Business models – Franchises

December 2010

What is a franchise?

A franchise is a way by which a franchisor creates a business model which is replicable, and licences a franchisee to operate this business model under the franchisor’s brand in return for a fee.

The franchisor will exercise some continuing control and will provide some assistance.

There are no special legal concepts involved – it is essentially just a form of licence arrangement.

Is franchising the best option?

When thinking how to grow a business you might want to think instead about how other business models might work for you. The nature of the product or service which the business relates to will be critical to your decision. You need to consider a number of factors such as risk, capital investment, available intellectual property rights, relevant markets and competition, growth and exit objectives and related timing, and employment obligations.

Other options might include setting up a sales agency or distributorship network; or a joint venture or collaboration of some sort; or a master franchise; or a combination of any of these.

Secrets of a good franchise

A strong replicable business model

A good franchise has a replicable model based on a business process or system with a strong brand which has a solid set of rules which can be set out in writing in an operations manual and pushed down to all franchisees. The more ‘collateral’ you can produce the better! If there is anything you can protect on the IPR front (by creating recognisable trademarks etc), so much the better, but many successful franchises rely more on the contractually imposed knowhow and operational requirements they place on their franchisees to create the value from their replicable system.

If you are thinking of building a franchise business it is important to give as much thought as possible to how you are going to develop and structure your business process. Ideally you want to thoroughly test the business model yourself and have a clearly documented system before you start rolling it out to franchisees. Once you start rolling it out you do not want to be changing the system in any big way, and you certainly don’t want to be agreeing variations to the system or to the contractual franchise terms. A usual way is to start one or two pilot operations yourself as though it were a franchise, and work on it until you are happy. Some successful franchises do however start on a more experimental basis with trial franchisees, who work with the franchisor to develop a refined system and contractual franchise structure, and who will be offered attractive commercial deals in return for their involvement (and the increased risk they take on by taking the franchise before the franchise has a strong value).

A win-win deal

A good franchise model should balance the franchisor’s wish to get paid lots of fees from different franchisees against the need to motivate and incentivise the franchisees.

Pros and cons of franchising:

Pros for a franchisor:

-A scaleable business model.  A quick way to establish your brand and distribution channels as widely as possible and build value.

-A good opportunity to build up a saleable business.

-Less capital investment (it’s shared to some extent with each franchisee)

-A motivated and incentivised workforce (ie your franchisees)

Cons for a franchisor:

-Less operational control on the ground. It’s important to have a well-established and well-documented system which franchisees must follow; and to make sure they do follow it. It’s also important to select your franchisees wisely, as they are the ones who will drive the business forward and build the brand value in their territory. Their failure will damage your brand. So it’s important to incentivise them as much as possible– to create a ‘win-win’ franchise model which doesn’t make it too hard for them and demotivate them.

-It’s not so easy – different skill sets are needed to manage and support franchisees, compared with traditional methods of running and building a business.

-It’s arguable that the rigid and controlled business processes which are needed for a franchise model have the downside of making the business less adaptable to change in a fast-changing world – eg new economies, technology, competition etc. No business can stand still…

Pros for a franchisee:

-Easier to start up because of the support provided by the franchisor, and the fact that you are working (hopefully) with an existing proven business model and reputation.

-Less operational risk compared to starting up on your own account, because of the head start on brand profile and the ability to drive sales.

-Less capital investment (it’s shared to some extent with the franchisor).

-You are your own boss and have the opportunity to own and grow your own business within whatever constraints are imposed on you by the franchise model.

-Ongoing support from the franchisor (a good one, anyway).

-Possible buying power and other benefits of size.

Cons for a franchisee:

-You have little opportunity to be ‘entrepreneurial’ in approach, in the sense of being innovative, creative, opportunistic or having a business which can have exponential growth.  You are bound by the strict business processes and other controls imposed by the franchisor. You do not have much ability to scale up the value of the business beyond whatever geographical or other restrictions apply to your franchise.

-You have only limited opportunities to realise a good value on a sale of your franchise (although a good franchise model will try to make it possible for a franchisee to achieve this).

-You are tied in. You have to continue paying franchise and other fees and contributions even if you think you have built your business up so it doesn’t need the franchisor’s help, reputation or processes  any more. Or, worse, the franchisor might be doing badly, or even prove itself to be financially unviable, causing knock-on reputational and financial damage to your franchised business. But you can’t just walk away because you continue to have obligations during the franchise period. And although the franchisee may be your company, you as its owner might well have been required to give personal guarantees of the franchisee’s obligations. You will also be tied in with restrictive covenants preventing you from simply breaking away and setting up on your own account or working for someone else in a similar business.

 

Franchisees, watch out for the following situations:

-You are offered a franchise but you are the first!

-The franchisor doesn’t have clear and well-documented processes by which the business is meant to operate.

-The franchise agreement is poorly worded and doesn’t contain provisions you would expect to see. ALWAYS (of course!) run it past an experienced lawyer. (By the way, the lawyer DOESN’T have to be a member of the Venture Capital Association – like many other organisations they charge their members an awful lot of money (for not a lot more than the ‘value’ of being accredited) which for many very capable lawyers who don’t spend their whole lives doing franchise work (and perhaps losing the wood for the trees as a result?) isn’t worth spending. You’ll have guessed I’m not a member!)

– Don’t just rely on what the franchisor says. Always do your due diligence on the franchisor and on its franchise business. Although they are likely to owe you a duty of care, and could theoretically be liable if they give you negligent advice, this only happens rarely (as in quite a recent case involving Kall Kwik in April 2010) as they will usually protect themselves with disclaimers, so you are unlikely to be able to sue them (throwing good money and time after bad) if their projections proved to be over-ambitious. Always have at least a soupcon of suspicion. Always prepare your own business plan, cash-flow forecasts, etc. Always involve an appropriately qualified accountant.

Always look to get references from existing franchisees.

Think hard about what you might be looking to achieve out of having the franchise against what you are going to have to pay the franchisor, the effort and commitment you are going to have towards the business, and the alternative options available to you.

Some (but by no means all!) standard franchise issues to consider:

-Territories:

The franchisor needs to make careful decisions about the territories it is offering to franchisees, and whether territories are exclusive to franchisees.

-Property:

How important are premises to the business? Where should they be located? Where should the risks lie? There are various different ways in which a franchisor may wish to deal with the question of premises. He will want to balance the ability to take over control of the premises if the franchisee fails or leaves against the risk of taking on the related liabilities. Much depends on how important the location of any premises is to the franchise business model. Where the premises are key to the business, the franchisor will often take a headlease (so the landlord is happy) and will grant a sub-lease to the franchisee. The sublease terms need to tie in with those of the franchise agreement.

-Intellectual property rights (IPR):

The more IPR the franchisor has, the better it can protect itself against infringement and competition. Some franchises have the benefit of patent protection for their product. Most will look to protect their brand with appropriate trade mark protection. However, many franchise businesses will not be able to protect themselves to a significant extent with registrable IPR in this way. Instead, they will depend on ensuring that their franchised business processes are protected by a combination of imposing confidentiality (and restrictive covenant) obligations on their franchisees, and by becoming sufficiently well-known to be able to rely on the law of passing off. Passing off applies where someone seeks to take advantage of the reputation in another’s goods or services by adopting a similar name or get-up or otherwise implying a link between his products or services and another’s. It’s all about protecting established goodwill or reputation in a business. Franchisors should do all they can to protect this, in terms of quality control etc.

Compliance with relevant laws:

You need to be aware of relevant laws, such as European and UK competition laws. For example, you need to be careful not to fix prices (although you can impose maximum resale prices, and can recommend resale prices) and not to impose restrictions on passive sales outside an exclusive territory or customer group (ie where the customer comes to the supplier even though the supplier hasn’t actively solicited that sale). Otherwise, competition laws are usually not too much of a concern, particularly if the franchisor and franchisees have a combined turnover of under £20m or a market share of under 15%. OnHand Counsel can produce draft agreements which are tailored to comply with relevant legislation (eg to comply with the EC block exemption for vertical agreements).

Restrictive covenants:

As a rule, courts won’t enforce restrictive covenants which go further than necessary to provide appropriate protection. This is one reason to be careful not to go over the top when drafting restrictive covenants. But a key aspect of franchise agreements is that the franchisor enables a franchisee to use and benefit from its knowhow. So the courts are perfectly happy to enforce these kinds of restrictive covenants in franchise cases, as a way to protect a franchisor’s specific knowhow from its competitors.

In a recent case, a franchisee company went bust and transferred the business assets to another company which continued a similar business. The franchisee and the new company argued that the restrictive covenants were in breach of the Competition Act 1998. The court upheld the covenant and awarded an injunction against the franchisee and the new company (because it was complicit in the breach of the covenant). Note that you don’t need to be a party to a restrictive covenant to be bound by it. So if someone approaches you and offers to help you do business in competition with their previous company, and you encourage them to do so knowing that they will bring trade secrets or will be breaking restrictive covenants, then YOU can be held liable as well. (For more on this case, read the judgment in Pittec (UK) Ltd v. Joinplace Ltd, 7 July 2010 – or don’t bother, just take my word for it.)

Need help?! The OnHand Counsel approach

This is by no means a comprehensive summary of things you will need to think about when considering setting up or entering into a franchise agreement.

Through the legal knowhow providers that I and most of the best UK law firms subscribe to (to whom I pay many £1,000s a year!), I have access to top quality franchise agreement precedents as well as to all sorts of other agreements and clauses to suit all sorts of scenarios. As with all precedents, I do not charge just for providing them. As far as possible, where a wheel has already been built I do not try to re-invent it; instead I try to find from my stock of wheels the wheel which can best be tailored to get the best job done for my clients. I generally charge fees simply by reference to the time I spend on any particular matter. This might include the time spent reviewing and selecting and deciding how best to apply and tailor the precedents and other knowhow available to me. But what clients really look to me for is not to re-invent the wheel, but to provide practical strategic advice as to the kinds of business deals they should be entering into and the issues they should be addressing, and practical advice and assistance in negotiating and putting together their business deals. My drafting skills can then be better spent in tailoring any agreement to meet their needs.