The essentials of a franchise contract
Like any other business agreement, buying a franchise means signing a contract to legally underwrite the rights and obligations of both franchisee and franchisor. This contract in the franchising world is called a Franchise Agreement.
The following topics are discussed further in this article to summarise some of the aspects of the Franchise Agreement:
- Key elements of franchising
- Intellectual Property
- Franchise agreement provisions/ clauses
- Grant clause
- Payment clause
- Franchisor and franchisee obligations
- Assignment/Cession/Alienation of rights
- Termination and after termination
- Restraint of trade
- Provisional period
- Competition Commission concerns
1. Key elements of franchising
A company that offers franchises to separate business entities or in some cases sole proprietors differs from other business agreements which can be summarised in the following key elements:
- It is a contractual relationship,
- The franchisor offers (or is obliged) to pass on know-how and offer further training on a continuous basis.
- The franchisee operates under a common trademark, format or procedure,
- The ‘licence to operate the franchise’ is still owned or controlled by the franchisor.
- The franchisee has or will make a substantial capital investment from his/her own resources.
2. Intellectual property
The licensing of intellectual property to the franchisee is a central theme of the Franchise Agreement. The three key areas of intellectual property in most franchise systems are trademarks, copyright and know-how.
A Franchise Agreement is in a way a sophisticated form of Licence Agreement where the licensor/ franchisor is either the proprietor or a holder of certain intellectual property rights or technology, which he/she allows the licensee/franchisee to use in return for remuneration or other advantages.
Two main types of franchising can be identified by the degree in which the franchisor entitles the franchisee to use its intellectual property.
Firstly, with product and trademark/trade name franchising the franchisee is only entitled to use the franchisor’s name or trademark and product for example some motor vehicle dealers. Secondly, with a full business format franchise, the franchisee uses the franchisor’s entire business concept, which includes the name, trademarks, copyright, goodwill, know-how, trade secrets, trade dress and similar intellectual property.
The Franchise Agreement is used to set out precisely what of and how the franchisee may use the franchisor’s intellectual property.
A trademark includes any sign/ graphic representation legally registered or established by use as representing a company or product including:
- A device, logo or representation
- A name or signature
- A word, words, phrase or slogan
- A letter or series of letters, even fonts
- A numeral or series of numerals
- The shape and configuration of a product or part thereof
- The pattern and graphics appearing on a product, packaging or advertising materials
- A colour or combination of colours
- A container for goods (packaging)
- Or any combination of the aforementioned
Franchises go through a lot of trouble to register their logos, slogans, colours etc. mainly to distinguish their goods and services in relation to others as well as to legally protect them from any abuse of these trademarks by other companies.
Copyright is the right given to the creator, author or other person who may own the copyright of certain types of works, not to have that work copied or reproduced without authorisation. In this context copyright applies to literary works such as manuals, documents, articles, promotional materials, disclosure documents and publications. Copyright also applies to artistic works such as photographs, logos, labels, menus, advertisements and diagrams. Computer programmes also enjoy copyright.
Even though a franchisor will outsource the creative process of logo design (for example), the legal copyright should always be transferred to the franchisor and not stay with the appointed artist.
The term know-how usually refers to the wealth of technical knowledge, commercial information and experience developed and acquired over time by an organisation. It is usually transferred to franchisees in the form of an operating and procedures manual. Many of the success features of franchises reside in the know-how, trade secrets and confidential information. If know-how or trade secrets are ‘leaked’ or become public knowledge, it cannot be protected and may become valueless. Competent confidentiality provisions should therefore be included in the Franchise Agreement and in employment contracts.
3. Franchise agreement provisions/ clauses
We now look at some of the important clauses in the Franchise Agreement.
As in any other contract, the parties must be properly identified and described. Then a section is dedicated to definitions usually starting something like this:
In this agreement, unless the context otherwise requires, the following words and phrases shall have the meaning hereunto assigned to them:
Definitions should include the trademarks, copyright, trade dress, know-how, trade secrets and other intellectual property. It should also include a description of the franchised business. Since the franchisor is allowing the franchisee to use its intellectual property, definitions should also cover as to precisely what intellectual property will be used in which territory and for what period.
The object of the Grant Clause is to grant permission to the franchisee to use certain intellectual property rights of the franchisor. There are various ‘levels ‘of licence use agreements and the grant clause will stipulate a:
- Exclusive License or Franchise Agreement,
- Sole Franchise or License Agreement, or
- Ordinary license or franchise
This basically comes down to the right to operate exclusively or non-exclusively in a specific area.
This clause usually includes at least three types of payment.
These are the upfront lump sum, which is usually described as a franchise fee and which is paid to obtain the license or franchise. The breakdown usually includes the costs of setting up the outlet, costs of training, legal costs and an amount for goodwill.
On-going fee payments could be fixed monthly, quarterly or annually. Alternatively, amounts based on a percentage of turnovers are paid.
In full business format franchises, a fixed amount or a fixed percentage of turnovers is usually made on a regular basis towards the promotion and advertisement of the franchise operation.
In certain franchises, administration is attended to on behalf of the franchisees by the franchisor in return for which the franchisee may pay to the franchisor a fixed monthly sum or a small percentage of turnovers.
The franchisor’s obligations are divided into initial and on-going obligations.
Initial obligations include:
- Assistance with the setting up of the premises
- The operations and procedures manual
- Disclosure of the entire franchise system to the franchisee and training the franchisee.
On-going obligations include:
- Additional necessary training from time to time
- Assistance with problems and management
- Providing guidance (in addition to the on-going management and development of the franchise system.)
The obligations of the franchisee are usually fairly extensive and include:
- Provisions that the franchisee should operate the franchise strictly in accordance with the franchise system, usually as set out in the operations and procedures manual.
- Fairly standard terms such as for example an obligation to pay all sums due timeously and to engage and properly train suitable staff
- Provisions that the franchisee should enhance and promote the intellectual property, goodwill and reputation of the franchise at all times.
- The franchisee should also advertise and promote the franchise in accordance with the directions, requirements and specifications of the franchisor from time to time.
- The franchisee should allow regular inspections to ensure quality control.
- Where monies paid by the franchisee are calculated as a percentage of turnover, the franchisee will be obliged to grant the franchisor full access to accounting records.
A franchise system should have a comprehensive operating and procedures manual. This should be a dynamic annexure to the Franchise Agreement and the agreement should provide that the franchisee shall act in accordance with the manual, as amended from time to time. This will enable the franchisor, where it makes prudent commercial sense to develop the business, to do so without having to continually sign updated Franchise Agreements.
The Agreement should contain a provision preventing the franchisee from ceding, assigning or in any way alienating any of his rights or sub-franchising without the written consent of the franchisor. This is an added protection to the franchisor and greater franchise system by preventing unskilled and inappropriate individuals as franchisees from entering the business.
In addition to standard provisions such as timeous payment, this clause should include provisions entitling the franchisor to cancel the Agreement if the franchisee fails to act in accordance with the operations and procedures manual; performs inadequately or maintains poor quality standards. Further, if there is any challenge on the proprietorship of the franchised intellectual property, this should also be ground for possible termination.
The Agreement should also provide for an after-termination clause in which the franchisor will be entitled to retrieve all materials, documents, programmes and products bearing, reflecting or embodying the intellectual property of the franchisor or which is associated with the franchisor.
Restraint of trade provisions should be reasonable with regard to territory, nature of activity and period. Although it makes sense to have all franchisees sign the same Franchise Agreement, the restraint of trade clause should be relative to the size/type of the franchise if the franchisor offers various options in franchises. If a court finds a restraint of trade provision ‘unreasonable’, it cannot be enforced. Rather include more reasonable restraints than broader restraints. This clause should also include the protection of intellectual property rights, such as customer lists, know-how, trade secrets and confidential information
The franchisor usually furnishes the franchisee with a competent disclosure document at least 14 days prior to signing the Agreement. A provision should be included in the Agreement confirming that:
- The franchisee was furnished with the disclosure document more than 14 days before the date of signature
- The franchisee is happy that he has been furnished with sufficient reasonable information to properly assess whether to buy the franchise or not.
Confidentiality agreements should be signed by relevant staff in franchisee outlets to protect the know-how, trade secrets and confidential information of the franchise system. These clauses could also be included in employment contracts.
Where appropriate, members, shareholders of close corporations, companies or other corporate entities should be requested to sign suretyship agreements to make them personally liable and accountable to the franchisor.
It makes good sense to include a provisional period of for example six months during which the franchisor will be able to terminate the agreement relatively easily if the franchisee does not achieve and maintain certain objectives and standards. It is often difficult to assess from the initial interview and a few contacts with the franchisee whether he will turn out to be a competent and successful franchisee.
4. Competition Commission concerns
Although Government originally assured FASA that the Competition Act was never intended to apply to franchising, there are no provisions excluding their applicability to the franchising sector and the position has in any event subsequently changed, which has led to considerable uncertainty. The concerns of the Competition Commission have included horizontal relationship collusion; vertical relationship collusion; retail price maintenance; exclusive territories; exclusive dealing; tying of products and intellectual property rights.
Unfortunately, many of the aforementioned provisions in franchise agreements and franchise systems that concern the Competition Commission are essential to and very often the reasons for the success of the franchises. However Government has recognised that franchising is a viable route to increase its development of small to medium type businesses in South Africa and a new Franchising Act has been drafted to introduce some regulation to the franchising industry. FASA has made substantial recommendations, which are in fact not very different from what FASA’s approach and practices have been for many years, being ethical franchising and protecting the interest of both parties with a view to an on-going win-win situation, coupled with the development of franchising in general.
It is essential that the Agreement properly identifies all aspects of the franchisor’s intellectual property and other proprietary rights and that these are properly protected and licensed to the franchisee. The contract should also focus on and accommodate the specific needs and requirements of the franchise operation and control the relationship between the parties in a positive and constructive manner.
A competent written Franchise Agreement is a key factor to promote and enhance a win-win situation and to protect the respective rights of the parties and the entire franchise operation.
As franchise agreements are extremely complex, legal assistance from an expert skilled in intellectual property and franchising is an essential investment that can save the franchisor huge amounts of money, time and tears.