Establishing a Franchise System
By Stone Group Lawyers on May 22, 2019
Considering Franchising Your Business?
Franchising is not itself a business, but a way of doing business. A franchisor is someone who has achieved a proven system for success through their business model and branching, and has chosen to duplicate that system by franchising.
The Australian franchise sector is arguably the most heavily regulated in the world. It is regulated primarily by the Franchising Code of Conduct ("Code"), with compliance actively monitored by the Australian Competition and Consumer Commission ("ACCC").
Is Franchising Right for Your Business?
The Code contains a checklist for what will constitute a 'franchise agreement'. Many distribution and licensing arrangements can unintentionally be caught by the criteria, meaning they will be a franchise for legal purposes. It is therefore important to correctly structure your business arrangement to reflect whether franchising is or isn't right for you. Consider some of the following pros and cons if you are considering establishing a franchise system:
The franchisor will have a high level of control over how a franchisee's business will be operated and how the brand will be used.Con
The franchisee must follow all the franchisor's systems and procedures for operating the business. Franchisors must always act reasonably and in good faith, which can be difficult for franchisors when trying to implement changes. Franchisees often don't realise the level of control a franchisor will expect and may not always be cooperative.
The franchisor owns the brand and franchisees effectively rent the right to use the brand for the duration of the franchise agreement. Subject to the provisions of the franchise agreement, the franchisor can change branding at any time.Con
The actions of one franchisee can reflect negatively on the entire franchise system and the brand image. The Code also places certain restrictions on how a franchisor can force a franchisee to incur significant capital expenditure (i.e. if updating signage would be costly).
Each franchise is an independently owned and operated business by the respective franchisee. That means franchisees are legally responsible for their own businesses, not the franchisor. There is no relationship of employer-employee between a franchisor and franchisees.Con
Again, the actions of one franchisee can reflect negatively on the entire franchise system and the brand image. Indirect liability can be incurred such as reputational damage to the franchisor. Certain actions of franchisees, such as underpaying employees in some situations, may lead to the franchisor being liable to the employee.
The Code and the Australian Consumer Law (amongst other laws) result in a very regulated but also structured industry. In many situations the law is clear on what the parties can and cannot do.Con
Franchisors often consider these regulations to be heavily weighted in favour of franchisees, and feel very restrained in what they can and cannot do. Franchisees consider these regulations as necessary to counter the inherent power imbalance in a franchising relationship. Failure to comply with regulations carries heavy penalties, which are enforced by the ACCC.
FEES AND ROYALTIESPro
Franchisors can charge franchisees upfront establishment and training fees, and then ongoing royalties for the duration of the franchise. This results in a steady stream of income which increases as more franchises are sold.Con
Franchisees expect to see value for their money and will generally expect franchisors to justify the payments. Franchisors will encounter difficulties simply charging for the use of their brand alone – there must generally be an element of ongoing support and brand development.
Many franchisors require their franchisees to all contribute to a centralised marketing and advertising fund controlled by the franchisor. So long as the way the fund will be used and administered is properly specified in the franchisor's disclosure document, the franchisor can expend the fund towards any legitimate marketing and advertising expenses for the franchise system as the franchisor sees fit.Con
Unless 75% of franchisees vote to waive the requirement, then at the end of each financial year the franchisor must have the financial statements of the fund audited and provide copies of the statements and audit report to the franchisees. Franchisors can find this burdensome, and can often experience backlash by some franchisees who may argue that the marketing or advertising activities were of no ascertainable benefit to that franchisee's particular business.
A franchise is a contract for a fixed period of time (a "term") meaning both the franchisee and franchisor are locked in. The franchisor is guaranteed ongoing royalties for the term and the franchisee can't walk away from the business if they have a change of mind (subject to the 7 day cooling-off period under the Code which starts when the franchisee signs the franchise agreement).Con
If the particular franchised business (or the franchise system itself) isn't successful, then the parties are both locked into a contract. Unless a mutual agreement is reached, then neither party can choose to walk away from the arrangement early.
A franchise system that offers consistency in branding, products and services is generally a successful franchise system. McDonald's is one example. The public enjoy the comfort of being able to:
- Recognise any McDonald's store from its distinctive signage;
- Walk into any store in the country with the same interior theme;
- Order from the same menu; and
- Receive a burger that tastes and looks the same because every store uses the same recipes, ingredients and packaging.
Franchisors wishing to change the products and services of their franchise system will generally be permitted to do so under the franchise agreement. However in practice, franchisees can sometimes be opposed to and unwilling to change an operations model that they are used to. Again, one franchisee who doesn’t comply with the franchise system can disrupt consistency and cause brand and reputational damage to the franchise system as a whole.
The right advertising and marketing campaign can make a franchised brand a household name.Con
In recent years, franchising has been placed under a bad media spotlight due to the actions of some larger franchise systems because of the alleged treatment of their franchisees. In times when the public opinion of franchising is poor, franchisors of that system (or franchisors in general) can find it difficult to sell franchises.
Franchisors often negotiate arrangements with suppliers for bulk supply to the entire franchise system. Many franchisors will force franchisees to only buy products or acquire services from approved suppliers/providers. Bulk buying can then return a rebate or commission to the franchisor.Con
Franchisors must disclose the existence of any rebate or commission to franchisees within the franchisor's disclosure document. Franchisees will generally expect to either share the benefit of the rebate, or have the rebate reinvested into the franchise system in order for the franchisee to share the benefit.
A franchisor must maintain a current disclosure document and update it annually. A properly drafted disclosure document ensures the franchisee is fully aware of the deal that they are signing up to.Con
There are many details that franchisors must disclose which a non-franchised business would not otherwise need or want to disclose to a counterparty. This includes information about the franchisor's financial position. Franchisors can find the obligation to maintain a current disclosure document to be burdensome and costly.
When a franchise agreement ends, a franchisee is generally bound to a non-compete restraint, provided it is for a reasonable time period and reasonable geographical area.Con
Restraints are only enforceable to the extent they are reasonably necessary to protect the franchisor's legitimate business interests. They are the subject of many disputes. Restraints can be difficult to enforce if the franchisee wants to continue with the franchise relationship when the franchise ends but the franchisor doesn't agree.
FRANCHISORS ENDING A FRANCHISE EARLYPro
The Code entitles a franchisor to terminate a franchise agreement early if the franchisee breaches the agreement and then fails to fix the breach within a reasonable time of being asked to do so. Other actions of a franchisee entitle a franchisor to terminate immediately, such as bankruptcy/insolvency, fraud, endangering public health and safety or failing to hold a licence/permit required to operate the business.Con
These are generally the only circumstances for which a franchisor can terminate a franchise early (subject to some other legal causes of action). Franchisors can feel powerless if there is a poor performing franchisee who is repeatedly in breach but brings their behaviour back into line each time, preventing a franchisor from being able to terminate. Subject to the provisions of the franchise agreement, generally the franchisor's only recourse would not be renewing the agreement when the term comes to an end.
FRANCHISEES ENDING A FRANCHISE EARLYPro
The Code does not currently entitle a franchisee to terminate a franchise agreement early, other than during cooling-off. A franchisee can only terminate early if there is an express right within the franchise agreement itself (subject to some other legal causes of action).Con
Due to the recent introduction of 'unfair contract terms' laws, franchisors may feel it necessary to place provisions in their franchise agreements giving franchisees similar rights to terminate. Failing to have a fairly drafted franchise agreement could land the franchisor in trouble with the ACCC.
The Code contains a set procedure to be followed if there is a dispute between a franchisor and franchisee. If the parties cannot resolve the dispute then one party can call for a mediation, which must then be attended. Mediations can be a cost effective way to resolve disputes (compared to court proceedings) and can often deliver an amicable outcome allowing the franchise relationship to continue.Con
Franchisors can sometimes feel that this is a burdensome process and may be abused by franchisees during minor disputes or franchisees who are not simply 'getting their way'. Mediations can become costly if lawyers are attending, and there is nothing to force the parties to resolve the dispute at the mediation.
A common cause of franchise disputes are misunderstandings about promises or statements a franchisor makes to a franchisee before entering the franchise. This is often about profitability of the prospective business and its prospect of success. Franchisors should only make promises or statements about things contained in the franchise agreement and the disclosure document, or about things for which they hold supporting evidence. Personal opinions should be avoided. A franchisor should ensure a document called a 'prior representations deed' is signed at the same time as the franchise agreement, recording any such things the franchisee may be relying on.Con
If a franchisee believes that a franchisor has made a promise or statement about something that was incorrect, or that the franchisor had no reasonable basis to make, then the franchisor can get sued if the franchisee can establish that they relied on that promise or statement to enter the franchise, and suffered loss and damage as a result of that reliance.
For site-based franchises, a franchisor will need to decide whether they will hold the lease themselves or allow the franchisee to enter a lease directly with the landlord. Holding the lease themselves gives the franchisor the easier ability to step in and run the business if the franchise ends early. On the other hand, if the lease is in the franchisee's name and it's not a good site, if the lease ends early then the franchisor has no contractual obligation with the landlord that they must honour – the lease is essentially the franchisee's problem.Con
If the lease is held by the franchisor and if the franchise ends early, the franchisor has the obligation to see out the lease until it ends – this puts the franchisor in a difficult position if it's a bad site and the franchisor doesn't want to keep the business open. If the lease is held by the franchisee (and if the franchisor has no 'step-in' right), then the franchise may end early and the franchisor may lose a great site – and further, the franchisee may disregard and attempt to breach their restraint by rebranding and continuing to operate from the old site.
These are only some of the considerations that should be taken into account. There are many others. Whether franchising is right for you will depend on your existing business model and your business objectives.
If you have a successful business that you wish to consider franchising, then at Stone Group Lawyers we can assist in all aspects of establishing and operating a franchise system including:
Working with you to determine whether franchising is right for your business, and advising on the best structure for your proposed franchise system;
Advising on the process of setting up a new franchise system, including compliance with the Franchising Code of Conduct;
Advising on the protection and structuring (or restructuring) of intellectual property, including preparing licence agreements and registering trade marks both nationally and internationally;
Preparing a full suite of compliant disclosure documents, franchise agreements, franchisee application forms, confidentiality deeds, step in deeds and all other documents to establish a franchise system;
Ongoing reviews and updates to existing documents when laws change, including annual updates to disclosure documents;
Submitting documents to your franchisees for new grants, renewals, resales of existing franchised businesses or franchise buy-backs;
Giving advice on day-to-day operational issues and regulatory compliance;
Issuing breach notices and notices of dispute to franchisees;
Resolving disputes between franchisors and franchisees through negotiation, mediation and litigation;
Advising on competition and consumer (formerly trade practices) issues and conducting seminars to inform you and your business about your obligations under the Competition and Consumer Act and the Australian Consumer Law, and assisting with implementing compliance programs in your business;
Preparing, reviewing, advising on and negotiating leases and occupancy licence agreements;
Preparing, reviewing, advising on and negotiating agreements with suppliers;
Acting on the sale and purchase of existing franchise systems.
DISCLAIMER This article is only meant to give you general information and should not be relied on as legal advice. Speak to one of our lawyers for more information.