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Article of Interest

What to do When Representing Franchisees
By:  H. Michael Drumm, Drumm Law, LLC

Franchise agreements are typically considered to be non-negotiable documents. While this may be true for large, established systems such as McDonald’s or Subway, most franchisors are willing to negotiate certain terms of the franchise agreement. The franchisor’s willingness to negotiate usually depends on factors such as the age of the franchise system, the degree of competition, the growth of the system, and the franchisor’s goals. Franchisors are more willing to negotiate in a down economy when new franchisees are difficult to obtain. Under the Federal Trade Commission Franchise Rule, 16 CFR Parts 436, every franchise offering, regardless of the industry, must follow the same 23-item format. This allows franchisees and their counsel to competently evaluate franchise opportunities across all industries. This article provides a general overview of what to do when representing a client that is interested in purchasing a franchise.

A. Non-Negotiable Documents

Franchise systems are based on the principle of uniformity. The goal is to replicate a successful system so that a person visiting a franchise location, regardless of location, would know what to expect before the visit. Franchise agreements are written to be non-negotiable to maintain this uniformity. Uniform franchise agreements also make it easier for the franchisor to manage enforcement. Good franchise lawyers recognize this fact when entering into negotiations with a franchisor. One of the most common complaints from franchisors and their counsel is that franchisees hire business lawyers who are not familiar with franchising and therefore negotiate the deal to death. The franchise agreement is not set up to be a balanced document. It will be skewed to the franchisor’s favor to some degree.

Notwithstanding this, certain terms of the franchise agreement may be negotiated without affecting the uniformity of the system—and benefitting the individual franchisee. These are generally terms that are specific to the franchisee.

B. Fees

Franchisees are often reluctant to hire a lawyer despite the fact that their purchase is an investment of a significant sum of money. It is becoming more common for franchisee lawyers to charge a flat fee to review the franchise-disclosure document and franchise agreement. When setting a flat fee, franchisee lawyers should delineate what is included in the flat fee. Does the flat fee cover only a review of the franchise disclosure document and franchise agreement? Does it cover a written memorandum? Does it cover negotiations with the franchisor? Does it cover drafting an addendum? It is of the utmost importance that this information be communicated clearly to the client and that the flat fee match the work involved. Franchisee lawyers also need to be aware of the timing of the deal. Franchise disclosure documents must be updated annually, within one hundred and twenty days after the end of the franchisor’s fiscal year (16 CFR Parts 436). Depending on when the franchise sale is set to close, franchisee lawyers may be required to review two franchise disclosure documents. Franchisee lawyers need to draft their engagement letter carefully to match the specific details of the transaction, for example, whether or not they will be reviewing the current document and the newly revised document or just one of these documents.

C. Registration States

One of the first questions that franchisee lawyers should ask their clients is where the franchise will be located. Additionally, a franchisee lawyer should also inquire where franchisee’s primary residence is located. If either answers is California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Virginia, Washington, or Wisconsin, state laws may offer the client additional protections over franchisees located in other states and require filings on behalf of the franchisor. Franchisors are required to file either notices or registrations in these states before they are able to offer franchises for sale. Franchisee lawyers can call the state office that administers franchise regulation to determine whether or not the franchisor is legally able to sell a franchise in that state. These states also restrict franchise agreements’ terms on transfer fees, general releases, choice of law and venue, and other items. If the client is located in one of the states, the franchisee lawyer will not have to negotiate certain items, as they are given to the franchisee by law. In such situations, it does not benefit the franchisee or franchisor to negotiate over items that the franchisor is required to provide by law.

D. Negotiated Changes

California and Wisconsin are the only states that specifically regulate the disclosure of negotiated terms. The Federal Trade Commission and other states, to the extent that they address the possibility of negotiated changes, give franchisors and franchisees wide latitude to negotiate agreements as they see fit. For example, the Washington Franchise Investment Protection Act states that it “does not preclude negotiation of the terms and conditions of a franchise at the initiative of a franchisee” and specifies that a franchisor “need not provide an amended offering circular” due to its agreement to the negotiated changes. This hands-off policy encourages free negotiation between the parties, which is consistent with the goals of franchise regulations in general. California requires the franchisor to re-register any negotiated changes. California also requires franchisors to file a Notice of Negotiated Change of Sale of Franchise within 15 days after the negotiated sale. After that, all California prospective franchisees must be given the following disclosures:

“The terms of Items ___ of this Offering Circular have been negotiated with other franchisees. A copy of all Negotiated Sales Notices filed in California in the last 12 months are attached as Exhibit "__.”

This aspect of California law is not universally known by all franchise lawyers. When representing a California client, it is up to franchisee lawyers to decide whether they want to ask for all negotiated changes during the previous 12 months. A franchisor that is unaware of this requirement may negotiate more freely. However, if the franchisor is aware of this requirement and has negotiated changes, franchisees are entitled to a list of such changes, which could benefit the client’s negotiations.

E. Confirm Franchisor’s Willingness to Negotiate

Certain franchisors refuse to negotiate. I have come across clients that will immediately discontinue talks with franchisees when they are presented with a list of requested changes. A franchisee lawyer should inquire through the franchisee whether or not the franchisor will review the requested changes. Even if a franchisor is not willing to negotiate, franchisee lawyers can still provide value by reviewing and explaining the franchise agreement. If a franchisor is willing to negotiate, it is the franchisee lawyer’s responsibility to guide the client on what is important. As stated earlier, the franchise agreement is not a neutral document and will favor the franchisor.

F. Review the Franchise Disclosure Document (FDD)

The FDD is the roadmap to the franchise opportunity. It contains 23 items of information that the Federal Trade Commission has determined to be important to prospective franchisees. The FDD can tell franchisee lawyers about the quality of the franchisor’s lawyer and the franchise agreement. The FDD also provides information regarding the business terms of the deal, such as the initial investment and required fees. As the FDD is required by the FTC and the registration states, misinformation or missing information may be a violation that will allow a franchisee to rescind a franchise agreement. The FDD is not a legally binding agreement; franchisee lawyers should review the franchise agreement carefully, as that is the binding document that controls the relationship.

G. Recognize Non-Negotiable Items

Certain items of the franchise agreement that are non-negotiable. These will be the items that deal with the uniformity of the system and include the branding of the franchise system and products and services provided by franchisees. Additionally, there are items that are non-negotiable to the franchisor because they affect the franchisor’s finances. These include personal guarantees, royalties, advertising fund contributions, and initial franchise fees. While you may not be able to negotiate the existence of these items, you may be able to negotiate their size. For example, you can request a cap on required capital expenditures or a cap on royalty or renewal fees.

H. Recognize the Negotiable Items

Many items in the franchise agreement can be negotiated to the franchisee’s benefit without affecting the uniformity of the system. These items include:

1. Right of First Refusal on Additional Territories
2. Right of First Refusal on New Brands
3. Additional Training
4. Trademark Infringement Indemnification
5. Pre-approved Transferees
6. Extra Renewal Terms
7. Deadline Extensions
8. Cure Provisions
9. Financing of the Initial Franchise Fee
10. Tiered Royalty
11. Deferred Royalty
12. Removal of Franchisor’s Right of First Refusal
13. Deferred Advertising Fund Contributions (especially important in new systems)
14. Reasonableness in All Franchisor Approval
15. Commercially Reasonable Caps on Product Purchases Required by Franchisor
16. Commercially Reasonable Caps on Inventory Levels
17. Addition of “Material” to Defaults
18. Elimination of Cross Defaults
19. Arbitration or Litigation
20. Waiver of Trial By Jury
21. Waiver of Punitive Damages
22. Commercially Reasonable Lease Addendum
23. Termination Fee
24. Addendum Terms in Renewal and Transfer Agreement
25. Same Royalty, Advertising Fee and Territory in Renewal Agreements

I. Deal Breakers

It is helpful to provide a franchisor with a list of items you want to discuss. A franchisee lawyer can point out an overwhelming number of issues that a prospective franchisee would like changed . In my experience, it is best to educate the franchisee on these items, present a list of items, let the franchisee choose which items are the most important, and present this narrowed down list to the franchisor. Requesting a rewrite of the entire agreement may cause the franchisor to walk away from the deal. Franchisee lawyers should work with their clients to determine which items are deal breakers. These may include the deletion of a personal guaranty or the right to purchase additional territories. Identifying the deal breakers may speed up the process and save the franchisee time and money.

J. Other Franchisees

Item 20 of the Franchise Disclosure Document lists the names of all current and former franchisees as of the end of the franchisor’s previous fiscal year. This information could be a potential franchisee’s most valuable information in deciding whether or not to purchase the franchise. Franchisors are bound by disclosure laws on what they can and cannot say, but current and former franchisees are not. Prospective franchisees should reach out to these franchisees and gather as much information on the franchisor as possible. This could include how the franchisor operates, financial information on the franchises, and, in the case of former franchisees, issues with the franchise system.

K. Trademarks

Item 13 of the Franchise Disclosure Document lists all trademarks currently owned by the franchisor. Franchisee lawyers should use this to determine whether or not the franchisor’s trademarks are registered. If the trademarks are not registered, a franchisee may be able to negotiate a term of reimbursement if the franchisee has to alter the trademark or logo as a result of trademark infringement issues (to illustrate, the Qdoba franchise had two prior brands before Qdoba—Zuma and Z-Teca).

L. Addendum

Franchisors rarely change the actual franchise agreement. This is a result of the nature of the franchise agreements: It is easier for a franchisor to have a single “master contract” than it is to have 300 individual agreements. As such, most negotiated changes come as an addendum to the franchise agreement. An addendum allows the franchisor to determine easily what changes were made to the standard agreement for each franchisee. Addenda are usually drafted by the franchisor, who has access to editable versions of the documents or simply likes to maintain control of negotiations. However, newer franchise concepts may request or require that franchisees prepare the addendum to save the franchisor on legal expenses.

M. Negotiation Process

Franchisee lawyers and prospective franchisees must determine who will do the negotiating. Is the franchisee a sophisticated business person who prefers to self-negotiate or a first-time purchaser who needs the guidance of counsel? It is also worthwhile to know whether the franchisor will negotiate directly with the franchisee and its lawyer or if franchisor’s counsel will be involved.

N. “Just Because”

It helps to have valid reasons for the requested changes rather than asking for them “just because.” For example, some franchise agreements do not require the franchisor to indemnify the franchisee if the franchisee is sued for using the franchisor’s trademarks. In such a situation, the franchisee would be required to use the trademarks under the terms of the franchise agreement and would be required to defend itself against a trademark infringement case. If the franchisee were to lose the trademark infringement case, it would be stuck in a situation where it would legally not be able to use the trademarks but still legally required to use them. Pointing out valid business reasons for requested changes makes it more difficult for the franchisor to reject such requests. Another good negotiation tactic is to shop the competition. Certain states publish the FDDs of the franchise systems registered in their state. It may ease negotiations if you are requesting a change that matches what the competition is already offering.

O. Expectations

The franchise agreement is set up to be non-negotiable. Accordingly, any terms that franchisee lawyers are able to negotiate should be seen as a victory. Whether it is one item or eight pages of negotiated terms, franchisees will be in a better situation having been represented by a competent franchisee lawyer.

H. Michael Drumm is licensed in Texas and Colorado. He focuses his practice on representing franchisors.