the franchise agreement that it would be illegal for them to do so. However, before you simply sign a franchise agreement and pay a franchise fee, you must understand that franchise agreements are indeed negotiable. It is not illegal for a franchisor to negotiate the terms of your franchise agreement. While you must be reasonable with your expectations about the franchise agreement terms that a franchisor may or may not be willing to negotiate, review the franchise agreement with your franchise lawyer and develop an approach to address and negotiate some strategic points that may enhance your rights as a franchisee. Some of the critically important franchise agreement terms that you should be evaluating with your franchise lawyer and potentially negotiating, include:

(a) Scope of your protected territory;
(b) Grace periods regarding the commencement of royalty obligations;
(c) Liquidated damages and liability for early termination;
(d) Renewal rights;
(e) Transfer rights;
(f) Cure periods for alleged defaults; and
(g) Potential "rights of first refusal".

(5) Sometimes the Best Decision may Be to “Walk Away” - It is critical that you remain “honest with yourself” during your due diligence investigation and the consulting with your franchise lawyer. That is, the franchise that you once believed to be a great opportunity (one that you were previously excited about and told your family you were purchasing) may turn out not to be what you expected. Sometimes in the excitement of this entrepreneurial venture you may be inclined to discount or overlook warning signs that should serve as a red flag. Understand that walking away from a franchise transaction, sometimes, may be the best business decision. 

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(Great, a lawyer answering a question about whether you need to hire a lawyer)

Answer? Yes - but not right away.  

The competent advice and guidance of a franchise lawyer will serve as a valuable tool (one of the many "tools" that are required) to be utilized on your road to entrepreneurship and the purchase of a franchise.  The advice provided by your franchise lawyer should be based on practical experience and involve a detailed review of the proposed franchise agreement and franchise disclosure document (FDD) and be followed by negotiatios with the franchisor.  However, while hiring a franchise lawyer is critical, it should not be your first step.

So what do I mean by "not right away"?  The process of buying a business is not a "sprint" (at least it should not be) but rather an "endurance event" that will require you to seriously evaluate your individual needs, business skills and expectations.  Once you have made this assessment, you will be faced with the challenging task of finding a business that is both profitable and right for who you are and your skill sets.  This is no easy task and will require that you do significant research (tons of resources available on the web), communicate with other business owners, communicate with existing franchisees (to do this, see "Contact Existing Franchisees before Signing a Franchise Agreement") and, possibly, seek out the advice of franchise professionals.  Don't just pick or get stuck on one particular franchise model or limit your research to the information provided to you by the franchisor's salesperson.  Remember, first and foremost, what matters most to a successful franchise investment are "profits" that will be  measured by your ability to take home money to your family each and every month.  So question everything.  If the franchise sells soup, then question how you will earn "profits" in the summer.  If the franchise sells ice cream, understand how "profits" are generated in the winter.  If the franchise appears to draw long lines or generate large revenues, then question what percentage of  those long lines and revenues are converted into "profits". 

Once you have completed your own internal analysis and "business review" , thats when the legal advice and analysis becomes critical.  The franchise agreement that you will sign will serve as the blueprint and road map for your business for many years to come.  As such, there are many, many critical issues that you must address with your franchise lawyer.  Some of the many issues that you must discuss and evaluate, include:

• The franchise fee that will be charged;
• The continuing royalty that you will be paying on a monthly or weekly basis;
• Advertising fund fees that you may or may not be required to contribute to;
• Approved vendors and suppliers of the supplies and products critical to your business;
• The protected territory that you may or may not be granted;
• Buildout and lease obligations that you will be required to undertake;
• Many, many other issues.

In many instances, (contrary to statements by a franchise sales person that their franchise agreement is "non-negotiable") your franchise lawyer will be able to negotiate and implement modifications to your franchise agreement that will have a substantive impact on your franchise investment and increase the odds for your success.  In today's economic climate, my experience has been that franchisor's are more willing than ever to negotiate with new franchisees.  Even things like deferring "royalties" for a number of months.  

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