This article was previously published by LJN's Franchising and Business Law Alert
Drafting the right franchise agreement for your client starts with the development of a franchise plan that establishes the framework of the franchise system. Too often, clients look to franchise counsel solely to advise them with respect to disclosure obligations, state and federal compliance requirements, and preparation of agreements. However, the success of the entire system starts with the development of a well-thought-out franchise plan. The client's considerations should include the following, among others:
1. The characteristics of the model franchisee. This is one of the most crucial elements of a successful franchise system. Considerations include what will be the franchisee's liquid net worth requirements, level of experience in the type of business being franchised, and its capacity to grow beyond a single unit. Franchising to unsophisticated or financially weak franchisees has the potential to lead to closed units, which must then be disclosed in the Franchise Disclosure Document ("FDD"). Reports of closed units will be a cautionary signal to the more-established franchise prospects. Furthermore, developing a corporate infrastructure based on projected store openings contracted for in multi-unit development agreements that subsequently fail to materialize has the potential to cripple a franchisor's operations.
2. Will the franchisor continue to operate units? Will the system be entirely franchised, or will the franchisor continue to develop its own units? If the franchisor plans to continue to develop units, then a determination regarding possible territorial restrictions for the areas to be franchised should be considered, as well as those areas held for company development.
3. Protecting key elements of the system early. It is critically important to secure registration as early as possible for the key elements of the franchise, including, but not limited to, trade and service marks, trade dress, and copyrights. The earlier in the franchisor's growth that trade or service mark violations are identified, the better. Inasmuch as most franchise agreements impose the duty of protection of the marks on the franchisor, it will be the franchisor's burden to pay for re-identifying franchisee operations that infringe. The more units involved, the more expensive the change will be. In addition to registration, counsel may also suggest that the franchisor consider trademark insurance.
4. Provide a clear and concise operations manual. A franchisor is well advised to provide a franchisee with an operations manual to guide it through the day's business, commencing with turning on the lights in the morning and ending with turning them off at night. The franchise agreement should include language requiring strict adherence to the standards of operations set forth in these manuals, as well as language restricting the number of available copies and imposing confidentiality restrictions on management and staff with access to the materials.
5. Financial modeling for each operation to ensure that unit economics work. Franchisors should be advised to work through the economics of each proposed franchise to ensure that the proposed enterprise would be adequately supported throughout every stage of development and operation. However, counsel must remind the franchisor that even setting forth the financial template will mandate compliance with the earnings claim disclosure guidelines in the FDD.
6. Securing a franchisor's intellectual property for the long term. As noted above, one of the most important aspects of the franchisor's system is its intellectual property, whether in the form of its proprietary marks, trade dress, operations manuals and, where applicable, recipes and software source code, among others. Increasingly, sophisticated franchisees recognize the need to protect their interest in the franchisor's intellectual property in the event of the franchisor's bankruptcy. This can lead to the rise of demands to escrow the franchisor's trade secrets to ensure that the franchise system will have access to such materials in a bankruptcy or other event that jeopardizes the franchisor's continued ability to support the system. Counsel must be prepared to negotiate these arrangements to protect the franchisor's interests and ensure that such materials are not widely disseminated or prematurely released. (However, a bankruptcy filing under Chapter 11 of the Code is a reorganization, which anticipates the franchisor's continued operation upon completion of a plan of reorganization. Therefore, such an event should not constitute an automatic release of confidential materials or trade secrets.)
7. Consider contract renewal before the initial deal is complete. Contract renewal terms are key provisions that often don't get the attention they should, especially in connection with less-mature systems. Many franchisors eager to close a deal view contact renewal as an issue for the future. However, a welldrafted renewal provision will help avoid future litigation. The standards for renewal should be well thoughtout by the client/franchisor and then articulated by the drafter of the agreement. Important considerations include: 1) whether the franchisee has consistently met company standards; 2) sufficient notice of a renewal exercise in order to plan for a renewal agreement or transition to a new operator; 3) how to obtain a release of potential claims; 4) whether a new agreement will be required; and 5) policies for updating operations (including physical plant, if applicable) to meet then current standards of the company. While the company will likely wish to retain successful franchisees and those with whom it enjoys good relations, it clearly will not want to be forced by contract terms to continue what it views as a bad relationship.
8. Ensure proper use of the Internet and social media channels. To the extent that a business relies on Internet outreach, it is important for a franchise attorney to make sure that alternative channels of distribution are controlled by the franchisor. Territorial violations as a result of web outreach can lead to claims against a franchisor if the franchise agreement does not adequately cover how these issues are to be addressed. A franchisor also should maintain control of website domain names and ensure that franchisees are not violating federal regulations governing the dissemination of spam e-mails. Furthermore, with the growing use of social media, it is critical that franchise lawyers include provisions in a contract that restrict derogatory or inflammatory statements made about the company. Negative information is often posted without identifying the author; nonetheless, it makes sense to include language in the contract relating to how social media will be handled. Disgruntled franchisees who view the Internet as a "safe" platform to say whatever they wish without impunity might create a mob mentality and seriously impair relations between the franchisor and its franchisees and seriously inhibit the company's future growth by creating concerns for potential new franchisees.
9. Draft to avoid litigation. Franchise contracts typically outline the duties of the company with regard to providing assistance to the franchisee. In doing so, it is important to draft such provisions in ways that will minimize potential litigation claims. Language needs to involve objective standards such as the "company shall provide from time to time, as the company deems appropriate," or "franchisor may provide such support as it deems advisable." In instances in which a company has an obligation to provide proprietary materials to the franchisee, the franchise agreement should clearly state that such materials are made available to the franchisee solely as part of the agreement, and the franchisor maintains control and ownership over the intellectual property. Where location is an important component of the franchise business, site-selection criteria can be provided by the franchisor to the franchisee, but the franchisor should limit its role with regard to site approval, as contrasted with site selection, in order to avoid claims that the franchisor was responsible for site-related issues. Increasingly, third-party actions against a franchisee now name a franchisor based on various theories of vicarious liability. It is therefore important that the agreement require that each franchisee have insurance to cover the potential applicable claims. Particularly in businesses serving alcohol, handling hazardous materials or waste, or generally involving other particularly litigious issues, the agreement should impose insurance standards that clearly state the amount and types of coverage that will be needed. Franchisees should be required to deliver certificates of insurance, assuring that the policies cannot be limited or changed without adequate notice and franchisor approval.
10. Neglecting to define standards of operation. Defining the standards of operation is crucial for a franchisor because the standards assure quality across the system. With a service business or retail operation in particular, one error can affect an entire system. Agreements need to set up very specific adherence to certain "tried and true" elements that have guided the success of the business. In some cases, this may mean setting controls on the trade dress to create familiarity with a concept and assure a recognized standard of quality.
11. Termination. Termination, whether through default or nonrenewal, should be accompanied by what actions and covenants attenuate the end of the relationship. Typically, termination provisions include those triggered automatically and, in most instances, by virtue of a bankruptcy, unsatisfied judgment, or other insolvency issue. The enforceability of an automatic termination by virtue of a bankruptcy is unlikely, but its inclusion is nonetheless recommended. Other terminations are triggered by defaults for which no opportunity to cure is extended, most in recognition of the fact that the cure will not undo the damage done to the franchisor and the system. Finally, there is a termination for which an opportunity to cure is extended, in recognition that a cure may be reasonably effected, such as the failure to make a timely royalty payment. The obligation of the franchisee upon termination should be clearly delineated. Obviously, all confidential materials should be returned, the units should be totally de-identified in order to ensure no further association with the franchisor, and any lease, telephone numbers, websites, etc., should be assigned to the franchisor. Where appropriate, the franchisor should include an option to purchase the franchisee's assets. Finally, the posttermination covenants should be set forth and drafted in a manner to ensure that the scope and extent will not negatively affect enforceability.
Conclusion
Taking the time to consider the elements outlined above will prove invaluable in creating a franchise plan that builds a strong foundation that will support future growth.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
