Franchise Code: End of Term Arrangements, Pt 3
The Australian government has a Senate inquiry into a franchise code. An options paper divides the Senate franchise recommendations into four parts. Here, similar to some of the issues I considered in Part 2, the benefits of this recommendation are unclear. Perhaps the clue is in the wording of the Recommendation itself (Recommendation 5) where a reference is made to the "potential transferability of equity in the value of the business as a going concern".
End of term arrangements - generally
Many, if not most, franchise agreements specify a fixed period for the grant of the franchise. A common term is for a period of 5 years, with perhaps one or two further 5 year options.
The option periods are generally exercisable by the franchisee provided that they are not in breach of their agreement (although each franchise agreement will contain its own criteria for the franchisee to meet before being entitled to exercise an option to renew).
At the conclusion of a franchise term the grant to use the franchisors brand names, marks and systems expires and the franchisee is, well, to put it bluntly, out of that business.
Restraints of trade are also commonly applied after the expiry or termination of franchises and although this does not seem to have made it onto the Senate's radar, the issue of restraints is very much a ‘live' issue in this topic.
The Options Paper notes - curiously - that franchise agreements are "often silent as to the rights and obligations of both parties at the end of the term of the agreement". I wonder whether this reflects a fundamental misunderstanding of franchise arrangements (or maybe I am the odd one out) - the grant of a franchise is basically a limited license for the franchisee to exploit the intellectual property of the franchisor.
When the franchise grant expires, so does the ability of the franchisee to use this IP, so why is there now an apparent call to allow franchisees the right to continue the business indefinitely or to receive a payment for the goodwill they generated by using the franchisor's system?
Goodwill
Without wanting to get too technical there are essentially 3 types of business goodwill: personal, site and brand. There are different schools of thought on the subject but I will limit my points to using these three (plus I don't want to confuse the lawyers among us).
How is each type of goodwill relevant to the end of the franchise term?
Personal goodwill: As the name suggests this is the goodwill that follows an individual; it is more pronounced in personal service industries than retail.
In franchising terms, when a franchisee's personal goodwill exceeds the benefits of the franchise system there is a temptation to move to an independent trading arrangement.
It is very difficult to transfer personal goodwill at the end of a franchise term, which is why restraints of trade are often imposed upon outgoing franchisees to stop them immediately opening a new store in competition to their former business.
Site goodwill: This is the goodwill that comes from the location of the franchise store, regardless of who owns the business. A franchisee that operates from the one location for many years will become a local ‘fixture' and customers will come to the business because they know it as part of the fabric of their everyday lives.
Site goodwill is easily ‘transferred' at the end of the term - whoever controls the location controls the site goodwill. This is why many franchisors take a head lease over the franchise business premises, so that if a franchisee moves on, the franchisor or a new franchisee will be able to benefit from the ongoing site goodwill.
Brand goodwill: This goodwill attaches to the brand or image of the business; it is the cornerstone of the majority of franchising in Australia (most franchises are ‘brand name' franchises rather than proper ‘business format' franchises).
In a business format franchise the franchisee will also acquire significant systems and protocols as to how to operate the business efficiently; these benefits, together with the brand/name/logo are what franchising is all about.
Brand goodwill belongs to the franchisor (or a related entity of the franchisor) and does not transfer at the end of the franchise term. But the relevant question is what about the contribution a successful long term franchisee makes to the enhancement of the brand?
The need to remind franchisees of the end of their term?
The Options Paper queries whether franchisees need to be better educated about the consequences of the franchise not being extended or expiring and whether there needs to be a formal review process by the franchisor and the franchisee to determine whether a franchise will continue.
Please don't tell me we now have to legislate to force franchisees to look after their own interests. Why should a franchisor be required to tell a franchisee that their term is coming to an end? What will that really achieve? The franchise agreement says what it says and it sets the rules for any options to renew, if any.
A franchisee will be aware of their term and their ability to renew - no, the problem seems to be something different; that some franchisees have not planned for their franchise having a limited lifespan. (Bear in mind that this is a completely different issue to franchisor unfairly denying a renewal).
The financial viability of the business must be considered at the outset - that is whether the business can generate a profit in the initial term, disregarding any further options which may or may not be available. For example, paying an initial franchise fee of $100,000 for a 5 year agreement will, in its simplest terms, add $20,000 per year to the cost of running the business. If the benefits of joining the franchise system will not cover this cost and more why are you still considering buying?
A pre-expiry review (as suggested by the WA Inquiry) does not advance the matter greatly; at best it will give the franchisee some warning that the end of the term really is the end of the term and they will need to look to their other options. It will also not change the franchise agreement.
The real issue?
It seems that the real issue in end of term arrangements is the perceived unfairness that the franchisor will obtain the benefit of the franchisee's hard earned business goodwill for nothing.
I am not aware of any franchise agreement that requires a franchisor to compensate the franchisee at the end of the term in recognition of the franchisee's enhancement of the franchise system and reputation. In essence the franchisee is being told "thanks for all the hard work mate, we'll take the benefits from here".
Restraints of trade in the franchise agreement may prevent the franchisee from using the personal goodwill they have accumulated.
But is it reasonable to ask a franchisor to pay for part, or all, of the business goodwill that the franchisee has built utilising the franchisor's system and brand?
This is a question that will generate strong views each way, however I lean in favour of allowing the franchisor to inherit the business goodwill at the end of the term based upon the thought that the initial bargain that was struck was to allow the franchisee to exploit the franchisor's system for a limited period of time and was intended to allow the franchisee to generate benefit for itself. Any goodwill benefits to the system are on the franchisor's side of the ledger.
Site goodwill however belongs to the possessor of the premises and this will be more relevant the longer the franchise business occupies the site. This will usually be addressed by the franchisor's system one way or another, depending upon whether the franchisor owns the premises or takes a head lease.
The change I would make is to prohibit the franchisor from imposing any restraint of trade upon the franchisee where the franchise agreement expires (as opposed to being terminated, which is a different issue). To be clear, this would not allow the ex-franchisee to continue to use the franchisor's systems or IP, but the franchisee can exploit their own experience gained in the business.
In Australia the basic legal position is that a restraint of trade is invalid unless it can be shown to be reasonable to protect the legitimate interests of the person seeking to rely upon it. If a franchisor is to take the benefit of the site and brand goodwill built by the franchisee - and by declining the franchisee an extension of the franchise - the franchisor's interests are adequately covered. The former franchisee, personal goodwill notwithstanding, simply becomes another potential competitor.
This Recommendation seems to be a reflection upon the standard of due diligence conducted by franchisees prior to investment - often overlooking end of term realities it seems - and adds no real protection to a franchisee's position, which will be dictated by the franchise agreement in any event.
This is part 3 of the following 4 part series:
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