A New Era in Franchising Continues to Emerge: Should a More Balanced Franchise Agreement Play a Role?  

Franchisors might consider the impact of their current agreements with respect to their stated policies of encouraging multi-unit franchisees.

By Aziz Hashim and Brian B. Schnell, CFE

The faces of franchising are changing, as many franchisors continue to recruit qualified multi-unit franchisees as key stakeholders for their system’s expansion.  The focus for these franchisors is no longer primarily “mom and pop” single store operators who often invest their life savings as first-time buyers in a business.  Similarly, existing multi-unit franchisees and other sophisticated candidates continue to seek growth or expansion opportunities through franchising.  These trends have gained momentum the past few years and will continue to do so in the future. For many franchise systems, successful multi-unit franchisees will fuel sustainable growth that if done properly can result in the franchise system and brand outpacing their competitors. The faces of franchising are changing, as many franchisors continue to recruit qualified multi-unit franchisees as key stakeholders for their system’s expansion.  The focus for these franchisors is no longer primarily “mom and pop” single store operators who often invest their life savings as first-time buyers in a business.  Similarly, existing multi-unit franchisees and other sophisticated candidates continue to seek growth or expansion opportunities through franchising.he faces of franchising are changing, as many franchisors continue to recruit qualified multi-unit franchisees as key stakeholders for their system’s expansion.  The focus for these franchisors is no longer primarily “mom and pop” single store operators who often invest their life savings as first-time buyers in a business.  Similarly, existing multi-unit franchisees and other sophisticated candidates continue to seek growth or expansion opportunities through franchising. This new era in franchising isn’t simply that more franchisors are expanding through multi-unit franchising rather than single-unit operators; that dynamic has existed for decades.  The new era is that more multi-unit franchisees and qualified candidates new to franchising are more sophisticated from a business, commercial and influence perspective.  The questions they raise, the expectations they have and the requests they make all are more complex and more demanding than even just a few years ago. A Changing Landscape Franchisors that recognize and proactively address this changing landscape should benefit compared to franchisors that sit on the sidelines or wait and react too late to change.  What we intend to explore over the course of the next few months and through a related series of articles is whether a more balanced franchise agreement plays a role in that changing landscape. Here are a few of the questions we will address: Should the modern franchise agreement be balanced or more balanced?  What might a balanced franchise agreement look like? What are the benefits and risks of a more balanced franchise agreement or a modern franchise agreement with more balanced provisions in certain key areas?  What are specific examples of franchise agreement provisions that a franchisor might consider changing as part of this approach? Recent developments suggest that these questions are appropriate as franchising encounters several important challenges and opportunities in the coming years.  These developments include: an improving economy that still has uncertainties like Obamacare and potential changes to minimum wage laws, all of which underscore the importance of unit-level performance for all franchise systems; recent proposed state franchise legislation in key states including California, Pennsylvania and Maine, which proponents have advocated is necessary because franchise agreements have become too one-sided to protect the franchisor with few, if any, protections afforded franchisees and therefore the state legislatures need to adopt legislation to protect franchisees; and despite these challenges, franchising remains healthy and extremely viable as an effective way for all stakeholders to grow a brand and business. Our objective is not to suggest that a franchisor must rewrite its franchise agreement, as that truly is a decision that requires a review of many different factors that are unique to a company and its strategic objectives, the franchise system and brand, and how the franchisor views its stakeholders, as well as many other competing interests and goals.  What we are suggesting though is that, in light of recent developments in multi-unit franchising, it would behoove franchisors to consider the impact of their current agreements with respect to their stated policies of encouraging multi-unit franchisees. Brands should ask themselves whether their current agreement is conducive toward recruiting and retaining multi-unit franchisees. Rather than simply rely on the franchise agreement it has used for years, a franchisor should at least consider the opportunity to provide more balance in some key provisions in the franchise agreement.  For some franchisors, change toward more balance in some key provisions may make sense.  For other franchisors, change may not make sense.  For many multi-unit and sophisticated franchisees, it may make a difference in their decision to join a system.  That is the beauty of franchising.  There is no one approach or one answer.  One size does not fit all. The Role of the Franchise Agreement In this first article, we begin with what we consider to be the role of the modern franchise agreement.  We then examine why franchisors and franchisees have disparate views on the franchise agreement and how confrontation occurs in franchise systems and the role the franchise agreement plays in those confrontations. At its foundation, the franchise agreement is the legal contract between the franchisor and franchisee.  It defines each party’s rights and obligations regarding important facets of the franchise relationship.  Rather than ambiguity, clarity and predictability should be the goal when addressing the franchisor’s and franchisee’s rights and obligations in the franchise agreement.  For example, if a franchisor does not grant any form of territory protection, then the franchise agreement should clearly state that the franchisee has the right to operate at the authorized location only and the franchisor can develop additional locations under the same or different trademarks or use alternative methods of distribution in any way it deems appropriate.  Predictability should be another cornerstone principle of a franchise agreement.  No franchisor wants a court to second-guess its decision when the franchisor’s intent was to be clear on what rights it was granting to the franchisee and what rights it was reserving for itself. Beyond its foundation, the franchise agreement is a living, breathing document that must allow the franchise system to change over the life of that agreement.  Franchisors often compete with larger companies with corporate locations as opposed to franchise locations.  These companies can roll out new product lines or new marketing campaigns with executive decisions and then immediately implement them.  If a franchisor cannot compete effectively with these competitors, it and its franchisees will not survive.  Accordingly, a franchisor must reserve rights in its franchise agreement to implement system-wide changes and otherwise evolve the system. Breakdowns often occur during conversations about the franchise agreement in large part due to the parties’ failure to recognize and understand the different perspectives that franchisors and franchisees bring to the franchise relationship and franchise agreement. Franchisors want to protect and grow the brand.  On the other hand, franchisees want to protect and grow their investment. The franchise agreement is the document that balances the interests of the franchisor, the franchisees and the system as a whole.  Franchisor and franchisee interests are at times aligned and at other times they are different.  Even though their roles in the system are different, that does not or should not mean they are at odds. Those conversations should begin during the franchise development process and continue throughout the franchise relationship. The franchisor and franchisees can then more easily focus on customer centric activities with the mutual objective of finding and keeping highly satisfied and loyal customers. A franchisor’s interest to protect the brand means that it can make changes to the system in response to customers’ demands and also can get rid of free-riding franchisees that refuse to play by the rules.  Using an economic analogy, it is the franchisee free-rider who refuses to play by the rules who potentially creates great risk to all the other stakeholders in the system. The franchisee who refuses to contribute to a marketing fund, who uses unapproved vendors or products or who violates the noncompete covenants is the franchisee that hurts not only the franchisor, but also the franchisees that play by the rules, and the system and brand as a whole.  All stakeholders in the brand should want a franchise agreement that allows the franchisor to effectively deal with free-riding franchisees. While most franchisees recognize the franchisor’s interest in protecting the brand, franchisors must understand the franchisees’ interest in protecting their investments.  The franchisees’ concerns often stem from their view that: they have little control about strategic decisions that the franchisor makes even though the franchisees’ investments in their businesses can exceed the investments of franchisor executives making those key brand decisions, and they have little recourse if those franchisor decisions turn out to be bad.  A related franchisee concern is the possibility that the franchisor will sell the company to new ownership which has a different outlook on how to grow the business.  We are not suggesting that a franchisor give up its unfettered right to sell the company, but it should at least understand the franchisees’ views and concerns. A balanced franchise agreement doesn’t mean provisions are mutual or reciprocal.  It also doesn’t mean the franchisor should give up decision-making authority, although the franchise agreement may recognize how the franchisor gets input from franchisees on key initiatives that will impact the brand or the franchisees’ investment in their businesses. Highly successful franchisors talk about the critical role that franchisees play in the success of the franchise system and brand. These franchisors often emphasize the collaborative approach they take with their franchisees.  What we are suggesting is that franchisors should take a look at how their franchise agreements reflect that collaborative approach.  This collaboration does not mean that a franchisor should have a franchise agreement that does not allow it to protect the brand.  The bottom line is that a strong franchise agreement is critical to the franchisor’s ability to enhance the likelihood that the franchise system will meet the needs of the franchise brand’s customers, including making necessary innovations and changes as those customers’ demands and needs evolve; and protects the interests of the various stakeholders who have an interest in the brand, including the franchisor and its owners, the franchisees and the brand customers.

Franchisees Demand More Balance to Key Franchise Agreement Provisions

Franchisees understand the need to implement change and evolve the franchise system.  Their fear is that franchisors will mandate change without properly testing or piloting the change, without taking into account franchisees’ return on investment in implementing and executing the change or without any meaningful input from the franchisees on what change should look like in the actual outlets.  A related dynamic that frustrates franchisees is the franchisor requirement that the then-current franchise agreement be signed as a condition to any transfer or renewal.  From the franchisee’s perspective, the then-current franchise agreement requirement can have an impact on the bottom line of the business and therefore a chilling effect on any potential sale. Several of these franchisee concerns are legitimate, as they seek a more balanced franchise agreement, but in the past, franchisees were rarely comforted with how a franchisor addressed those concerns in the franchise agreement.  Do the existing franchisees have a voice in system-wide change, either through a franchisee advisory council or franchisee association or other means?  Does the franchisor lead through a spirit of collaboration rather than dictating change?  These dynamics are important even though they may not be specifically addressed in the franchise agreement.  In instances where franchise agreements do recognize the rights of an independent franchisee association or advisory council, and what impact or role they might play in system change or changes to the franchise agreement, that recognition is typically the result of prior litigation in the system and a negotiated settlement. Here are examples on how certain franchise agreement provisions might be more balanced (as noted earlier, franchisors may determine that none or some of these points make sense for their system, or they may address the points outside of the franchise agreement):Recognize the franchisee’s investment in the brand.  What is the value of that investment to the brand and should it be recognized in a manner beyond simply a license to use the franchisor’s trademarks and system;Allow the franchisee to monetize his equity.  Include reasonable transfer provisions and full disclosure that there may be no post-term rights which may render a portion of that investment useless if the franchisee does not amortize appropriately; Allow the franchisee to manage his risk.  Unlimited personal guaranties, post-term guarantees and guarantees of future assignees can create significant contingent liabilities;   Guarantee franchisee consultation on material issues that have a system-wide impact; Be transparent about sources of revenue from supply chains; Have franchisee profitability as a pillar of brand decision making.  Policies which only enrich the franchisor through sales increases without regard to the impact on franchisees will not be sustainable in the long run;   Have reasonable exit provisions if the business doesn’t perform.  If a franchise fails and the franchisor has confidence in its brand, should the franchisor take it back and resell it? Offer practical territorial protections for the particular business being franchised; Commit to franchisee engagement in the franchise agreement through reference to meeting with franchise advisory councils/franchisee associations or; Do not use the operations manual inappropriately.  Some brands use the operations manual to make policy changes because they cannot make the change through the franchise agreement. Highly successful franchise systems and struggling franchise systems often have very similar franchise agreements.  Given that dynamic, it is reasonable to assert that the franchise agreement often is not the problem.  But with the current state of affairs in this new era of franchising, the franchise agreement will continue to receive closer scrutiny.  We therefore endeavor to explore many of the key provisions in the franchise agreement and outline the franchisor and franchisee perspectives. Part of our endeavor will be to identify ways to potentially find common ground.  In some instances the answer may be that common ground is possible.  In other instances, common ground may not be possible. Our request is that you take a constructive look at your franchise agreement.  The key factors may be how you and your franchisees interact and collaborate with one another and whether the system’s focus is on the brand and brand customers.  The highly successful franchisors include franchisees in conversations regarding system-wide decisions and value franchisee opinions, still reserving the right as the franchisor to make system-wide decisions.  These franchisors explain their decisions without having to rely on a reason that includes some form of “I can make this decision because I am the franchisor and you must comply because you are the franchisee.”  The franchise agreement then permits the franchisor to protect the brand if free-riding franchisees refuse to play by the rules. A related objective is that we want to change the level of discourse on the debate if a franchise agreement is too one-sided or whether it is or should be fair or balanced. Rather than staying resolutely “locked in” to positions much like the tea party conservatives and far left liberals, we encourage meaningful and substantive engagement among the key stakeholders in a franchise system and brand and other interested advisors.  When done in a meaningful and productive way, the results will be a stronger foundation on which the parties can build something that is sustainable for all stakeholders. We look forward to your feedback and insights.

Aziz Hashim is president & CEO of NRD Holdings LLC, and IFA treasurer who served on IFA’s Franchise Relations Best Practices Task Force. Brian B. Schnell, CFE, is a partner with Faegre Baker Daniels LLP. Find them at fransocial.franchise.org.