Drawing his five-part franchising series to a close, Grid Law founder David Walker reveals what franchisors need to know about protecting their business through every stage of the franchise journey, from successful branding to terminating agreements.
As a successful franchisor there will be three key elements to your business. These are:
- A strong brand
- A business system you can replicate
- A network of franchisees running their own profitable businesses
Your continued success (and the success of your franchisees) will depend on how well you protect each of these elements.
You protect your brand by registering it as a trademark. You then control how your franchisees use your brand by granting them a licence of these trademarks. This trademark licence (which may be part of the franchise agreement) explains exactly how they can and should use the brand in their own business.
You protect your business system by carefully explaining what it is and how it works in your operations manual. The franchise agreement then creates a legally binding obligation on each franchisee to keep the system strictly confidential and follow it according to your instructions.
Together, the trademarks and the franchise agreement enable you to keep tight controls over each franchisee.
In this article were going to look at three common situations where you may need to exercise these controls to protect your business and the businesses of your other franchisees.
Take a look back at the rest of David’s franchising series
A franchisee wants to sell their business
The end goal for many successful entrepreneurs is to sell their business. This is their opportunity to cash in on all their hard work because they can often receive a lump sum payment that’s many times greater than their annual profit.
For an entrepreneur who has started and grown their own business, it’s entirely their choice to whom they sell their business and on what terms. However, when a franchisee wants to sell their business it’s not that simple.
As much as you may be delighted with how successful the franchisee has been, your priority will be the continued success of the business. Therefore, you will want to approve any prospective purchaser and place restrictions on who the franchisee can sell their business to.
The franchise agreement and operations manual will usually contain details of these restrictions and any minimum criteria the prospective purchaser must meet. For example, you may set minimum standards relating to the prospective purchaser’s business experience and financial standing.
You will also likely insist that they undertake (and pass) your training to ensure they know how to use your systems effectively.
Alternatively, you may want to give yourself a right of first refusal to the buy the business of any franchisee who wants to sell.
The death or incapacity of a franchisee
Part of my role as a solicitor is to raise the difficult “what if” questions that nobody really wants to talk about. In my experience, addressing these issues before they occur usually leads to the best outcome for all involved.
One of these situations is what happens if the franchisee dies or becomes so seriously ill that they can’t run the business? (When I refer to the franchisee in this situation I’m assuming they’re a sole trader, but this is equally relevant if they’re the majority shareholder and managing director of a franchisee company.)
This will be a difficult and emotional time for the franchisee’s family and it’s inevitable that without your intervention, the business will suffer. So, as supportive and sympathetic as you will be to their personal situation, in reality the best way you can help is to ensure that the business continues.
To allow this to happen, the franchise agreement will usually contain “step in” rights (discussed further below) or the right for you to appoint a manager who can continue running the business.
It’s also common for the franchise agreement to prevent the franchisee’s business from automatically transferring to a family member when the franchisee passes away.
The reason for this is the same as when a franchisee wants to sell their business. You must ensure that someone suitable continues to run the business to protect the brand and system for everyone’s benefit.
In reality, this is also best situation for the franchisee’s family. It maintains the value of the business until it can be sold and the executors of the deceased’s estate don’t have the additional burden of running it according to a strict system at a difficult and emotional time.
When you (the franchisor) needs to terminate the franchise agreement
The ultimate control you have over your franchisees is the right to terminate their franchise agreement. Their whole business is built on their entitlement to use your brand and system. When you terminate the franchise agreement, you’re removing this entitlement and as you can imagine, this could be disastrous for their business.
So, when should you exercise this right?
Clearly, it’s going to be a serious situation and the circumstances in which you can exercise this right should be clearly set out in your franchise agreement.
For example, one of the attractive features of a franchise business is that it generates consistent results. When customers walk into any branch of a franchise business they know what to expect because all franchisees must follow the same proven system.
If you have a franchisee who doesn’t follow your system, their results will be inconsistent with the other franchisees. This will be disappointing for your customers because they will no longer receive what they’re expecting.
Therefore, to protect the integrity of the system and the results it generates, you may exercise your right to terminate the franchise agreement if a franchisee fails to follow the system.
Consequences of termination
After terminating the franchise agreement, or on the death or incapacity of a franchisee, you will want to minimise the potential damage to your business and the remaining franchisees. To do this, you will need to act quickly to sever connections with the franchisee. This may include exercising your “step in” rights.
Effectively, “step in” rights allow you, the franchisor, to “step into” the franchisee’s business and continue running it. This may be on a temporary basis while a purchaser is found for the business or you may decide to keep the business for yourself.
If you decide to keep the business for yourself, you will usually pay the franchisee a set amount calculated according to a predetermined formula that’s set out in the franchise agreement. This may be something along the lines of the value of the assets and equipment in the business less any amounts owed to you, for example any unpaid franchise fees.
It’s almost impossible to cover all potential scenarios with such a formula and it’s unlikely to give the franchisee a very good sale price for their business. So be aware that exercising this right, especially if the franchisee disputes the grounds on which you have terminated the agreement, can lead to a legal dispute and both of you ending up in court.
If you don’t have any “step in” rights, or you choose not to exercise them, the franchisee may be able to continue running their business. However, they will have to stop using your branding and business system.
Ensuring the outgoing franchisee completely rebrands is relatively easy to enforce but preventing them from using your systems may be very difficult. For this reason alone, you may decide that it’s in your best interests to force the outgoing franchisee to stop trading altogether.
If you insist on this you may also put restrictions on them to prevent them from setting up a competitive business. But remember, if you do put restrictive covenants on the outgoing franchisee they must be reasonable. If they’re not, they may be unenforceable.
As you have seen in this series, franchising offers some excellent opportunities for you to grow your business. If there’s anything you would like me to elaborate on, or if you have any questions about franchising your business, please feel free to email me at email@example.com and I’ll happily answer them for you.
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