The warning signs in franchise deals

The only way to be sure about any agreement is to check with other franchisees to see how they have been treated. Context – how the system is run – is far more important than the agreement itself.

The Globe and Mail
August 1, 1997

The warning signs in franchise deals
John Southerst


Signing a franchise agreement puts you in a bind. “Don’t sign away your rights,” your lawyer advises. If a dispute winds up in court, judges will expect that you have read and understood every clause. Don’t expect the courts to strike down the terms of the contract.

The decision on whether the agreement is fair or not is your, right now. It is not good strategy to leave it to a judge, later.

That leads to another dilemma: Few contractual terms automatically brand the franchise agreement as “bad,” says Toronto franchise lawyer Ned Levitt. It all depends on other circumstances: for example, the franchise chain’s track record with other franchisees, what else it is offering or taking, and the overall prospect for earning a profit.

“A franchise business is like a bowl of rice,” says Mr. Levitt. “It’s how much they [franchisors] are taking from the bowl that’s important.”

Let’s look at a few standard provisions, and what quagmires may lurk within:

EXCLUSIVE SUPPLIER ARRANGEMENTS: The franchisor locks the franchisee into buying only from certain suppliers. Often, the franchisor is foremost among them. In the hands of big, experienced operators such as KFC, this isn’t an issue. But if this is the third franchise in a very new chain, the franchisor may not deliver on time, every time, or it may gouge you on prices.

REBATES ON VOLUME PURCHASES: The franchisor reserves the right to all rebates on volume purchases of supplies. Major franchisors usually include this provision to avoid haggling with franchisees over how much of the discount they have passed along. That’s a thin excuse, but so long as a franchisor spends a good portion of it to build the system through advertising, advisory services and so on, it’s probably fair. In the hands of a new or unscrupulous franchisor, however, this provision can scrap one of the main incentives for buying a franchise – purchasing power.

TERRITORIAL PROTECTION: This is a tricky one. Many franchisors no longer offer exclusive territory. If it’s a fast-food business in a mall food court, you probably don’t care because the customer traffic will still be there. But if you’re selling home alarm systems, you need to be able to knock on enough doors in your territory to make enough sales to meet your projections.

But territory can be too generous. New franchisors sometimes offer exclusive territories that are too big. Not only does this stunt the synergies of the franchise chain – imagine the results if McDonald’s had permitted only one restaurant for Toronto, one for Montreal, one for Vancouver – it’s also a recipe for conflict. When the franchisor wakes up to what has happened, it could try to frustrate the franchisee in order to force a sale and redraw the territorial boundaries.

TERM OF AGREEMENT: It must be long enough to earn a return on the total investment. For a Molly Maid franchise, with a total investment of about $17,000, a five-year term is sufficient. Fast-food chains usually need a 10-year term, while a full-service restaurant such as Swiss Chalet, with total average investment of up to $1-million, normally needs a 20-year term to make financial sense.

The difficulty arises when, for instance, a 10-year term is broken into two five-year terms, with renewal subject to possible increases in royalties and the “consent” of the franchisor. The new contract could be unpalatable, or the franchisor could simply refuse to renew. Therefore, the franchisee has to consider it a five-year investment. If the agreement stands up under a five-year term, fine. If not, renegotiate.

ARBITRATION: Many franchisors now force franchisees to sign away their right to sue in the event of a dispute. Instead, you must submit to arbitration. This may work to the franchisees’ advantage, as it can avoid costly legal proceedings. But if the franchisor uses the clause to tie up disputes, it could be frustrating. Expect the franchisors to provide an ombudsman and an advisory council, and check on the outcomes of mediations with existing franchisees.

While no single term makes an agreement “bad,” bad franchisors do exist, says Vancouver consultant Norman Friend of the Franchise Group. Bad franchisors may reveal themselves by refusing to put their verbal representations in writing.

“If they say you’ll make a million, or that they’ll buy the franchise back at the same price if you don’t make money, make sure they put it in the franchise agreement. If they’re not prepared to do that, it was obviously garbage. Talk is cheap.”

The only way to be sure about any agreement is to check with other franchisees to see how they have been treated. Context – how the system is run – is far more important than the agreement itself.

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Risks: Masterpieces of deceptive wording and artful omission, Gouging on rent and equipment, Gouging on supplies, Secret kickbacks and rebates, Arbitration, Must buy only through franchisor (tied buying), Tied contracting, Contracts across systems are virtually the same, Indemnification provisions, Protect gross negligence, wanton recklessness and intentional misconduct, Sign away human rights and legal remedies, Encroachment (too many outlets in area), Refusal to renew contract, Renewing contract much tougher, Coerced waiver of legal rights, self, Within the four corners of the contract, Canada, 19970801 The warning

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