Drafting and Negotiating a Franchise Agreement
by Martin D. Fern 

Introduction
The centerpiece of the legal relationship between parties to a franchise is a written license commonly called a “franchise agreement.” Pursuant to a franchise agreement, the owner of the franchise rights, commonly called a “franchisor,” grants a license to the owner of the franchise business, commonly called a “franchisee,” a bundle of rights necessary to establish and operate the franchise. These rights include a license to use the franchisor’s trademarks or service marks, its operating system, and trade secrets. The franchisor also usually provides fairly comprehensive services designed to enable the franchisee to develop, open and operate the franchise business, including training, site location, design and construction of the franchisee’s premises, ordering of equipment and supplies, and so forth. In exchange for these rights and services, the franchisee usually agrees to pay the franchisor a sum of money at the inception of the franchise agreement and recurring fees and charges throughout the duration of the relationship.

A lawyer representing a company embarking upon a franchise program is typically asked to assist in structuring and drafting a form of franchise agreement that will be offered to new franchisees. A lawyer representing a prospective purchaser of a franchise is typically asked to analyze and assist in negotiating the franchise agreement (and other agreements) that the franchisee is asked to sign. This article addresses these tasks.

The Need for a Standard Form of Agreement
The regulation of franchise offerings necessitates that the franchisor uses a standard form franchise agreement that is offered to all new franchisees. This is because laws in fifteen states and a Federal Trade Commission regulation, often called the “FTC Franchise Disclosure Rule” or simply, the “FTC Rule,” require delivery of a standard disclosure statement to prospective franchisees prior to the execution of any agreement or payment of any consideration in connection with the sale of a franchise. The required franchise disclosure statement, called a “Uniform Franchise Offering Circular” or “UFOC,” contains detailed statements about the terms and conditions of the franchise being offering and requires that the form of agreement that is used in connection with the sale of the franchise be attached as an exhibit. Thirteen states require that the UFOC be registered with a state governmental authority. In California, the Department of Corporations is the relevant authority. In addition to these laws, a number states, including California, have adopted laws, sometimes called “franchise relationship” statutes that prohibit discrimination among franchisees. California’s statute is called the Fair Dealership Law (Civ. Code, §§ 80-86). Offering materially different deals to new franchisees during contemporaneous transactions, absent reasonable justification, may violate these laws in some states which have anti-discrimination provisions (California’s Fair Dealership Law does not. Civil Code § 51.8 prohibits discrimination in a civil rights sense in connection with granting franchises).

Therefore, state and federal franchise regulatory schemes require that the franchisor offer the same form of agreement to all prospective franchisees. As noted below, however, with the exception of the State of California, this requirement does not mean that the agreement that is actually signed must be uniform in all cases and some opportunity for negotiating changes to the agreement does exist.

Other Legal Considerations
Drafting a franchise agreement requires a broad understanding of a considerable body of law. Of course, general principals of contract law affect franchise agreements. In addition, there may be industry specific issues that must be taken into account. For example, industry specific laws govern gas station and automobile franchises. The nature of franchise relationships requires a working knowledge of laws governing distribution relationships, such as federal and state fair practices and anti-trust laws, and trademark law. Finally, while rarely do state or federal laws mandate specific provisions in a franchise agreement, state franchise disclosure and relationship laws contain (usually reasonable) limitations on the contents of a franchise agreement, especially provisions dealing with rights of association among franchisees, early termination and renewal of the term of the franchise, and issues relating to transfer and succession, and provisions regarding venue for dispute resolution.

Issues in Structuring and Drafting a Franchise Agreement
Franchise agreements can be best understood by thinking of them as composed of three distinct parts. The first part of the franchise agreement consist of elements that would be found in virtually every commercial contract used in the United States. I call these elements the, “common contract elements.” The second part of a franchise agreement are those clauses which distinguish a franchise agreement from other kinds of similar relationships, such as purchase and sale agreements, personal services agreements, and trademark licenses. I call this second part of the agreement the “franchise elements.” Finally, the part of a franchise agreement, which I call the “contract details,” contains the details of the relationship.

The Common Contract Elements
Every franchise agreement has in common provisions that are basic to virtually all U.S. commercial agreements. These are fairly simple and include the following:

• A section that identifies the parties to the contract—i.e. the name of the franchisee and of the franchisor. This section is typically found at the beginning of the contract, usually in the first couple of lines.
• The date on which the contract was made or signed. This is often also found at the very beginning of the contract, since it is a convenient way of identifying the agreement, but sometimes the date the agreement is signed is placed at the end of the agreement, in the place where the contract is signed.
• Signatures of the parties. This section is ordinarily at the end of the contract.
• A variety of recital clauses designed to establish the context of the agreement. Such recital clauses, called “whereas” clauses in more antiquated forms of contacts because each recital would be preceded by the word, “whereas,” usually follow the section that identifies and dates the agreement. Some forms of franchise agreements also place recitals at the end of the agreement, to detail such issues as the circumstances under which the contract was reviewed and signed.

The Franchise Elements
Every franchise agreement, without exception, contains certain elements that make the relationship a “franchise” under U.S. law. Without these elements, the agreement simply does not establish a franchise. These elements distinguish a franchise from other kinds of relationships, such as employment relationships, partnerships, product or services purchase agreements and trademark licenses. Thus, every franchise agreement contains the following four elements:

• There is a grant of a right from the franchisor to the franchisee to engage in the franchise business that is the basic subject of the contract.
• The franchisee is granted the right and agrees to use the franchisor’s operating systems and marketing plan in the establishment and operation of the franchise business. Sometimes these systems include proprietary information and trade secrets, but it is not necessary that the franchisor’s operating system and marketing plan consist of proprietary or secret information and rarely are all of the franchisor’s plan and system truly confidential or proprietary
• The franchisor grants to the franchisee a license to use the franchisor’s trademarks or service marks to identify the franchisee’s business and the goods or services offered and sold at the franchise business.
• The franchisee agrees to the payment of consideration to the franchisor other than simply the wholesale price for goods purchased from the franchisor. Such consideration is typically paid both at the inception of the agreement in a lump sum and thereafter through periodic payments, often in the form of monthly royalties and other fees, such as training fees, advertising fees, real estate and equipment lease and purchase payments, and required purchases or products and services.

The Contract Details
While every franchise agreement contains a variety of clauses containing the details of the relationship, these details vary considerably. The contact details in a franchise agreement may include all of most of the following:

• Term—While occasionally a franchise relationship will endure indefinitely, the better practice is to specify a term after which the contract expires unless it is renewed. This enables the franchisor to update the relationship and the contact periodically. Typical terms can be for fairly short periods such as five-year terms, or last for as much as ten, twenty or even longer terms.
• Renewal Term—It is usual for the franchisor to grant the franchisee a right to renew the agreement upon the expiration of the initial term for further extended periods. Often there are conditions to renewal, such as the absence of contract breaches, the payment of renewal fees, written notice of the exercise of the option, and the execution of the current form of agreement.
• Products and Services Specifications—Franchise agreements contain a variety of provisions regarding the products and services offered and sold by the franchisee, including (but not limited to) those relating to quality. Many of these provisions are designed to assure uniformity of goods or services offered and sold by all franchisees in the system.
• Territorial Rights and Limitations—Franchisees are sometimes granted rights to operate their business from a defined location that is agreed upon at the inception of the agreement. Some, but not all, agreements protect the franchisee from incursion of a competing franchise or company owned business within a protected geographic area.
• Non-Competition and Repurchase Rights—Frequently, franchise agreements will prohibit the franchisee from engaging in similar or competing businesses during and even after the end of the franchise. To guard against a valuable franchise from becoming an independent and competing venture after the end of the contract if it is not renewed, some agreements grant to the franchisor the right to purchase the franchise business on terms that tend to favor the franchisor. The enforceability of post-term non-competition covenants varies among the states, including California which strongly disfavors such covenants.
• Transfer and Succession—Franchisors often wish to preserve the right to approve of a transfer of the franchise business. Since the general rule in American business contracts is that absent a contractual restriction the contract is assignable by the parties, it is typical to find a clause dealing with assignment by the franchisee. To avoid doubt, a franchise agreement may also have a clause dealing with the franchisor’s right to assign the agreement, especially to the operator of a competing franchise system. Franchise laws in force in many states regulate franchise transfer and succession rights to some degree and the lawyer drafting a franchise agreement must be familiar with the limitations imposed by these laws.
• Default and Enforcement Provisions—Standard franchise agreements typically contain fairly comprehensive clauses dealing with the right of the franchisor to terminate the agreement prior to the expiration of its stated term on account of the franchisee’s default. Franchise laws in force in many states require that the franchisor be reasonable in exercising its rights of early termination. These laws restrict the freedom of franchisors to terminate a franchise prior to the expiration of the stated term arbitrarily or without giving the franchisee a reasonable right to cure those defaults that by their nature may be remedied after notice. California’s Fair Dealership Law, mentioned earlier, seeks to prevent arbitrary early termination and non-renewal of franchises.
• Franchisor’s Duties—Franchisors typically undertake a variety of obligations to the franchisee, both at the inception and during the term of the franchise. These include assistance in locating the site for the franchise business, constructing and equipping the franchise establishment, training of the franchisee and his staff, ordering goods and services, assistance in advertising and public relations, and other operational assistance rendered to the franchisee.
• Franchisee’s Duties—Franchisee’s also accept a variety of obligations to the franchisor in addition to the payment of required fees and the other obligations mentioned above. These obligations relate to the manner in which the franchise business is operated and include such matters as the preparation of food or other products, the performance of services, appearance of the premises and employees, and required purchases of goods and services.

Limitations on Negotiating a Franchise Agreement
In a typical commercial transaction, the lawyers for each side try to win the right to draft the initial document because the drafting party has the strategic advantage of slanting the document in its own favor. Even after negotiations, many of these provisions remain more favorable to the party that had the privilege of drafting the first version of the document. In franchising, however, both practical considerations and franchise legislation and regulation dictate that the franchisor’s lawyer initially draft the form of agreement. This is because of the state and federal franchise disclosure laws, including the California Franchise Investment Act (Cal. Corp Code § 3100 et seq.) that require delivery of a standard form of franchise disclosure statement at the first personal meeting between the franchisor and franchisee or before the acceptance of any consideration from the franchisor and state franchise relationship laws that prohibit a franchisor’s discriminatory behavior towards franchisees.

Limitations on negotiating come from practical considerations as well. Franchise relationships tend to be of long duration and successful franchise systems involve numerous franchisees. It is extremely difficult to administer a franchise system with significantly different franchise agreements from franchisee to franchisee. In addition, unlike many other commercial relationships, a franchise is a continuing relationship. Since, it is difficult, often impossible, to keep the contents of an agreement truly confidential, giving one franchisee more favorable terms than others tends to breed resentment and consequent relationship difficulties. Because of these issues, rarely, if ever, will a well established, successful franchisor or a franchisor with a franchise in high demand, be willing to negotiate any important aspect of the franchise agreement. Such franchises are generally offered on a “take it or leave it” basis.

While the California franchise registration and disclosure law, the Franchise Investment Law (Cal. Corp. Code §3100 et seq), known as the “FIL,” does not expressly prohibit negotiations of a franchise, for many years the Department of Corporations, the regulatory authority assigned responsibility for enforcing the FIL, took the position that negotiating the terms of a franchise agreement was akin to offering an unregistered franchise and that signing a franchise agreement that materially differed from the one that was registered was the sale of an unregistered franchise, although the changes resulted from bona fide negotiations. This position was codified into law as a result of regulation adopted by the California Corporation’s Commissioner (California Regulations § 310.100.2, reproduced at 1 Bus. Franchise Guide (CCH) 5050.071) that required the filing of a “Notice of Negotiated Sale of Franchise” in a form specified by the Commissioner within 15 business days after the negotiated sale is consummated. In addition, the regulation requires that a copy of all such forms filed within the previous 12 months must be attached to the franchise offering circular given to all future prospective franchisees as an exhibit. This regulatory burden to negotiations makes it cumbersome, expensive, and difficult to engage in negotiations of the terms of the franchise in this state. Moreover, as a practical matter, because of the disclosure requirement that follows negotiations, once a franchisor agrees to change a provision in a franchise agreement as a result of negotiations, every subsequent prospective franchisee is likely to demand the same change. The practical effect is that once a franchisor agrees to a change in a franchise agreement, it must be willing to make the same change for all future franchisees. This obviously further discourages negotiations. Thus, at the time of writing this article (November, 2003) negotiating the terms of a franchise agreement in this state is highly problematical from a franchisor’s perspective. This is true even if the negotiations are initiated by the prospective franchisee or if the prospective franchisee or his representative is sophisticated and experienced.

California is the only state with presale franchise registration and disclosure rules that discourages bona fide negotiations of a franchise agreement. Recognizing the negative consequences of this situation to California franchisees and franchisors, the Department of Corporations has recently indicated willingness to change the law in this state concerning negotiated changes to a franchise agreement. However, as of the date of writing this article California’s negotiated changes regulation remains in effect.

Even if these burdens and considerations are overcome, there remains another important obstacle to negotiating a franchise. That is the cost to the franchisor necessary to obtain legal advice concerning contract changes. Most franchise transactions do not yield sufficient revenues, at least at the inception of the agreement, to justify the substantial legal fees necessary for the franchisor to obtain advice concerning changes the franchisee might request for a single franchise.

Constructing a Reasonable Agreement
When drafting a contract, there is considerable temptation to make it as favorable to your side as you can, with the view that the other side to the agreement will request changes anyway. In view of the constraints upon negotiating a franchise agreement discussed above, the best advice to a franchisor is to structure an agreement that from the outset contains terms and conditions that are balanced and fair to both parties. An unreasonable, one-sided agreement is likely to be an obstacle to selling franchises. Moreover, a lawyer representing a franchisor must bear in mind that franchise relationships are long term and to a considerable degree depend for their success upon continuing cooperation and goodwill between the parties. Therefore, even if the franchisor succeeds in imposing an overly harsh, one-sided franchise agreement, attempting to enforce such an agreement is going to create an adverse, contentious relationship with its franchisees and lead to negative consequences to everyone involved.

Negotiating a Franchise Agreement
As discussed above, even assuming the legal bar against negotiations in California is removed by action of the Commissioner of Corporations, well established franchisors and those with sufficient demand for their franchises will rarely, if ever, consider changes to any material provision in the franchise agreement for the reasons discussed above. New franchisors that are eager to sell their first franchises will often be willing to negotiate some of the terms and conditions of the franchise agreement. Even the most flexible franchisors will, however, resist negotiating the amount of the fees paid by the franchisee at the inception or during the term of the relationship. In addition to the business reasons for such resistance, the rules for the preparation of the franchise disclosure statement that must be delivered to prospective franchisees expressly require disclosure if a uniform initial fee is not charged to all franchisees (see Item 5 of the UFOC Guidelines, published in CCH, Business Franchise Guide, Volume 2). If the initial fees differ, the franchisor is required to disclose the formula used to determine the fee, or the range of fees charged during the prior year.

In the experience of the author, counsel for a prospective franchisee is most likely to find a receptive ear from a relatively new and eager franchisor in negotiations involving provisions covering the following issues:

• Mandatory contributions to national or regional advertising funds—Such requirements are premature in relatively new franchise systems and many new franchisors will agree to either eliminate the provision entirely or defer the required contribution until such time as the franchisor has a sufficient number of franchisees to sustain a meaningful national or regional advertising program.
• The size of the franchisee’s territorial rights—Franchisees tend to be greedy on this issue. New franchisors should be cautious about granting overly generous territories in the absence of reasonable performance requirements that would assure that the territory that is granted will be adequately exploited.
• Post-term non-competition and repurchase options—From the franchisor’s point of view, a reasonable post-term non-competition covenant or repurchase right is the only practical way of preventing a break-away franchisee.
• Franchisee’s rights to transfer the franchise business—From the franchisor’s point of view, it wants to have reasonable control of who it will be doing business with. From the franchisee’s point of view, he wants to be able to enjoy the fruits of his labor by being able to cash out on the equity he has established in the franchise business by being able to sell to the highest bidder.
• Options to acquire additional franchises—Franchisee’s who are among the earliest franchisees of a new system want commensurate reward for the higher risk being taken.
• Default and termination clauses—Many franchisors will be willing to grant longer cure periods and even to delete cross default clauses for multiple franchise owners.
• Minimum performance requirements, including the timing of commencement of the franchise business—This is an especially sensitive issue for franchisees who agree to establish a franchise business for a relatively untested concept.

Conclusion
In California, for the present at least, counsel representing a franchisor should draft a franchise agreement that is likely to be reasonably acceptable to both sides to the agreement and advise his client to reject efforts at negotiating the contract because of the costs and constraints on negotiations. Counsel representing a California franchisee should be aware of the limitations on negotiating facing a franchisor, but in the face of unreasonable or unfair contract terms should advise his client to obtain a fair and reasonable agreement or find another franchise opportunity.