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Advice & Tips Ask an Expert Current Issue September/October 2020

Q: Why is the start of my franchise relationship the best time to think about the end of it?

A: The period in which prospective franchisees begin to seriously consider entering into a franchise relationship is undoubtedly an exciting time for them. During this period of investigation, it is natural for prospective franchisees to focus their attention on questions that loom large during the start of the relationship: How much money will I make? What will my expenses be? How much of an investment is required? How strong is this brand? What support will I have?

While answering those questions is undeniably important, it is easy for a prospective franchisee who is focused on the start of the business relationship to ignore no-less important questions about how that relationship can come to an end.

Franchise agreements can come to an end in any number of ways. They can expire naturally when their term and any renewal terms end. They can be terminated by the franchisor for reasons such as non-compliance with the franchise agreement. They can be rescinded by the franchisee if certain important information about the franchise was not completely or properly disclosed. They can be transferred if, for instance, the franchisee wishes to sell the franchise to another, or new, franchisee or back to the franchisor.

In deciding whether to enter into a franchise relationship, prospective franchisees would be well-advised to turn their attention to the circumstances surrounding the termination and transfer provisions in the franchise agreement that they are being asked to sign.

Natural expiration

Franchise agreements are typically for a fixed term, with one or more renewal terms. In some cases, the term is defined to be for a certain period, such as five or 10 years. In other cases, the term may be defined to expire sooner if, for instance, the premises are governed by a head lease that expires sooner than the term of the franchise agreement.

To be entitled to a renewal, the franchisee must typically meet certain strict requirements. These could include modernizing the premises, which often involves a significant renovation cost. The franchisor also typically requires a renewal fee and that the franchisee be in strict compliance with the franchise agreement at the time of the renewal. To exercise its right of renewal, the franchisee must normally provide written notice to the franchisor within a fixed period prior to the expiration of the term; failure to provide timely notice could result in the loss of the renewal right.

Bases for termination by the franchisor

A breach of the terms of the franchise agreement by the franchisee will typically entitle the franchisor to terminate the agreement before its term expires, either immediately or after first giving the franchisee an opportunity to “cure”, or, correct, the breaches.

Curable breaches tend to be relatively less serious than non-curable ones, and would normally include the first one or two late payments of royalty fees, the failure to provide reports of gross revenues or other financial reporting to the franchisor, the failure to comply with the system’s standards, and the sale of unauthorized products or services.

Non-curable breaches would typically include the franchisee’s insolvency, the loss of any lease governing the franchised premises, repeated breaches of an otherwise curable breach, the franchisee’s abandonment of the franchise, the forced closing of the franchise by government authorities, conduct on the part of the franchisee that materially impairs the franchisor’s goodwill or that endangers public health and safety, and intentional under-reporting of royalties.

Bases for termination by the franchisee

Franchise agreements usually do not permit the franchisee to terminate. A franchisee experiencing financial difficulty or lack of support from the franchisor may find itself without any contractual remedies other than attempting to sell the franchise to another, or new, franchisee or back to the franchisor; however, a sale to a third party would almost certainly require the consent of the franchisor, and franchisors frequently withhold such consent.

An abandonment of the franchise may result in litigation by the franchisor, particularly if, after abandonment, the franchisee enters into a business that is competitive with the franchisor.

Transfer of the franchise

Most franchise agreements permit the franchisee to sell the franchise to a new, or existing, franchisee, or back to the franchisor, but only if certain strict conditions are met. The franchisor will want to be satisfied that any proposed purchaser has the sufficient capital and experience to operate the franchise. The franchisor will also typically require payment of a significant transfer fee. The franchisee usually must be in compliance with the franchise agreement at the time of the proposed transfer. The franchisor may insist that the franchisee’s principal(s) will personally guarantee the performance of the buyer for a period of time.

The franchisor may also wish to buy the franchise, but is not obligated to do so and may not always be in a financial position to do so.

These comments relating to transfers also apply in circumstances when the franchisee or its principal dies or becomes disabled and his or her heirs or successors wish to continue to operate the franchise.

Conclusion

Before signing the franchise agreement, the prospective franchisee should pay close attention to the term, renewal conditions, and termination and transfer provisions in the franchise agreement. Ideally this review should be undertaken in consultation with a franchise lawyer, with a view to identifying whether the provisions are commercially reasonable and, if not, negotiable.

The prospective franchisee should also investigate its franchisor’s culture of termination. Some franchisors are less tolerant of breaches than others. The franchise disclosure document is required to list former franchisees whose franchise agreements have been terminated. The prospective franchisee should investigate the circumstances of those terminations, including, where appropriate, by contacting such former franchisees. A search of reported court decisions and the court’s files with respect to the franchisor may also be appropriate.

By focusing not only on how the franchise relationship will start, but also how it could end, the prospective franchisee can make a better, more informed, and well-considered decision before making its investment.

Idan Erez
Associate
Hoffer Adler LLP
ierez@hofferadler.com

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