Hello and welcome. My name is Amie Larter, and this is the Buying a Franchise podcast, vital listening for anyone interested in buying it’s in the process of buying a franchise.
Each episode I’m joined by Sarah Stowe, editor of Inside Franchise Business, Australia’s leading franchise hub to help us guide through everything we need to know about the franchise buyer’s journey.
Sarah, today you’re going to help us get an understanding of key items in any franchising agreement.
Now as I understand it this is a contract between the franchisor and the franchise buyer. So what is the franchise agreement and how does it differ from a standard business contract?
Hi, Amie. Well, the franchise agreement is a legal document that specifies the rights and responsibilities of the franchisor who owns the business and the franchisee who is buying into the business. It’s, it’s effectively a binding agreement that’s the basis of the ongoing relationship between the franchisor and the franchisee. So while it is a business contract, it does have specific elements that govern the relationship between the two parties. Now sometimes people are surprised that an agreement favours the franchisor.
Of course, the agreement is written by the franchisor franchisor’s lawyer, so it does have their interests uppermost. But it’s important to know that there are rules that govern a franchise that aim to create a well-balanced document that doesn’t unfairly constrain the franchisee.
I’ll just mention here that every franchise agreement has to comply with the franchising code of conduct, code of conduct or the code, as you might hear it referred to by franchisors. This code really shapes every franchisee franchise or relationship. It’s a mandatory rule book, if you like, that outlines what franchisors and franchisees can and can’t do, provides procedures and time scales for certain things such as dispute mediation and the signing up to and exiting a franchise agreement.
OK so just to be clear, the franchise agreement is bound by the code – now the code is another podcast I’m sure – and is written by the franchisor, so does the franchisee have to accept it as is or is there room for negotiation?
In some cases, it may be possible to negotiate certain elements of the agreement and, and that’s really why it’s good to use the services of a franchise lawyer who understands the intricacies of the agreement and can also spot if any clauses are unfavourable.
Yeah ok, so let’s delve in to the differences between a regular business contract and a franchise contract. What are the main elements of this agreement you need to consider as a potential franchisee?
For a potential franchisee the two crucial differences would be the inclusion of a fee structure and the specific obligations of franchisee must observe during the terms the term of the agreement. But there are quite a few elements to be aware of, and they all have an impact on how appropriate the business is for you and for your situation.
The key points range from the term of the agreement, the initial franchise fee and ongoing fees to the location or territory, the supply arrangements in place, marketing and training commitments, and of course to your obligations as a franchisee. And then what happens when the agreement is terminated.
OK so let’s start at the beginning with the term. Assuming that terms vary depending on sort of what franchise you are looking at, what are some of the questions someone should ask when considering the length of the franchise term?
It’s important to know whether the term can be renewed. That’s the first thing, and how many times, and it’s worth checking to see how many franchisees do renew their agreements and if they have had time within the first term to get a return on their investments so they are not just renewing so that they can recoup their funds.
Just a note about renewals. Be aware the renewal is an option. It’s not actually a guarantee that’s for both the franchisee and the franchisor, but they do have to be solid grounds for a franchisor to refuse to renew a term if the agreement allows for it. If there’s going to be a lease involved, find out whether the franchise term and the lease term can be aligned. That makes it a whole lot easier to manage when it comes to renewals. So you aren’t left with a renewed franchise agreement, but know to operate from, or in fact vice versa.
OK and moving on from the term, the second element that you mentioned is the initial franchise fee and any upfront costs a buyer should expect when making a purchase,
Yeah, the initial franchise fee is usually fixed, but it’s not always. Essentially this is like buying a license to operate the business. It’s what you pay as a franchisee. It’s what you pay the franchise all for the right to use the brand, to use the processes and procedures to have access to support, and sometimes the cost of the initial training. There isn’t any guidance at all on what this figure should be. Whether or not it is good value is up to the buyer and their advisors to, to make that evaluation. Other upfront payments will vary depending on the type and size of business that’s being purchased, and these are very much costs that any business franchise or otherwise would incur.
Ok and you’ve used the phrase initial or upfront costs, tell me about the ongoing franchise fees and any other frees that there may be, what exactly are they and how much would a franchisee need to pay?
Ongoing franchise fees are a standard inclusion in a, in a franchise agreement. The two most common ongoing fees are the franchise or royalty fee could be referred to, and the marketing levy.
When a franchisee pays the royalty fee, it’s like a license fee, allowing them to use the brand systems and intellectual property on an ongoing basis. The monthly royalty fee can be calculated in a number of ways as a percentage of gross revenue or a profit, a combination of both, or it may be a fixed amount each month. How it is defined will actually be explained in the individual franchise agreement. The marketing lev is often charged as a percentage of revenue, and this goes into the franchisor’s marketing fund. It’s important to understand exactly what this is for, because while you might expect that it pays for all your marketing expenses, the reality is a marketing fund serves to support national promotions and campaigns.
That means generally local area marketing used to promote a franchisees business is an additional cost, and that’s the responsibility of the individual franchisee. There isn’t a set percentage charge to these fees, but a quick scan across a number of brands will show that a five to 7% royalty fee and a marketing fee of two to 4% is fairly common.
The fee percentage is also dependent on the type of industry and of course, what’s included in a business. So it’s worth having a closer look at this element if you believe the fees are are high or very low. The franchise fee goes towards franchise support, that’s things like admin costs and staffing. So if it’s a low bar that might indicate a very low level of support. There may be staff training fees, and if you sell the business before the end of the term, there is usually a fee payable to the franchise, or that’s expressed as a fixed fee or a percentage of the sale price.
OK so that’s really what an ongoing fee will include. Next item that you mentioned is territory. Can you shed some light on this?
Yeah, it quite simply means the geographical borders that you’ll be operating your business within, and that’s defined by elements including the demographics of the area, market size, and the population density. Franchisors can offer exclusive territories, which means that you are the only franchisee who can operate within that area. Or a territory could just have marketing exclusivity. Now, that allows other franchisees to provide a service in your area, but they can’t promote their business in your space. There’s actually even a non-exclusive territory which limits you to operate in a much smaller sphere.
Now, that might be a food retail business that allows you to operate in the same prescribed location and be confident at the same time that another franchisee from the same network won’t open up next to you, gives you some exclusivity.
What’s important to consider when you’re looking at this is whether the territory, whatever the type it is, is big enough for you to build a viable business. And what would happen if the site or territory next to you became available? Would you have first right of refusal? You might also find out whether if you become too busy to full a potential of your, to fulfill the potential of your area you can sell off part of your territory.
OK so, you’ve gone through the term, the initial or upfront costs the ongoing fees and the territory. You also mentioned the supply chain as a key part of the franchise agreement. Now I’m sure given the vast array or types of franchises that on the market that can be quite different depending on the business. Help me explore this.
Sarah (09.42 )
Yeah, it can play a key role in the business. And, and you’re right because there’s a lot of variety according to the type of business and particular agreements. Some sectors, the cost of goods is a big expense. So if you take a food franchise getting the right ingredients at the right price can make a big difference to the franchisees bottom line.
So the franchise agreement will indicate where the franchisees have to use specific suppliers for essential goods or whether they can source their own supplies from a company of their choice. Now, of course, one of the benefits of being in a franchise is the buying power of the brand. So there are definite advantages to having a preferred supplier.
Potential franchisees should check the details of the supply arrangements to see what the rules are in times of short supply. For instance, can they source locally if there’s a problem with the national supplier, what are the charges? You’ll need to factor these into your analysis of the business’s viability.
OK, so this franchise agreement, does it refer to a franchisee’s obligations to operate the franchise?
That’s right, it does. So in addition to how you source your essential supplies, there are, there are of course a few other key commitments that are set out in your franchise agreement. And this is where it differs from a, a straightforward business contract. You do have to follow certain rules.
So as a franchisee, you have a responsibility to follow the rules that cover intellectual property, and this obviously includes the use of branding, any logos, any branded material that you might use in your business operations. You may be required to buy particular items of equipment. And there will be capital costs that are associated with any expected outlay, if it’s a substantial outlay of capital, has to be included in the franchise agreement. So a franchisee can factor in the costs to their budget.
Other elements that may be included as an operational responsibility may be a minimum performance level required, you may need to, to reach certain benchmarks. The franchisor might require attendance at a national conference or at state meetings. The sharing of financial data with the franchisor is quite common. Even a commitment to be involved with local community, these are all things that would be outlined in the franchise agreement and they are obligations for the franchisee.
So we’ve sort of covered what you need to look for when purchasing a franchise and everything through to running and operating the franchise. What does the franchise agreement tell us about the other end, getting to the end of the business contract and what it might mean to terminate the agreement?
Well there are a few options around what happens at the end of a franchise term. As I’ve mentioned, there isn’t an automatic renewal to a franchise agreement so it’s important franchise buyers understand what the franchise agreement tells them about extending their franchise term, should they choose to do so.
The franchise agreement will also outline what are the conditions a franchisee has to comply with if they want to sell their business before the end of the term, and the circumstances in which the agreement can be terminated by either party.
The franchisee’s rights and obligations will be explained in the franchise agreement – for instance, do they have any rights to goodwill? Are there any restraint clauses included?
And obvious though it sounds, it’s important to know the date of the end of the agreement.
Usually after you have made some initial inquiries about the business and you’ve determined that you want to pursue the opportunity further, you’re serious about this particular franchise.
It’s worth noting that the franchise agreement is just one of six key documents that a franchisor has to provide a potential franchisee.
There is an information sheet which explains some of the risks and opportunities that exist in franchising in general. That’s not brand specific. It’s a standard information sheet.
The second document is the key fact sheet, and this does relate specifically to the business concerned, and it provides us in a set format, some basic facts about the franchise. Then there is the disclosure document. Obviously the franchise agreement we’re talking about here, a copy of the franchising code of conduct, and a copy of the lease and relevant lease disclosure statements, if that’s appropriate.
It might seem like document overload, but at this point, a potential franchisee now has the opportunity to delve deeper and decide whether or not this franchise is going to be a viable option for them.
OK so we’ve talked about the disclosure document in a previous podcast Sarah, and I think the point you raised then is probably pertinent here too. Even with a franchise lawyer looking out for you it’s really important that people read these documents for themselves.
You’re right, I mean, understanding what you’re buying into is crucial, Amie. So taking the time to read the franchise agreement and the other documents is worthwhile, so you can really grasp what the franchisor is asking of you, and in turn, what will be provided in return. That’s the smartest way to head into business really with your eyes wide open.
Indeed, thank you for these insights in the franchise agreement. If you‘d like to find out more about the documents mentioned check out our other podcasts in Buying a Franchise.
When you buy a franchise, you’ll be signing a business contract with the owner of the brand, the franchisor. And that’s what the franchise agreement is, a business contract that sets out rules and obligations that both sides need to follow.
Key points highlighted
In this podcast we highlight some of the differences that you will find in a franchise agreement as opposed to a business contract. It’s a must-read document, because it shapes how you can run your new business and what you can do if there are disagreements with the franchisor. The franchise agreement will also outline what has to happen when you decide to sell your business.
This podcast takes an overview of the key elements of the agreement – each brand will have its own version, so franchise buyers do need to read it.
The franchise agreement is different from the disclosure document, which is referenced here. That’s another of the important documents handed to a franchise buyer.
Would-be franchisees will also get a copy of the Key Facts Sheet, which is a tool that can help readers navigate the disclosure document. It has to conform to a standard format.
You can find out more about this on the ACCC website.
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