There are many key items to review in a franchise agreement, and big red flags that should cause a prospective franchisee to walk away from the table. But it doesn't always have to be a take-it-or-leave-it scenario when an entrepreneur is reviewing a franchise company's key terms for investment. There are two parties in this business deal.
In fact, Richard Rosen, a New York City-based lawyer who heads his own firm and has worked with hundreds of entrepreneurs on franchise deals, and is the current chairman of the New York State Franchise Bar Association, said it's crucial to understand that a franchise corporation is typically willing to negotiate beyond what they state in franchise documents. "The franchise agreement is universally compiled to be favorable to the franchisor," said Rosen.
That's not a surprise, as any company is going to act out of economic self-interest. "Most franchisees, for whatever reason, don't negotiate these agreements as carefully as they should. ... It's reasonable to ask for changes," he advised. The following seven items are the important ones that a franchise company is most likely to be flexible on.
1. Fight for the best definition of your territory
Franchise companies have to state if there is no protected territory, but that's not the only case in which a prospective franchisee should be pushing back against the corporation. The territory is one of the most important franchise agreement terms to negotiate, and it is one over which many companies are willing to budge. "You can push for a better definition of this," Rosen said.
2. Fight unreasonable restricted covenants.
Say you are a chef and you've just sold a restaurant franchise, but plan to open another restaurant because that's what you do. If you agreed to a lengthy non-compete period as part of the restricted covenants in your franchise agreement, you may cripple your ability to work in the industry you love and the only one in which you have an ability to generate a good income. That's why it is critical to negotiate restricted covenants related to the "post-term" period before signing a franchise agreement.
If the non-compete listed in the franchise agreement is for a decade, when local legal precedent says it can only be a few years, this unreasonable restricted covenant might be the sign of an unsophisticated franchise company, and simply be a red flag signalling you should walk away from any deal.
But you can try to have the covenant set aside entirely. Or, there is often room to reach a compromise. For example, using the restaurant example, you can agree to not open a new restaurant that has more than 60 percent of sales in same food niche of the franchise you have just exited.
3. Push for the strongest renewal rights, but don't expect an easy fight.
Among all of the contract terms that a franchisor is likely to negotiate, the length and form of renewal rights is a tough battle for franchisees. But a franchisee should attempt to negotiate renewal rights to avoid a disaster scenario. Ideally, you want the right to renew perpetually; in the least, a lengthy renewal option. If unsuccessful, Rosen's legal advice is simple: if the renewal terms are not reasonable to you, and the franchise company does not prove to be flexible, walk away. The alternative is to be pushed out years later, likely against your will.
4. Don't let a franchise company acquire your business on the cheap.
Try to eliminate the provision that gives the franchisor right of first refusal and restate to say any sale to the corporation should be at fair market value as a going concern, not "depreciated value," which is one of the biggest red flags in a franchise deal.
There's one key provision that should be included in any negotiation over franchisor right to acquire a franchisee business: Internal transfers. This refers to a sale of the business to a partner, which should be exempted from the franchisor's specifically stated right to purchase.
A franchise agreement will typically include a guaranty section that can be extensive and the idea is to ensure that the franchisee's new business will cover expenses that are reasonable and are owed to the franchisor. But these guaranty sections are often overly broad.
Franchisors may try to include many third-parties, including landlords and suppliers or tax authorities, in a guaranties section. Rosen said something as clichéd as a person slipping and falling in a restaurant and then suing the franchisee and the franchisor could be a situation in which an overly broad guaranties section leaves the franchisee on the hook for all damages when the corporation is sued.
When negotiating a guaranty section it is fair for a franchisee to be responsible for financial obligations specific to their business, fees such as royalties and advertising, and terms among restricted covenants, including use of confidential information. "But for all others, try to get those out," Rosen said.
6. Don't agree to an opening schedule that is too aggressive.
Multi-unit franchise owners need to push back if a franchisor is setting an opening schedule for multiple locations that is too aggressive.
It's fair of a franchise company to not expect an opening schedule for 10 locations to take 30 years, but at least one year between new location openings is a good period to ensure a franchisee has enough time to negotiate leases and secure financing, let alone deal with zoning and permitting issues, as well as contractors. Most development schedules will state that the location needs to be open and operating one year from the time of deal-signing, but Rosen said it's better to negotiate for a deal that only requires the multi-unit franchisee to have entered into a lease for the next location within a year and to be proceeding with due diligence.
Multi-unit owners also need to make sure their territory is protected, even if they do not complete a full schedule of units. Say a franchisee opens three out of 10 planned units. They need to make sure those three are protected as a territory, even if the additional locations are not completed. "You can lose your territory if you don't properly complete these terms," Rosen said. "You need to make sure with respect to the units you did open that you have separate 'mini-protected territories.'"
7. Don't allow a franchisor to punish all your locations for the failure of one.
This is what is known as a "cross-default provision."
For example, a franchisee opens 50 fast food locations of a brand and one of those locations defaults. A cross-default provision could state that the franchisor has the right to then default on all of a franchisee's locations and buy them all back at the "depreciated value."
In some cases a franchisor should retain the right to employ a cross-default provision: if a franchisee commits fraud it would be fair for the corporation to assume full control of all units. But the key for the franchisee is to not leave themselves vulnerable to a mistake beyond their control but that has the power to wipe out their ownership. Say a food location had a rogue manager who wasn't keeping the refrigerator at the right temperature which resulted in spoilage, and then health violations, and ultimately doomed the unit, but all of the other locations the franchisee owns are running smoothly.
These provisions can be negotiated out entirely, or in the least the difference between a franchisee committing fraud and events beyond the owner's direct control, like the spoilage example, can be successfully written into the agreement.