By Peter Snell
For most prospective franchisees new to franchising, a multi-page and standard form of franchise agreement is a new and unknown entity. For many, all contracts may look the same, or at least similar; therefore, it may be hard for a prospective franchisee to know if the agreement meets their needs. Are franchise agreements really all the same, or similar? The short answer is no, they are not.
Franchises may take many forms, and may be simple or complex arrangements, or somewhere in between. Even the simplest form of the agreement may be lengthy, and may contain numerous clauses. However, some of the clauses will be the same, or similar, no matter what type of franchise is being agreed to. Due to these perceived similarities, confusion often arises. This article looks to address some of this confusion in the following discussion.
In an effort to show the differences between types of franchise transactions, three common types of agreements that differ in how a prospective franchisee may purchase one or multiple franchised units will be explored.
For most prospective purchasers of a franchise, the subject of the transaction is the acquisition of the rights to establish and operate a single franchise. Most often, this means a single franchise to be established and operated at a single location.
However, not all franchises operate from a fixed and predetermined location. In many cases, the subject of the transaction is the acquisition of the franchise rights to establish and operate a single unit, within a single, defined area or territory.
Franchise lawyers will often refer to this type of transaction as being for a “unit franchise.” With this type of franchise transaction, a franchisee usually has a specific length of time to propose a location for the physical establishment of the franchise unit. Upon the proposal, the franchisor often has a specified time to either approve or disapprove the location.
However, not all franchises involve only a single unit, be it a single location or a single area or territory. In fact, some business transactions could be more complicated, and more extensive.
Multiple-unit franchise agreement
The prospective franchisee may wish to acquire a franchise to establish and operate multiple units. In some cases, if the specific number of units is known and is being granted for certain in the initial agreement, then the multiple unit franchise agreement will simply grant the rights to establish and operate the specific number of units that are involved.
If, however, the rights being granted are for the establishment and operation of multiple units, but are based on the “one at a time” method, then the franchise agreement will deal with the establishment and operation of the first unit, and then go on to provide for the potential development of multiple units in the future. Often, the granting of further units is based on the fulfillment of certain conditions before the rights to establish and operate any of the further units will become certain.
An option to be exercised by the franchisee for further units would likely also cover only a defined area or territory, and be exercisable by the franchisee within a defined time frame. For example, the prospective franchisee may acquire the right to establish and operate further units by way of a right of first refusal. This option would only be exercisable if the prospective franchisee has already fulfilled the conditions set out in their initial agreement. The right of first refusal may be exercised by the franchisee in the event the franchisor is proposing to establish and operate further units within the area or territory and the time frame, covered by the right of first refusal as defined by the initial franchise transaction.
From the franchisor’s perspective, certain conditions may be imposed that would have to be fulfilled by the franchisee before the franchisee would become entitled to exercise any such option to establish and operate any further units. Examples of such conditions may include:
- satisfactory operation of the existing unit or units;
- available financing;
- available management personnel to complete the required training and manage the multiple units in accordance with the franchisor’s specifications and standards; and
- any time limits which the franchisor may also have imposed in respect of the right to exercise the option, or the right of first refusal, or to establish and operate any further units.
Area development franchise agreement
If the area or territory within which the multiple units are to be established and operated is a large one, the nature of the agreement may be that of an area development franchise agreement. In this case, a larger territory is set aside, within which the franchisee will be entitled to and obligated to establish and operate multiple units.
Because area development agreements are often exclusive in nature, the franchisee will likely have to commit to establish and operate a certain number of units within a certain number of defined time frames. This commitment is often referred to as a “development schedule,” or a “performance schedule.”
The franchisee will meet the development or performance schedule by establishing and operating the required minimum number of franchises in the area or territory within the defined time frames. If they fail to meet the development schedule, the franchisee will risk losing its exclusive hold on the area or territory for further franchise unit development.
Not only may an area development franchisee risk losing its exclusive development rights by failing to meet the development or performance schedule, it may also risk losing any and all further development rights within the area or territory. To lose this right would freeze the franchisee’s expansion at the number of units already developed and being operated, leaving the balance of the area or territory open for the franchisor to grant further development rights to another franchisee.
In an area development franchise agreement, the franchisor may often put forward two forms of agreements to the franchisee. The first form is the “Area Development Franchise Agreement,” which describes and deals with the area or territorial development rights being granted. The second form is the “Unit Franchise Agreement,” which is to be entered into to govern the actual development and operation of each individual unit.
The above describes three common variations of a franchise agreement that may be entered into between a franchisor and a single franchisee, for development and operation rights within a franchise concept or system. To better understand which structure works in a particular system as a franchisor, or which structure to buy into as a franchisee, be sure to engage franchise advisors and lawyers as needed.