Hannah Kaufman Joseph
Franchisors - Big Brothers with Big Fees
The New York Times just published an article highlighting many concerns we have been sharing with our franchisee clients. The days of franchisors making their money from upfront, one-time licensing fees and royalties are long gone. Recent trends indicate that franchisors have found a myriad of ways to be paid by franchisees, usually without being obligated to provide any additional services or support in exchange.
More and more, when reviewing franchise agreements for entrepreneurs considering purchasing a franchise, we find that the relationship involves numerous additional fees for "technology management," bookkeeping, and reviewing marketing materials. These costs add up incredibly fact, and potential franchisees are often unprepared for the impact such expenses will have on their profitability.
What's worse, even though franchisors have the right the charge and collect these fees, their franchise agreements rarely include explicit covenants and duties for those franchisors to actually deliver the services that a franchisee is (apparently) purchasing.
In addition, many franchisors now require their franchisees to use general contractors, design professionals, and architects to do the build out of their retail locations, and have no control over these contractual relationships (including pricing). Of course, the franchisor also receives a "referral fee" from those vendors, or is even sometimes under common ownership or otherwise affiliated with the contractor or supplier.
In the past, franchisees were almost always required to follow a franchisor's requirements for a store's design and layout, and franchisors retained approval rights over the selected location. However, now franchisors are going much further, and requiring franchisees to enter into construction agreements which are an exhibit to the franchise agreement. This requirements inhibits the franchisee from negotiating the terms for construction of its store - which means that the franchisee can't shop for the best price and terms in the marketplace. In some cases, the required construction agreement may be with a contractor that could be unqualified, underinsured, or even, affiliated with the franchisor. If there are problems with the construction work itself, the franchisee usually is left without the remedies that it would have had if it had been able to select its own contractor and negotiate the agreement directly.
Historically, franchisors have been able to control the suppliers of a franchise's products if those products are proprietary to the franchise itself. For example, McDonalds can require its franchisees to purchase branded paper goods from a designated source. But, in Indiana and several other states, McDonalds can't require franchisees to buy Heinz ketchup from a designated source, because that product can purchased anywhere. Interestingly, now McDonalds has found a way around this restriction by branding its ketchup packets; because the Golden Arches are printed on those packets, McDonalds can require franchisees to buy the items from the source it designates. Of course, when franchisors require certain proprietary products to be purchased from a designated supplier, they either collect a kickback or even sell the products to the franchisee themselves, at a markup.
Franchisors continue to push the limits of how much they can control their franchisees. Unfortunately, that control often comes without sharing any liability or business risks. Franchise agreements are written to ensure that a franchisor is fully insulated from claims by the franchisee themselves, as well as their customers, employers, landlords, and vendors. For example, franchisors can require a franchisee to pay for a proprietary point of sale computer system that a franchisee must use in its store, but then the franchisor refuses any liability if that system does not operate correctly. In fact, most franchisors even disclaim that the system will be supported, upgraded, or even free of intellectual property infringement claims.
All of these problematic business practices and trends are compounded by the fact that franchise agreements are rarely subject to negotiation. A potential franchisee would be wise to engage legal counsel to review the contract, but they should not expect to have much, if any, leverage to request revisions.
Oftentimes, over the term of the franchise, a franchisee will pay the franchisor hundreds of thousands of dollars - in almost any other business transaction, it would be unthinkable to pay that amount of money without the involvement of sophisticated legal representation aggressively negotiating the best deal that can be achieved.
However, in franchise relationships, franchisors typically refuse virtually any changes to their agreement, even sometimes declining revisions that are required under applicable state law.
The moral of the story is that prospective franchisees should use great care in evaluating a potential franchise relationship. It can often be much more challenging to make money than it appears, even in the most popular or successful retail outlets. And even though a franchise agreement may not be subject to negotiation or revision, having an attorney review the contract can identify the many ways a franchisor can control the business, ultimately giving a franchisee crucial information they should consider when deciding whether to purchase the franchise.
When reviewing a franchise agreement for a client recently, I saw a provision that required the franchisee to give the franchisor 24/7 access to video footage of the location. This obligation represents the most extreme and troubling example of what some franchisors require. In the worst cases, franchisors seem to be becoming a "Big Brother" type relationship, where they have all the upside and the franchisee has all the risk.