A franchise agreement is a legally binding document that outlines a franchisor's terms and conditions for a franchisee. Every franchise is governed by these terms, which are generally outlined in a written agreement between both parties.
The franchise agreement will govern everything about how the franchisee runs the new business and lay out what they can expect from the franchisor. Learn more about what's in the agreement and what it will mean if you decide to franchise your business or become a franchisee.
What Is a Franchise Agreement?
In the United States, a business becomes a franchise if it meets the definition established by the Federal Trade Commission (FTC), known as the FTC Franchise Rule. Under the FTC Franchise Rule, there are three general requirements for a franchise agreement to be considered official:
- The franchisee’s business is substantially associated with the franchisor's brand. In franchising, the franchisor and each of its franchisees are sharing a common brand.
- The franchisor exercises control or provides substantial assistance to the franchisee in how it uses the franchisor's brand to conduct business. Because the franchisee is an independent contractor and not a joint employer, generally those controls cover brand standards and do not extend to the human resources of the franchisee, nor do they extend to how the franchisee manages its business—aside from meeting the requirements of the brand standards—on a daily basis.
- The franchisor receives a fee from the franchisee for the right to enter into the relationship and to operate its business using the franchisor’s trademarks. The fee can be an initial fee of at least $500 or it can be a continuing fee—with certain exemptions provided under the law.
Several states have also passed laws that define a franchise, and the definitions may include some relationships that do not meet the FTC Franchise Rule.
A franchise agreement is a license that establishes the rights and obligations of the franchisor and the franchisee. This agreement is designed to protect the franchisor's intellectual property (IP) and ensure consistency in how each of its licensees operates under its brand. Even though the relationship is codified in a written agreement that is meant to last as long as 20 years, the franchisor needs to have the ability to evolve the brand and its consumer offering to stay competitive.
The agreement also needs to be flexible enough to allow the franchisor to make contractual modifications that reflect decisions in response to franchisees' specific needs. However, there are no changes to the stipulation that franchisees must manage their independently owned businesses daily in accordance with brand standards.
How a Franchise Agreement Works
The franchise agreement needs to deal with some basic elements, including, but not limited to:
- Overview of the relationship: This includes the parties to the contract, the ownership of IP, and the overall obligations of the franchisee to operate its business to brand standards.
- Duration of the franchise agreement: This involves the length of the relationship, the franchisee’s successor rights to enter into new agreements, and the requirement to upgrade the franchisee’s location.
- Initial and continuing fees: Franchisees generally pay an initial and continuing fee to the franchisor for entering into the system and remaining a franchisee. Agreements also typically include a number of side fees. Most franchise systems provide for a payment to an advertising or brand fund that is used by the franchisor to market the brand to the public and for other contractually defined purposes.
- Assigned territory: Not every franchise agreement grants a franchisee an exclusive or even a protected territory, but specifics about the territory must be defined. Franchisors also need to deal with reservation of their rights within a franchisee’s territory, including alternative distribution sites and sales over the internet.
- Site selection and development: Franchisees generally find their own sites and develop them according to the franchisor’s standards. The role of the franchisor is generally to approve the location found by the franchisee and then approve, prior to opening, that the franchisee has built its location to meet design and other brand standards.
- Initial and ongoing training and support: Franchisors generally provide a host of preopening and continuing support, including training, field, and headquarters support, supply chain, and quality control.
- Use of intellectual property including trademarks, patents, and manuals: The IP of every franchise system is its most valuable asset, some of which will change as the system evolves. The agreement defines what is licensed to the franchisee, how the franchisee can use the IP, and the rights of the franchisor to evolve the system through changes to the franchisor’s operating manual.
- Advertising: The franchisor will reveal its advertising commitment and what fees franchisees are required to pay toward those costs.
- Insurance requirements: Franchise agreements will define the minimum insurance a franchisee is required to have prior to opening and during the term of the agreement.
- Record-keeping and the right to audit the franchisee’s records: The franchisor defines the records that it needs its franchisees to maintain, the software franchisees are allowed to use, and its rights to access and audit that information.
- All the rest: Some may call it boilerplate, but in well-developed agreements, it is not. Among the myriad issues contained in the franchise and other agreements are the franchisee's successor rights, default, termination, indemnification, dispute resolution, resale rights, transfer rights, rights of first refusal, sources of supply, local advertising requirements, governing law, general releases, personal guarantees, and roll-up provisions.
Before Signing a Franchise Agreement
The FTC rule requires that franchisors provide to prospective franchisees a presale franchise disclosure document (FDD), which is designed to provide potential franchisees with the necessary information for purchasing a franchise. Considerations include the risks and rewards, as well as how the franchise compares with other investments.
Franchisors are required to provide the FDD to prospective franchisees at least 14 days before signing it. If the franchisor then makes any major changes to the agreement, it must allow at least seven days for the franchisee to review the completed franchise agreement before signing it.
The franchise agreement is long, detailed, and provided to prospective franchisees as an exhibit to the FDD well in advance of signing it to ensure they have time to review the agreement and get advice from their lawyers and other advisers.
Franchise Agreement Pitfalls
Franchising is about consistent, sustainable replication of a company’s brand promise, and an agreement must detail the many business decisions that go into creating a franchise system. It’s complex and, in most instances, a contract of adhesion, meaning an agreement that is not readily subject to change.
Because a franchise agreement is meant to reflect the uniqueness of each franchise offering and explain the dynamics of the intended franchise relationship, copying another franchise system’s agreement is likely the single biggest mistake a new franchisor can make.
In developing a proper set of franchise agreements, each of the elements of the franchise need to be evaluated. Prior to having the lawyers begin to draft the agreements, it is essential for the franchisor to first develop its business plan and decide on all of these important issues. For most franchisors, it is important that, in addition to working with qualified franchise lawyers, they first work with experienced and qualified franchise consultants to craft their franchise offering.
- A franchise agreement is a legally binding document that sets the terms of the relationship between a franchisor and franchisee.
- Franchisors must give a franchisee 14 days to review all disclosures before signing an agreement.
- Both parties should thoroughly review franchise agreements with the help of a lawyer before signing.