Focus on Franchise Security

Graeme Payne is a partner in Bird & Bird’s global retail and consumer group, which supports and advises start-ups, entrepreneurs, SMEs and blue chip multinational luxury, retail and food and beverage businesses across the full spectrum of legal and commercial issues. With offices throughout Europe, the Middle East, the Far East and Australia, Bird & Bird’s team are ideally placed to advise growing food and beverage businesses on international expansion, brand protection, reputation management, HR, technology including mobile payments, e-commerce, food regulation, labelling, advertising and marketing, commercial property and corporate issues.

Investing in a food and beverage franchise is a significant decision.  Unfortunately many potential franchisees fail to take proper independent legal and specialist franchise advice.  This has a number of potential consequences including, not only a failure on the franchisee’s behalf to understand their legal and commercial rights and obligations from the outset of the relationship, but can also mean that the potential franchisee misses the opportunity to negotiate certain legal and commercial amendments to the franchisor’s standard documentation.

Food and beverage franchises often require significant upfront capital investment commitments including the lease, fit-out, engagement of staff and the purchase of initial stock and equipment.  The investment levels will further increase for those franchisees looking to become multi-unit operators.

It is therefore important that potential franchisees are fully aware and advised of their legal and commercial exposure. 

There are a number of inherent risks in franchising and from the potential franchisee’s perspective, can be broadly broken down as follows:

Personal liability – Franchise agreements will potentially require both personal operational and financial commitments from key individuals in the franchisee’s business – which could include personal guarantees if the franchisee company fails to comply with its payment obligations.

Financial exposure – In addition to the opening fees and on-going royalty fees, a number of seemingly benign provisions in the franchise agreement can expose the franchisee to significant capital investment requirements.  For example, the ability for the franchisor to oblige the franchisee to update or refresh the branding and/or to comply with the franchisor’s refurbishment recycles can have significant financial ramifications as well as consequences for the franchisee’s relationship with the landlord. 

Loss of business / loss of capital investment – A franchisor’s standard franchise documentation will often provide for a number of grounds and scenarios where a franchisee can have its business terminated. In multi-unit relationships there is the potential for a franchisee to lose its right to operate the franchise from all of its outlets even when the breach alleged by the franchisor has taken place in relation to one unit only.

Potential franchisees should therefore engage specialist franchise solicitors to review the franchise agreement with these three key areas sitting as the background to any comments/areas of pushback. Discussed below are just some of the key provisions of the franchise agreement that franchisees need to be aware of and which should be discussed with their specialist franchise advisors. 

Intellectual property

Potential franchisees should ensure that the franchisor has adequately protected the key intellectual property rights, in particular the trademarks, which the franchisee will be obliged to use throughout the term of the relationship. The franchisor’s brand is often a critical factor to the success (and value) of a franchise. In the context of a food and beverage business the trade mark and branding elements will impact upon menus, staff uniform, trade dress and more importantly, the advertising and marketing to be undertaken by the franchisee. Franchisees - particularly of international concepts - should therefore ensure that the franchisor has invested properly in its brand. Otherwise the franchisee is exposed to potential third party claims.

Nature of rights

Franchisees will need to ensure that if they are being granted the right to operate an outlet from a particular location, that other franchisees of the franchisor will not be setting up in close competition or that the franchisor itself will not be setting up a corporate premises within the immediate vicinity. Franchisees will therefore need to check that if they have been promised exclusivity in a certain area that the franchise agreement expressly provides for this.

Sourcing of equipment and ingredients

A key area for food and beverage businesses will be the sourcing of equipment, menu items and core ingredients. The franchisee will need to ensure that the franchise agreement adequately deals with the responsibility for sourcing such items and the potential financial implications for the franchisee. A well drafted franchise agreement should also provide the franchisee with the opportunity to source from alternative suppliers (to those nominated by the franchisor) in the event that the franchisee can source either superior quality products or similar quality products at a better price.

Commercial property

One of the most significant investments for franchisees in the food and beverage sector will be the lease of the commercial property. The franchisee will need to ensure that the franchise agreement and the lease fit together in terms of term and renewal, permitted use, and avoids potentially conflicting obligations to the landlord and the franchisor in terms of refurbishment cycles. The franchisee will also need to consider whether the franchisor wishes to have a step-in right vis a vis the property and the potential consequences for the franchisee (and its right to use the premises) in the event that the franchise is terminated. 

Termination grounds

From the outset the franchisee, working in tandem with its legal advisors, will need to ensure that the termination grounds are clear and reasonable. A well drafted franchise agreement should clearly define those breaches which lead to instant termination and those breaches where there is an opportunity for the franchisee to remedy. As mentioned above, where the franchisee has invested in commercial property – particularly so in the case of multi-unit operators – the franchisee will need to ensure that it is capable of using the property beyond the term of the franchise arrangements.  The franchisee will therefore need to check carefully any post termination or post expiry restrictive covenants that may prevent the franchisee from using the premises as a food outlet following the termination or expiry of the franchise agreement.

Financial obligations

The franchisee will need to ensure that the financial provisions of the franchise agreement reflect the commercial proposition discussed with the franchisor. Franchisees will need to carefully review any exclusivity fees, store opening fees, training fees, support fees, on-going royalties and advertising and marketing related contributions. It is advisable that the franchisee also reviews the franchise agreement in conjunction with its accountant and factors in both the express fees and costs detailed in the franchise agreement together with other potential capital investments, for example, refurbishment of the premises, into its business plan.

Business sale 

The final key area that a franchisee should pay particular attention to, is the right for both the franchisor and the franchisee to sell their respective businesses.

Most franchise agreements will provide a right for the franchisor to sell the franchisor’s business without consulting with the franchisee and this can have serious implications in the event that the new owners no longer wish to continue with franchising or wish to introduce significant changes which would require further capital investment by the franchisee. 

It is also important that the agreement provides a right for the franchisee to sell its business and that the terms of such sale are not unduly onerous upon the franchisee, for example, an obligation to pay a high percentage of the sale price to the franchisor.

Specialist advice

In summary, franchise agreements are typically heavily weighted in the franchisor’s favour, and therefore, franchisees who are investing in a franchise business must take appropriate legal and commercial advice on the implications of the franchise agreement and consider negotiating amendments to unduly onerous legal and commercial provisions.