What “Never” To Negotiate In Franchise Agreements – Part 4

Fox Rothschild LLP

The Fox Rothschild associate team of Megan Center and Alex Radus recently gave a presentation at the International Franchise Expo in New York City on the “Top Ten Provisions to ‘Never’ Negotiate in a Franchise Agreement”.  We have prepared a summary of this presentation in four separate blog posts.  The first post focused on central themes of franchise negotiation, the second post addressed protecting the confidentiality of franchise negotiations, and the third post addressed the first five of our top ten provisions.

This last installment details the second set of our top ten provisions to “never” negotiate.

1)  Changing Marks/Renovations/Upgrades

• Typical Provision:  Franchisors can require franchisees to update and renovate their units, as well as upgrade furniture, fixtures and equipment, at any time during the franchise relationship. This also includes franchisors’ rights to change their marks.
• Franchisee Argument:  Franchisees want to limit uncertainty in their financial obligations.  Depending on the circumstances, they may request a spending cap, reimbursement from the franchisor, and a grace period while they ramp up when they will not be obligated to spend more.  Franchisees may request additional concessions with respect to new marks, because they will be helping build goodwill from day one.
• Franchisor Argument:  Franchisors have weighed the liabilities they may incur in connection with the franchise agreement and priced the initial franchise fee because of that analysis. Shifting any additional liabilities on franchisors skews this analysis. This practice can be extremely expensive even if granted this for one franchisee. Renovations and upgrades will likely benefit the unit by modernizing the unit and keeping up with customer preferences. Customers could be turned off by a stagnant brand. Franchisors need to ensure consistent experience from the brand across the board.
• Compromise:  Franchisors can agree to a maximum expenditure during the term of the franchise agreement. Franchisors can agree to not impose this requirement during the first few years of the term of the franchise agreement. Franchisors can also agree to provide franchisees with a certain credit against its local advertising requirement depending upon the expenditure.

2)  Termination/Cure Period

• Typical Provision:  Franchisors can terminate the franchise relationship for a whole host of reasons. These reasons, or defaults, commonly fall into curable defaults and non-curable defaults.
• Franchisee Argument:  Franchisees will seek to de-risk their investment by requiring notice of violations and period in which to cure, with extensions if they are attempting to cure.  Franchisees will be especially sensitive to the possibility of losing their business due to “technical violations” or cross-defaults (i.e., breach of agreements other than the franchise agreement).
• Franchisor Argument:  Some defaults of the Franchise Agreement are so egregious that they cannot be cured. These types of defaults attack the heart of the franchise relationship and are likely irreparable. While there may be required revisions based on state law, these provisions are drafted with particular precision and attention.
• Compromise: Our first bit of advice to lighten the situation is to blame the lawyer! Termination rights are impactful and drive franchisor outcomes. Franchisor counsel understandably spends significant time and energy focusing on this section of the franchise agreement and that is why it can be so voluminous. If a franchisee has concerns about a specific event of default, the franchisee and franchisor can deal with each in turn.

3)  Indemnification

• Typical Provision:  Franchisees are required to indemnify franchisors for any claims or losses that franchisors incur in connection with that franchisee’s operation of its franchised unit.
• Franchisee Argument:  Franchisees seeking parity will ask for the franchisor to indemnify them.  They will argue this is fair due to the risk that they could face litigation based on the franchisor’s acts and omissions.
• Franchisor Argument:  This practice can be extremely expensive even if granted for one franchisee. Franchisors’ time and resources are better spent further developing the franchise system instead of reimbursing franchisees for or defending lawsuits against franchisees, many of which can be frivolous.
• Compromise:  Franchisors can agree to indemnify a franchisee for any suits related to trademark infringement if the franchisee was using the trademarks in accordance with the franchisor’s standards and specifications. Additionally, franchisors can agree to indemnify their franchisees if such claims are directly caused by franchisors’ willful misconduct or gross negligence. That way, franchisees will get a bit of comfort that they will not have to pay for claims arising from certain of franchisors’ actions.

4)   Assignment

• Typical Provision:  Franchisors can freely assign their rights under the franchise agreements without obtaining franchisees’ consent.
• Franchisee Argument:  Franchising is a relationship-driven business model.  Franchisees invest not only on the strength of the system, but also because they believe in the management team’s ability to grow the system and support their franchisees.  Franchisees may seek to restrict founder’s and management’s ability to exit the system, including approval rights over assignment.
• Franchisor Argument:  Franchisors are unable to predict every future business opportunity they may encounter. Franchisor founders need to ensure an exit strategy. Franchisors cannot restrict the sale of the entire franchise system because one franchisee objects. The ultimate acquisition by a larger franchise system, even if competing, could increase efficiencies and levels of support of the underlying brand.
• Compromise:  Franchisors can agree to only assign the franchise agreement to third parties that agree to assume the responsibilities and obligations underlying the Franchise Agreement. Franchisors will be required to do this regardless and it will give franchisees a bit more comfort in a sale situation.

5)  Personal Guaranty

• Typical Provision:  All of franchisee’s owners and each owner’s spouse must sign a personal guaranty making each individual personally liable for, and personally bound by, the terms and covenants in the Franchise Agreement.
• Franchisee Argument:  More than nearly any other provision, the personal guarantee will keep franchisee’s up at night.  For obvious reasons, they will not want their or their spouse’s personal assets at stake.  They may argue that, like other investments and business ventures, their risk should be limited to their contributed capital.
• Franchisor Argument:  Franchisors are entering into this relationship with the expectation for a relationship of a certain duration and the expectation of a royalty and advertising fund revenue stream. Franchisors expend significant costs and expenses in assisting a franchisee with opening its franchised unit. The use of the personal guaranty ensures that the franchisee has some skin in the game and franchisors are not left chasing shell entities. The personal guaranty risk is part of the analysis a franchisee has to take in connection with the operation of its independent business.
• Compromise:  Generally, franchisors can agree to waive the requirement for a non-owner spouse to sign a personal guaranty so long as the spouse signs a confidentiality and non-compete agreement. If the franchisee candidate is someone a franchisor strongly desires to have in the system, the franchisor can impose limits on time and amount of money it can obtain against the franchisee. However, any concessions that are granted in connection with the initial franchise agreement should lapse with any renewal franchise agreement or purchase of additional units because the uncertainty of the relationship is removed from the equation.