Franchising allows a small business owner to have a tried and true method for opening their own business by utilizing a system already in place. Franchises are created when a franchisor grants a franchisee the right to use its brand, systems, and support in exchange for initial and ongoing fees.
A franchise agreement outlines rights, responsibilities, restrictions, and financial obligations for the franchisor and the franchisee; therefore, it is extremely important that a potential buyer read these documents before entering into a franchise purchase.
FDDs are provided to all potential buyers by the Federal Trade Commission as a means to allow buyers to make an educated purchasing decision regarding their investment.
In other words, reviewing your franchise agreement and Franchise Disclosure Document before signing will help ensure you have made an informed decision with regard to your future business venture.
What Is a Franchise Agreement?
A franchise agreement is a binding contract that defines the rights and obligations of both parties and sets how the franchised business must be operated, including requirements and consequences for non-compliance.
The agreement grants the right to operate a franchised business at a specific location, along with fees, brand standards, and compliance requirements. The franchise rule, which was enacted by the FTC in order to enforce federal disclosure laws, is another force that has shaped this document.
In addition to providing an FDD to prospective franchisees, the FTC requires that franchisors allow a minimum of 14 days for review before agreeing. The former uniform franchise offering circular served as a similar disclosure mechanism before it was replaced with the FDD.
Key elements outlined in a franchise agreement
- Initial franchise fee and all additional franchise fees.
- The required building equipment and construction, and how to present your store.
- Rules that govern operating the franchise and how you will operate it as a franchisee.
- How much territory have you been granted, and where are you located in relation to the rest of the franchisees.
- What training and support is owed by the franchisor to you.
- Terms regarding renewal, transfer, termination, and resolution of disputes between the parties.
5 Reasons a Strong Franchise Agreement Protects You
A well-drafted franchise agreement does more than protect the franchisor. It also helps the franchisee understand the rules of the system, evaluate risk, and plan for long-term franchise ownership.
1. It sets clear rules and governance
The strong agreement outlines the terms of the daily operations for the franchise. This includes approval rights, operating guidelines, and when the franchisors’ prior written approval, or their written consent, is needed.
As an example, prior written approval from the franchisor could be required for a franchisee to relocate, transfer ownership, modify the appearance of their store location, etc.
If a site must be approved by the franchisor, that requirement should be clearly stated before the franchisee signs a lease or commits to a buildout. Clearly outlining the governance structure will help reduce misunderstandings and clarify expectations for both parties involved.
2. It protects the brand and intellectual property
The agreement protects the franchisor’s reputation, trademarks, operating system, and franchisor’s proprietary methods.
Each of these limitations may be in place for no other reason than to help ensure that each location in the franchise system has an equal opportunity to benefit from the brand image and the long-term viability of the business model.
3. It promotes consistency across locations
Consistency is one of the biggest strengths of the franchise business model. Regardless of which location you visit, your experience should be as close to identical as possible.
This level of consistency can be found with an operational manual, approved vendors, and the use of company-approved software, service protocols, in store marketing techniques.
Most franchisees are required to adhere to product preparation, staffing, quality control, reporting & customer experience.
4. It reduces misunderstandings and disputes
A detailed contract provides a level of clarity for all parties regarding their obligations, like fees, training, advertising obligations, territories, compliance with local regulations (such as food safety), and default provisions (what will happen if either party fails to fulfill an obligation).
And remedy provisions (how each side will be able to seek satisfaction from the other if one or both fail to fulfill an obligation). Clarity on these items may result in less potential for future disputes and make dispute resolution easier should disputes occur.
5. It aligns both parties for long-term success
A good agreement balances the interests of both the franchisor and franchisee. It provides the franchisor with the tools needed to protect their system; meanwhile, it also serves as a guide for the franchisee in order to help them operate successfully.
Best agreements reflect the reality that the franchisor desires consistent brand standards and systemwide growth, while the franchisee desires a viable market, practical support, and a fair chance to build a profitable local business.
Critical Provisions to Review Before Signing
Before entering into any franchise contract, focus on the provisions that directly affect profitability, control, and risk. This step is especially important when buying a franchise, as these provisions determine your long-term financial stability and operational flexibility.
This is where many prospective franchisees either protect themselves or overlook costly issues. As a prospective franchisee, you must review those contractual provisions that will most directly impact your profit margin, level of control over your business, and risk exposure.
In addition to protecting yourself in this area, you may be able to avoid potential problems with your financial viability by examining some costly areas you may have otherwise overlooked.
1. Initial and ongoing fees
Franchise owners need to know the total cost structure of a franchise. The total cost includes:
- The amount of the initial franchise fee
- Recurring Royalties
- Technology fees (if applicable)
- Training costs (if applicable)
- Renewal fees (if applicable), any additional ongoing fees
As mentioned above, royalty language can tie payment to gross retail sales, generated by the franchise owner’s gross retail sales. Identify how each term is defined within the agreement.
Does the agreement account for customer and discounted sales? Will refunds be deducted? Is there a minimum payment required regardless of whether revenue has dipped?
You should also confirm whether royalty payments are based on weekly or monthly reporting, and whether any hidden charges apply, including shipping expenses paid for products, supplies, or marketing materials.
2. Territory and exclusive rights
A territory can help or hinder a unit’s financial performance, so your contract must specify whether you have a unique territory, if it applies to one franchised location, and whether the franchisor can establish additional units, kiosks, online channels, or new business models near your territory.
If your rights are tied only to the franchisee’s location or franchised location, make sure the boundaries are defined. This includes the franchisor’s ability to sell through electronic commerce channels, to use non-traditional distribution venues, or to develop new products or services.
3. Training and support
One reason many people choose franchising is access to initial and ongoing training. The agreement should explain what the franchisor’s initial training program includes, where it takes place, and whether attendance at the franchisor’s designated training facilities is mandatory.
Also, if the franchisor has an obligation to provide additional ongoing education (i.e., workshops, seminars, conferences, etc.), the agreement should describe these obligations and how they will be delivered.
4. Operating standards and system control
Many franchise agreements require franchisees to comply with the franchisor’s operations manual, vendor standards, and approved systems, which ensure consistent and high-quality operation within the franchise model.
When reviewing your franchise agreement, make sure you carefully review all clauses that pertain to:
- approved suppliers
- site standards & site inspections
- product/service requirements
- reporting obligationsreporting obligations
- required software & technology
- local marketing rules
- use of proprietary methods of the franchisor
Also, pay attention to clauses stating that actions are subject to the franchisor’s sole discretion.
5. Marketing and advertising commitments
When it comes to many of these contracts, there will be a contribution component for national, regional, or local advertising. Take time to determine what you have to contribute, who will run the campaign, and if there will be any direct benefits to your area from this money.
Also consider local promotional methods and pricing flexibility. Check if the contract defines customer and discount sales. Make sure that the language supports your overall marketing plan; do not view this part of the contract as a separate or stand-alone item.
Ultimately, when you sign the contract, you need to have sufficient flexibility to promote yourself locally, but at the same time protect the brand.
Franchisee Development Obligations and Approval Rights
The obligations of a franchisee are much broader than just making payments. Typically, a franchise agreement will outline specific requirements that the franchisee is required to follow regarding the operation of their business. These typically include:
- Adhering to the operations manual.
- Using approved equipment and vendors.
- Maintaining the property.
- Meeting quality standards.
- Participating in training.
- Submitting reports and financial statements.
If the franchisee requests design assistance, relocates, transfers ownership, or seeks exceptions to standard operations, the franchisor may require a franchisee’s written request and the franchisor’s prior written approval.
- design assistance,
- relocation of a unit,
- transfer of ownership (including transfer of an ownership interest),
- request an exception to the franchisor's standard operating procedures,
- requests for changes to signage,
- requests for remodels of the premises,
- requests for changes in supplies,
- requests for local promotions or offers, and
- requests for changes in corporate structure or ownership.
In some cases, the franchisor’s prior approval requirement applies to signage, remodeling, suppliers, local offers, and even ownership changes involving such ownership interests.
The Role of the Franchise Disclosure Document and Legal Counsel
The Franchise Disclosure Document (FDD) does not provide the same information contained within the franchise agreement; it should always be reviewed in conjunction with the franchise agreement.
The FDD provides a framework for understanding what your franchise offering contains, such as:
- litigation history,
- fees associated with opening and operating a franchise location,
- estimated investment to open and operate a franchise location,
- restrictions placed on the operation of the business,
- training provided by the franchisor,
- support provided by the franchisor,
- suppliers used by the franchisor,
- system standards provided by the franchisor,
- and may include financial performance representations.
A franchise attorney must be included in any serious review process. An attorney who knows franchise law can explain to you:
- whether the contract terms are commercially reasonable
- which provisions may be negotiated
- how renewal and termination rights work
- if the dispute resolution mechanism is fair
Understand Financial Performance and Business Planning
Be cautious with the financial performance representations if they are included in the FDD. Compare any reported income data from the FDD with what your costs will be, that is:
- the initial franchisee fee
- lease and construction
- software and technology
- labor
- inventory
- insurance
- recurring (i.e., on-going) fees
- advertising contributions
Renewal, Exit, and Dispute Resolution
First-time homebuyers often place too much emphasis on the initial costs of purchasing a new home and fail to review the back end of their purchase agreement.
When you sign your agreement for your new home, it should be clear about your rights during each year of renewal, as well as your transfer rights.
It should address whether the franchisor can buy assets at fair market value, and how inventory, signage, equipment, or a former franchised location is handled after termination or expiration.
Answer these questions very thoughtfully:
- Will the agreement renew itself, with new conditions (terms), or will it require an entirely new contract?
- What are the consequences for the franchisee if they fail to comply with the requirements for renewal?
- Are there non-competition or confidentiality agreements that will bind the former franchisee in some way upon exiting the franchise?
- Is the franchisee allowed to sell their business without receiving prior written approval from the franchisor?
- Does the franchisor have an option of first refusal to purchase your business before you may attempt to sell it?
- What is the applicable method for resolving disputes: through mediation, by using an arbitrator, or by filing suit?
- Can either party pursue emergency relief, including seeking injunctive relief?
Key Takeaways Before You Sign
A franchise agreement is more than paperwork; it is the rulebook for your entire franchise relationship, explaining what the franchisor grants, what the franchisee acknowledges and accepts, and what happens if the franchisee fails to meet required standards.
It also sets forth the economics of the deal, operational controls, training structure, and limits on your flexibility as an owner.
This contract represents the “rules” for a successful relationship with a franchisor, including all details of what is granted by the franchisor, what you are acknowledging or accepting, and the consequences if you fail to meet performance levels established in the agreement.
In practice, there are several things that you should know about:
- your initial franchise fee and all other ongoing franchise costs
- how to determine your "gross retail sales."
- whether or not you will have a protected territory.
- which items require prior written approval from you by the franchisor.
- what form of support are provided in the initial training program for the franchisee.
- any restrictions imposed upon both you and the franchisee regarding business operations during and after the term of this agreement.
FAQs
A franchise agreement is the contract between a franchisor and a franchisee. The franchise agreement outlines the rights and responsibilities of both parties as well as all of the agreed-upon fees associated with running a franchise, including operational and marketing requirements, what territories are allowed to be used, required training, and how long the term of the franchise will last (including whether it can be terminated).
The franchise disclosure document provides potential buyers of a franchise with factual details concerning the franchise opportunity, as well as the legal agreement that a buyer will sign in order to run the franchise operation. In accordance with the FTC’s Franchise Rule, an FDD must be given to the buyer prior to their either entering into the franchise agreement or making any payments for the purchase.
Typically, you will find an initial franchise fee, and then royalties, marketing contributions, and tech charges as part of your continuing fees. Royalty obligations are often based on gross retail sales or the franchisee’s gross retail sales, so franchisees should review how those amounts are defined before signing.
Territory matters because it determines whether the franchisee has protection around a specific franchised location or a group of franchised locations. In addition to protecting the local market for that location, a well-defined territory clause will limit intra-franchising competition, and define if the franchisor can have additional locations, channels, or service providers located near to the franchisee.
Yes. A franchise attorney can review your franchise agreement, compare what you have agreed to in your franchise agreement with what was disclosed in the FDD, and help you understand some potential legal risks of being a franchisee.
And point out key provisions dealing with renewals, transfers, restrictive covenants, default events and dispute resolution processes. Getting a legal review done on your franchise agreement can provide an educated base upon which to decide to invest in the franchise.
Conclusion
The franchise agreement is more than a mere contractual obligation. It is the operating framework for the business franchised hereunder and the foundation of the entire franchise relationship.
In addition, it forms the basis of the franchisee-franchisor relationship. It also protects the brand, outlines your franchisee’s obligations, and gives the franchisor tools to maintain consistency across the system.
Before signing any franchise agreement, you need to carefully review the franchise disclosure document (FDD) and then compare it thoroughly to the actual agreement. You should also have a consultation with a licensed attorney who specializes in franchising law.
FranchiseCoach, Adam Goldman, may be able to assist you in transforming your business goals into a clear, confident business plan. Your success story begins by understanding the contract prior to committing.
