Franchise Term, Period of Franchise Agreement

A commonly-held perception of many people ­– even many potential and current franchisees – is that a franchise is a business like any other, and that a franchisee purchases a right that ensures the franchisee returns on their business investment and hard work for as long as they wish to remain with it.

However, this is not really the true nature of franchising. In its simplest interpretation, a franchise is the right to use someone else’s business system for a fixed period (usually referred to in the franchise agreement as the ‘Term’) and then to stop using it at the end of that period.

This article considers why finite Terms are used and what might happen to a franchisee’s business when the Term of the franchise finishes. It also has some advice for would-be franchisees about what to expect, what to look for in an agreement, and what to ask for from your lawyer and accountant.

The typical business format franchise systems that have developed in New Zealand and indeed in most Western jurisdictions involve a franchisor (owner or originator of the original ideas, systems, trademarks, goodwill etc) selling to a franchisee a franchise. This franchise is effectively a lease of the right to use those brand names, systems, know-how, etc, combined with a level of franchisor support, advice, group purchasing advantages and similar for a defined and usually finite period of time: the ‘Term’.

The franchise agreement might also allow for a renewal period and this may be referred to as a ‘renewed’ or ‘further’ Term. Most agreements do have at least one renewal option with a specified period, but this renewed or further Term will also (usually) have a maximum period or measurable end date.

Some examples of how different franchise agreements might specify the franchise Term:

• An initial period of 7 years + one right of renewal of a further 5 years; or
• 5 years plus two further renewal periods of 5 years each being a total maximum term of 15 years; or
• A term of 12 years.

The length of the Term is often specified in a Schedule at the back of the franchise agreement, or perhaps in a section of the agreement headed ‘Term’ or similar. It is an essential component of any franchise agreement and one of the first pieces of information that should be established when considering a franchise.

When the initial Term and any specified renewals come to the end, the rights of the franchisee to use the franchisor’s system and intellectual property are over… run out… expire... are totally extinguished... and join the choir invisible. It is an ex-franchise.

Why Have A Term?
So when you buy a franchise, you are buying it for a limited period of time. Why? There are good reasons.
When modern franchising was developed in the middle of the last century, many franchise agreements were granted on a ‘forever’ basis or on exceedingly long terms. The first fast food franchise in the UK, for example, granted 50 year terms when it started franchising in 1954, which means their earliest franchise agreements only came up for renewal last year. Imagine the changes that have happened in the market since those days, and consider what would have happened to any business which had failed to change its modus operandi during that time.

As any franchise grows and expands, improvements and alternatives to existing ways of doing things develop. For example, a franchisor might require a franchisee to install a computerised stock control system that wasn’t required when the franchise was granted originally, or population movements or roading changes might mean that existing territories are too large and leave gaps where competitors can gain leverage. This means making changes to the franchise agreement, which is not practical on an ongoing basis. Renewable terms set a known time at which those changes can be made.

Equally, one of the most important factors in the success of any franchise is consistency, but as systems develop and improve over time, consistency inevitably slips. Having renewable terms gives the franchisor a big stick – or a carrot, depending on how you look at it – with which to ensure that franchisees are periodically required either to update to the latest standards or exit the system.

The pace of change is constantly increasing, and it would be a far-sighted franchisor indeed who could foresee what would be required of a franchise in five years’ time, let alone 15. Ultimately, of course, the renewal periods come to an end and with them so does the right of the purchaser to operate as a franchisee within that system. Good franchisees may well be offered a new agreement at that point, depending upon the franchisor’s situation and plans, but there is no obligation for the franchisor to do so. Let’s look at what happens if no agreement is offered.

What Might Happen
In a strongly written agreement, when the franchise agreement comes to an end the franchisee normally has to destroy or hand everything back to the franchisor – uniforms, manuals, documents, signage, product, fitout, etc. They may have to vacate the premises and assign the lease to the franchisor. Depending on the specific agreement, they may also have to sign over telephone, fax numbers and email addresses to the franchisor, along with client lists and similar.

The agreement often provides that the franchisor has the option to buy the assets of the business at a fair value but this often equates to not much more than book value. There is almost never a requirement that the franchisor pay for any goodwill of the business because the franchisor does not recognise that a franchisee has any goodwill to sell at this stage of the relationship.

The lawyer for the franchisor would suggest that a franchisor should not be required to re-purchase rights which have expired and that any value of goodwill of the business either expired with the franchise term, or was only ever owned by the franchisee during the currency of that term and reverts back to the franchisor upon expiry.

And if the ex-franchisee thinks that they can pick themselves up, dust themselves off and carry on under their own name down the road, they will usually find their franchise agreement contains a restraint of trade/no competition clause which kicks in when the agreement comes to an end.

This will say something about the franchisee being prohibited for a certain number of years in a certain geographical area from working in the same industry, competing with the franchisor in any way and/or poaching franchise customers or suppliers. Such a clause may be under a heading ‘Consequences on Termination’ or, ‘Restriction on Competition’ ‘Restraint of Trade’, or even somewhere under ‘Franchisee Obligations’. This has the effect of stopping a franchisee using the experience and expertise which they have gained within the franchise system when they leave it.

So the likely consequence of the expiry of the Term and a restraint of trade is that an ex-franchisee must expect to be looking for a new opportunity in a different industry or a different area.

That is why a potential franchisee needs good legal and accounting advice before going into a franchise. They need to recover their initial investment plus a reasonable income on that investment during the term because, unless the franchisor chooses to offer a new agreement, it is highly likely there will be nothing (other than physical assets) to sell at the end of the term.

What Should Prospective Franchisees Look For?
Look for a franchise agreement that is clear in its intent as to what happens at the end of the Term, even if you initially feel it is pro-franchisor (all franchise agreements are pro-franchisor, because not only do they own the intellectual property that makes it possible for franchisees to operate but they also need to be able to protect the system for the benefit of all the other franchisees too).

Some franchisors will negotiate the provisions of a franchise agreement, but many will have a ‘take it or leave it’ attitude, especially if there is a well-established brand or more than one potential franchisee eager to sign up.

If you can negotiate, the length of the Term is commercially relevant. It will vary according to industry, but a decent length Term means that a good franchisee will have the opportunity to have recovered his or her set-up costs, made use of depreciation on plant and, with good advice, have made a significant financial success of the business well before any expiry concerns arise.
You might also ask the franchisor what they have done upon expiry of previous franchise terms. Franchising being a relatively new business structure in New Zealand, there are not that many systems which have experienced expiry of term issues so far, but it is increasingly being discussed. If the franchisor gives any undertaking or commitment as to what will happen upon expiry, try and get it in writing.

Professional Advice
You must to speak to a lawyer with a background in franchising to have the meaning, obligations and risks of the franchise agreement explained to you. This should result in you entering the agreement with no surprises down the track.

You don’t have to like what you sign, but you do have to be aware of and accept the implications of your franchise, both good and bad, if you elect to go ahead. Your franchise lawyer can point out unusual or unacceptable provisions of the agreement and negotiate on your behalf.

In addition, you must go through the potential income scenarios with an accountant to establish if this is a worthwhile investment. On the basis that there is very little left to sell at the end, within the period of the Term you need to look at recovering your initial investment along with a reasonable return on that investment and a return for your time and effort. All these returns should be factored into the franchisee’s calculations over the Term of the agreement.

Regardless of what the provisions or procedure might be upon expiry of the franchise Term, it is to everyone’s advantage that the franchise agreement leaves no room for doubt or misinterpretation.

While the above discusses what the literal position may be in many franchise agreements, there are many franchisors who are happy to pay some consideration for goodwill for an expired franchise; or to allow a departing franchisee at the end of their term to sell their business and grant the purchaser a new term; or even negotiate an entirely new term with the existing franchisee. This is quite acceptable and, to most franchisees, desirable, but again the franchise agreement needs to set out clearly what the expectations and procedure are so there is no room for misunderstanding.

It makes good business sense for both the franchisor and the franchisee to enter into a long term relationship. Any franchisor who has gone to the trouble of developing a worthwhile system does not want to lessen its appeal and potential by appointing short-term franchisees.

The good franchisor ideally wants the franchise system to operate in a manner which allows for growth and development of the system. A long-term agreement with balanced provisions is more likely to do this.
If a franchise agreement is not clear on the length of Term, conditions of renewal of Term and the procedure upon expiry of the Term you need to ensure you clarify these things with the franchisor before signing. This is fundamentally important when it comes to assessing whether your franchise purchase is a prudent business investment of your time and money.