Structuring the Franchise Relationship

In the first of our two articles, we presented an overview of federal and state disclosure laws regulating the offer and sale of franchises. In the second article, we examined the risks in business relationships that the parties initially did not intend to be treated as a franchise, but upon reflection, are recast as franchise relationships, which we called hidden or accidental franchises. These hidden franchises are posited to exist by a dissatisfied party usually upon expiration or termination of the relationship in order to obtain a legal advantage granted by the law to franchisees. Today, we will discuss the basic considerations of structuring a franchise offering or relationship based on a desired growth model. These articles are intended to provide an overview to the practitioner who does not regularly practice franchise law or is unfamiliar with regulations concerning the offering, sale and franchise relationships in the states at issue. Should specific issues arise relating to franchise law, we strongly urge our readers who do not concentrate their practices in franchiser law to seek out competent co-counsel familiar with the crazy quilt of state regulation which may affect the structuring of these franchise offerings.

Generally, a unit franchise agreement authorizes a franchisee to operate an individual, single geographic location for the point of distribution of the franchisor's goods or services. The unit franchise agreement may limit the distribution activities from that location by identifying the channels of commerce where the distribution may be advertised or may occur. The location may define the point of distribution as being limited to real estate and may prohibit offerings of the franchisor's products or services over the internet. An individual or unit franchise grants a franchisee the right to develop and operate one outlet within a defined territory, which may be limited to the four walls of the address of the franchisee's building.

A unit franchise agreement does not typically address the possibility of a franchisee acquiring additional units. Expansion rights may be negotiated by a unit franchisee, but such rights are rarely contained in the unit franchise agreement. An individual or unit franchise is often offered in connection with service business franchises in which the franchisee's expertise is critical to the success of the business, or for businesses requiring a hands-on, owner-operator. The drawbacks of individual or unit franchises are their unsuitability for passive investors and that it represents a relatively slow method of growing a franchise system. Expansion rights are typically granted upon a showing that the unit franchisee has fully exploited its existing market and has demonstrated the ability to expand successfully.

Exclusive development agreements grant a unit franchisee an incentive to expand typically promises some measure of exclusivity in the market to be developed. This expansion is typically conditioned on the financial wherewithal of the franchisee, demonstrated success in the franchisee's existing markets and conditions exclusivity on demonstrated achievement towards the development plan. These exclusive agreements are merely options to hold the areas available for the franchisee to exercise a right of first refusal over the area to be developed and provide unit franchisees to concentrate the development of its locations.

An area franchise agreement is a more aggressive mode of growth which generally provides for multiple outlet franchises and imposes on the franchisee the obligation to develop multiple franchisees within a defined territory. The significant elements of an area franchise agreement are the territory and its definition, whether the territory is exclusive or the conditions upon which exclusivity may lapse, time frame for development of the number of units the franchises has committed to develop, whether and to what extent the franchisor will assist in development, fee obligations, and conditions upon which the area franchise agreement may terminate and the consequences of such termination. Consequences of termination of an area franchise agreement may include termination of existing individual unit franchise agreements operated pursuant to the area agreement, as well as potential termination of the area franchise agreement because of violation of individual outlet franchise agreements. The franchisor typically negotiates to receive a portion of its initial franchise fees at the outset to guard against the lost revenue incurred by the franchisor where the area developer ties up the geography but does not develop the locations to provide a stream of revenue to the franchisor.

Subfranchising is a very aggressive method of growth which allocates many of the obligations of the franchisor to the subfranchisee. It is often the path to the fastest growth and is often accompanied by growing pains. In subfranchisng, a subfranchisor is not only granted a right to develop and operate franchises within a defined territory, but also assumes some of the support responsibilities of the franchisor in the geographic area and may subfranchise others to operate individual unit franchises. In this arrangement, the franchisor and subfranchisor enter into a subfranchise agreement which licenses the subfranchisee to open units and provide some of the franchisor's services to units within its geographic territory. Often, the subfranchisee's business plan is to open the units and then sell and provide some of the services to the units. In a variation called Master Franchising, the master is actually empowered by the franchisor to fully act as the franchisor exclusively within a geographic territory. Such rights may include the offering and sale of initial franchises and supporting these franchises. In subfranchising, the franchisor may be a signatory to the unit franchisee. In a master relationship, the franchisor may not even sign the unit franchise agreement issued by the master even though the franchise agreement grants a limited right to use the franchisor's system.

The economics of subfranchising typically provides that the franchiser and subfranchisor share in franchise fees paid by the unit franchisee, depending upon their relative investment and the services that each renders to the franchisee. Upon termination of the subfranchise agreement, the unit franchises are either automatically assigned to the franchisor under the subfranchise agreement, or the franchisor has an option to buy the subfranchise agreements. It is also important to negotiate rights for the franchisor to control the subfranchisor and unit operator's real estate where the system is location dependent.

Subfranchising may lead to remarkable expansion at a much faster rate than any other method of expansion and has been used by some of the largest franchisors in the world to expand their businesses. The risks are great in subfranchising because of the expansive powers granted the subfranchisee. An ineffective subfranchisee can cause an entire market to suffer and may create fail to police the franchisor's system or proprietary rights. A subfranchisee which fails to meet its performance obligations to franchisees often causes a franchiser to face the very litigation risk it sought to avoid in the first instance. Disappointed franchisees will seek all available deep pockets for redress. Even if the franchisor is not a signatory to a unit franchise agreement, the franchisee will seek recovery against the franchisor whose brand name is identified with the franchisee's business.

In summary, franchising provides structures for growth not available in any other business model. The franchisor can craft an agreement carefully controlling the reciprocal responsibilities of the unit franchisee, the developer, the area developer and the subfranchisee. These are the factors you should consider in deciding which type of franchise agreement to use.

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