When partners become rivals

You can trust the franchisor based on its past history, he says, but many wary investors will choose to walk away from such unrestricted agreements. “The likely outcome then,” he says, “is that franchisors will end up with less sophisticated franchisees. ”Which may be just what they bargained for.

The Globe and Mail
April 18, 1997

When partners become rivals
John Southerst


Unlike most chains, Mr. Submarine actually defines territorial rights in its franchise agreeements, right down to the street names. Tibor Kolley/The Globe and Mail

Small business owners expect competition, but they get upset when the competitors turn out to be their partners. This is a common occurrence in the franchising world, where the practice is known as encroachment.

Usually, allegations of encroachment arise when a chain opens a new store near an existing one. Sometimes, it is unintentional. For mature franchise systems with plenty of locations in every market, it becomes difficult to open new units without stepping on existing franchisees’ toes.

But disgruntled franchisees accuse some systems of using encroachment as a strategy, opening excessive numbers of stores in one area to pump up royalties on gross revenue, without giving franchisees a chance to turn a profit. When a besieged owner fails, the franchisor simply resells the store and banks another fee from the new owner.

These days, encroachment is an even bigger issue as franchisors search for growth through new avenues of distribution.

H&R Block, for instance, now offers tax services on the Internet. Taco Bell sells a line of its products in grocery stores. The Body Shop distributes catalogues by mail. And countless fast-food chains have set up min-outlets in non-traditional locations, such as department stores, hospitals, universities and factories that are not far from existing franchisees.

How existing owners react to these initiatives often depends on how the chain communicates with them. Still, a potential for competition with fellow franchisees is there.

In the United States, where fast-food chains have a head start of 10 or 20 years, franchisees frequently take allegations of encroachment to the courts. Not so in Canada.

Encroachment is “the number one concern and topic” among franchisors, says Toronto franchise lawyer Frank Zaid, but “there’s nothing specific happening in the courts.” Encroachment disputes are numerous, he says. “They’re just not public yet.”

One reason there are no court decisions is that chains are compensating existing franchisees for lost business to avoid going to judges for decisions.

“A lot of this gets hassled out on the doorstep of the courts,” says Ned Levitt, another franchise lawyer in Toronto.

As a would-be franchisee, you should ask:
1. Does the franchisor offer exclusive territories?
2. Does the franchisor have plans for future distribution channels?
3. Is there a mechanism to determine the impact of new outlets on existing franchises in the same area?
4. Does the franchisor have a compensation policy for such cases?
5. Would you be compensated for the impact of lost sales or would you only be given right of first refusal on nearby franchises?
6. Does the franchisor reserve all rights to himself and none to you? If so, consider walking away.

Other franchisors take a more preventive approach. Unlike most chains, Mr. Submarine actually defines territorial rights in its agreements, right down to the street names. It specifically exempts universities, hospitals, factories and highway locations from the territories so there can be no dispute over future outlets in these unconventional locations.

“Anyway, these places have their own customers,” president John Tobin says. “University students eat on campus and factory workers eat lunch in the building.”

Large U.S. franchisors often stipulate impact policies in their agreements as another way to defuse disputes. The Tony Roma restaurant chain’s agreement says the franchisor and franchisee will split the cost of an independent study to determine whether a new restaurant will take away more than 10 per cent of the franchisee’s sales.

Either party can commission a second study if it disagrees with the results of the first, and if the two sides are still at odds, they must submit to arbitration.

Formal policies on the impact of new franchises haven’t caught on widely in Canada. Still, many chains – including Mr. Submarine – conduct studies to settle disagreements.

The border line between “acceptable” impact and egregious damage to the existing franchisee appears to be about 10 per cent of sales, says Toronto lawyer Paul Jones. A 20 per cent potential drop in sales is too high, he says.

At the same time, a franchise system aims to promote its trademark and that carries the obligation to sacrifice something for greater visibility.

Indeed, some franchisors believe the existence of a high-performing location indicates that a territory is underexploited. They argue that if they don’t open more outlets, competitors will. “So they say the franchisee will be hurt anyway,” says lawyer Mr. Levitt. “Better it’s us than someone else.”

But what happens if the damage is too severe? Ideally, the franchisor will drop the idea – or the encroachment policy may set a compensation formula or provable loss of revenue.

Another way to resolve the dilemma is to give the nearest franchisee the right to buy the new outlet. But a franchisee who accepts may wind up running two failing stores instead of one if the second one actually cannibalizes sales from the first.

Franchisees have a few viable defences against encroachment by a determined franchisor. Most agreements state up front that the franchisee buys nothing more than an address. Franchisors usually claim the right to open other outlets and adopt whatever modes of distribution they choose.

“A franchisee should be alert to the meaning of such clauses,” says lawyer Mr. Jones.

You can trust the franchisor based on its past history, he says, but many wary investors will choose to walk away from such unrestricted agreements. “The likely outcome then,” he says, “is that franchisors will end up with less sophisticated franchisees.”

Which may be just what they bargained for.

John Southerst is a Toronto business writer who can be reached by E-mail at moc.eriw-eht|htuosj#moc.eriw-eht|htuosj.

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