There is a common misconception among prospective franchisees that they're “buying” a franchised business when, in the majority of cases, they're really only “renting” it.
It’s a simple explanation for a more complicated topic "term" and if you're a franchisee, once the term of your franchise agreement ends, subject to any right you have to renew, so does your right to operate the franchised business.
The term of a franchise agreement can be any period of time, but in my experience, contracts for retail “bricks and mortar” businesses are normally five years. Landlords are often only prepared to give the franchisee this length, and the franchise agreement will be "co-terminous" with the lease of the premises with each contract essentially ending on the same day.
If you, as a franchisee, are negotiating your own lease, you should know that some commercial landlords will not grant renewal rights for their commercial properties, probably to keep their options open. If your franchise rights are only for five years, and you have no right to remain in possession of the premises beyond that time, there may not be enough years in the term to recoup your initial investment.
Other landlords will negotiate renewal rights. It is in your interest as a prospective franchisee to obtain the longest term possible, with as many renewal terms as possible, under both the franchise agreement and any lease agreement.
In many cases, it's not the franchisee that is negotiating the lease with the landlord, it’s the franchisor, who has negotiated a longer-term “head lease.” This entitles it to sublease those premises to franchisees without seeking the landlord's consent.
Even if the franchisor has negotiated a 20-year head lease with the owner of the premises, the franchisor is, in all likelihood, still going to grant the franchisee a five-year term with one, two or perhaps three renewal options.
But this doesn't mean the franchisee will necessarily get the same “deal” he or she secured five years earlier. Every agreement contains conditions of renewal and one of them will be that the franchisee executes the franchisor's then-current standard form, which may contain financial terms that differ from the original deal. This allows a franchisor the right to change its franchise agreement and other agreements every five years. Royalty rates may go up. Other fees may rise.
One thing to consider negotiating is how much of the original deal from 2012 will be in the franchise agreement in 2017, when the franchisee has the option to renew. Try to ensure that any exclusive territory that was negotiated in 2012 is not reduced or eliminated in 2017, simply because the franchisor has chosen to present its “then current form of franchise agreement” to the franchisee in 2017.
If there's something fundamental to the deal in 2012, make sure it carries over for subsequent renewals.
Sure, you might have paid the franchisor an initial franchise fee of $40,000, royalties and advertising fund contributions totaling 10 per cent of your gross sales for every year of the term, plus $500,000 to construct and develop the premises, which you might have mortgaged your house for. But all you have the legal right to do is to operate the franchisor’s business system pursuant to its standards of operation and under its brand and trademark for the term of the franchise, which can be extended by virtue of a renewal. Then, I’m afraid, it's over.
Adding more ammunition to the argument that you rent a franchised business as opposed to owning one: even though you may lawfully own all of the assets on the premises, a non-competition covenant within the franchise agreement will normally prevent you from operating a similar business from the same premises when your franchise term is over, and you can't use the franchisor's business system or trademark.
Most franchise agreements contain an “option to purchase” clause, in which the franchisor, at the end of the franchisee’s term, has the right to purchase all of the franchisee’s business assets for a price equal to their fair market value as determined by one or more appraisers. Sometimes the buyout formula is expressed as a function of the depreciated value of the assets.
Since fair-market value is normally “diddly-squat,” franchisees might find that the business assets they've spent $500,000 on are only appraised at $50,000, and that's all the franchisor is prepared to pay them under the option-to-purchase clause. One reason might be that the value of, say, used restaurant equipment is in fact diddly-squat anyway (75-per-cent to 90-per-cent less than the new value of that equipment).
But it all depends on what the appraiser determines to be fair market value. Perhaps you can negotiate a floor price for it or because in some agreements no good will is attributed to the assets and the appraiser is instructed to assess fair market value on a liquidation basis you can negotiate fair market value based on the business “being operated as a going concern, including good will.”
All of this suggests franchisees should go into their deals with an exit strategy, with the best one being to sell the business as a going concern at a time when there are many years remaining on both the lease and the franchise agreement, while the franchisee's financial statements show the business thriving. In that case, the business is worth what a bona fide purchaser is prepared to pay for it, as opposed to waiting until the end of the term and any renewals with little left to sell and much to lose.
Special to The Globe and Mail
Tony Wilson practices franchising, licensing and intellectual property law atBoughton Law Corp.in Vancouver, he is an adjunct professor at Simon Fraser University, and he is the author of two books: Manage Your Online Reputation , and Buying a Franchise in Canada . His opinions do not reflect those of the Law Society of British Columbia, SFU or any other organization.
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