There are 10 key items to review related to a franchise agreement, and seven contract terms that should be negotiated whenever possible. But in some cases, franchise document red flags should make a prospective franchisee walk away from a deal.
Richard Rosen, a lawyer who heads his own New York City-based firm that has worked with hundreds of entrepreneurs on franchise agreements, and is the current chairman of the New York State Franchise Bar Association, said the following red flags can often spell doom for franchise owners, either sooner or later, and they are too often overlooked in the process of signing a franchise agreement.
1. No protected territory is delineated.
A franchise document has to indicate if no territory is specified. And it is a leap of faith for any franchisee who knows they lack a defined territory to believe a franchise company won't ever encroach on their market. Some franchises make a distinction between urban and suburban businesses, and don't offer territories in cities. But don't take "no territory" for an answer. Play hardball with the "no territory" franchise corporation.
2. A lengthy non-compete period for former owners.
A good example of a post-term restricted covenant that should be a red flag is a lengthy non-compete. These are typically limited by local law to a period of a few years, but some franchise companies will go ahead and include a non-compete period of 10 years, even if it's legally unenforceable. Either way, it's a major red flag, and a franchise contract term that an entrepreneur should never accept even if the courts would ultimately be on their side.
3. Lots of litigation involving franchisees.
Some amount of litigation is likely for any company, but it would be of major concern if a franchisor is engaged in multiple litigation with its own franchisees, at a level that is significant relative to the overall size of the franchise system. "That tells you that disputes are not being resolved amicably. They're going to court. And that's a bad sign," Rosen said.
4. Renewal rights that are not perpetual.
Anything less than a perpetual renewal right for your franchise can lead to problems. Even with a 10- year franchise and one ten-year renewal, a franchise owner isn't as protected as it may seem. For example, an owner is in year 13 and decides to relocate and wants to sell the business, but there's only 6.5 years left on the contract, and that makes the franchise less desirable for a potential buyer. That can be very painful for an owner that wants to maximize the time, money and effort they have put in over the years to making a business successful.
Even in cases where a franchise company allows an owner to renew for a 10-year period and the owner has no intention of selling, there is nothing but a perpetual renewal right that will fully protect the business. A franchise company could decide to convert to all company-owned units or a multi-unit developer could come into a territory and offer a franchise company a more attractive package deal for your franchise once that renewal period ends.
5. Right to buy your franchise at a "depreciated value."
What you agree to at the beginning of a franchise agreement can become a source of great pain years later after you've worked hard for your success. And it's not only renewal rights where this nightmare scenario can devastate even the most succesfsul franchisees.
A franchise agreement that allows the franchise company to acquire your business at the end of an ownership term at the "depreciated cost value of assets" could result in a shockingly low sales figure. A franchise could be in business for two decades, have invested $500,000 in the business, and be generating gross sales of $3 million and net income of $500,000 annually, but all that will be used to calculate the sale price is the depreciated value of that $500,000 investment, which after two decades could be as little as $20,000.
"The most common formula is 'depreciated value' and it's the worst," Rosen said.
6. Unit churn
A franchise disclosure document has to show how many units have closed over the past three years. It also discloses new units, but an equal number of new units to units being closed is not a "wash." It could be the sign of a serious issue, unit churn. That's one way in which less than stellar franchise systems hook franchisees: they look like a very popular franchise because they are selling a lot of new units.
There can be legitimate reasons for a high number of unit closures, including a franchise shutting down in a region, but if there's ever a big number in this FDD item, you want to find out why.
7. Short statute of limitations
This may not be at the top of the list, but it can be important: franchise corporations have become more aggressive in reducing the statute of limitations for claims that can be brought against it by a franchisee.
Why is this a problem? Because they are creating statutes in their franchise documents that are not aligned with existing state law. Rosen has seen franchise agreements lowering the statute of limitations to as little as one year regardless of how many years a state legislature has put on the books.
"You would think if a legislator says these claims get three years a francise would not reduce that," Rosen said, adding, "I've taken the position when negotiating that I won't agree to it; the franchise can't supercede the legislature." But in a few cases courts have sides with contractual agreements, which is why Rosen says, "If you see this at all, it's a red flag."
8. Limitation on damages
Disputes will occur between franchise corporations and franchisees. Sometimes, the franchisee will be in the right, and the actions of a franchise corporation should result in significant damages. For example, when a franchise company makes an earnings claim that turns out to be false but was the reason a franchisee opened a location, and ultimately contributed to the location failing.
The issue comes up when there is a limit on damages that is well below the investment made by the franchisee. Say a franchisee paid a $75,000 fee and royalties over two years, and spent $750,000 for a physical build out of a location. A vast majority of franchise agreements are going to have a limit on damages, and that's to be expected, and is reasonable. It's any case where the limit on damages is obviously well below the initial investment fee and startup costs, that a franchisee should be concerned. "Blatantly unfair," Rosen said.