6 Essential Elements of Franchise Agreement: Licensing vs Franchising

A legamart lawyer guiding a client to sign a Franchise Agreement

Introduction

Franchise agreements may seem simple in terms of definition, but you should consider that the clauses are tailored to fit your business and needs. A typical franchise agreement should include clauses pertaining to location, duration, operation, fees, and use of intellectual property. However, basic knowledge would not suffice to conclude such an important contract, and professional legal advice is necessary.

A newly established restaurant in Canada is seeking to become as popular as McDonald’s. Besides, the owner hopes it can give its customers the same feeling they have when tasting McDonald’s fast food. But how can it make that happen legally? Is there a contract to entitle the owner to that? And if so, how should it be drafted?

What Is a Franchise Agreement?

A franchise agreement is a legal agreement between a franchisor and a franchisee involving the franchise rights that authorizes the franchisee to conduct business, or offer, sell, or distribute goods or services identified or associated with the franchisor’s Intellectual property in exchange for royalty payments, such that the franchisor’s business is duplicated within a specific franchised location. By entering into a franchise agreement, the franchisor can expand its company without the risk of debt or the cost of equity.

At the same time, the franchise relationship ensures that the franchisee operates the franchise consistently with the franchisor’s trademark and know-how. In exchange, the franchisee’s obligation is to makes payments to the franchisor in the amount, terms, and conditions established in the franchise agreement.

Franchise Agreement governs specific business relationships and transactions similar to that of a Build-Design Agreement. In certain circumstances, a Design-Build Agreement can include provisions or references to elements related to a Franchise Agreement, especially if the construction project is associated with a franchise business. 

For example, in Franchise Location Construction, wherein if a franchise business is expanding and planning to open a new location or renovate an existing one, a Design-Build Agreement may be used to govern the construction project for the franchise outlet.

Who are the parties involved to a franchise agreement?

The parties involved in a franchise agreement are; the franchisor and franchisee.

A franchisor is an entity or an individual who owns the business or brand and grants the franchisee the franchise rights such as right to use the business systems/model and intellectual property in exchange for a fee or other obligations. The franchisor provides training and other resources to the franchisee to help them operate the business in accordance with the franchise system and brand standards.

A franchisee on the other hand is an individual or entity that operates the business under the franchisor’s brand and business model in exchange for a fee including initial fees and/or ongoing fees or royalties paid to the franchisor Franchisors are mostly entrepreneurs of small businesses. Franchisee get franchisor’s headquarters support and is responsible for complying with the franchisors standards as well as the brand standards.

What are the parties’ obligations in a franchise agreement?

A franchise agreement is a legal agreement that outlines the terms and conditions of franchise relationship between franchisor and franchisee. It is a legally binding document that defines the operating procedures of parties including territorial rights, training and support as well as termination, renewal and dispute resolution clause such as an arbitration clause. The agreement sets out each party’s obligations and some of them include; –

Franchisor’s Obligations

  • Provide the franchisee’s business with a business model and system for the franchised business.
  • Ensure the franchisee get initial and ongoing trainings by offering its human resources to support the franchisee’s employees.
  • Assist franchisee with site selection suitable for the franchised outlet as well as its store design.
  • Help the franchisee with strategies for marketing and advertising of the brand.
  • Monitor and enforce quality standards and brand consistency in all jurisdictions.

Franchisee’s Obligations

  • Pay the franchisor initial and any ongoing fees such as franchise fees, royalties or any other continuing fee.
  • Observe and operate the franchise business according to the franchisor’s standards, guidelines and services authorized by the franchisor.
  • Use the franchisor’s trademarks, logo and other branding materials correctly and not involve itself in any competing business while acting in a franchisee capacity.
  • Participate in the initial and ongoing trainings provided by the franchisor.
  • Comply with all relevant passed laws and regulations.

What are the types of a franchise agreement?

There are various types of franchise agreements, here are some of them:

  • Master franchise agreement: this is a franchise system that allows the master franchisee to sub-franchise the franchised business concept within an assigned territory. These rights are usually secured by an initial franchise fee charged by the franchisor.
  • Business format franchise: this is the common type of franchise agreement where the franchisor provides the franchisee with a complete business outlook including the products and all ongoing supports.
  • Management franchise: This is a type of franchise agreement where the franchisee is deemed solely responsible for the management of the franchise business under the franchisor’s brand. The franchisee is given the right to distribute the franchisor’s products in a particular jurisdiction.
  • Product of distribution franchise: This type of franchise agreement grants the franchisees the right to distribute the franchisor’s products in a particular area under the franchisor’s intellectual property at a royalty fee paid to the franchisor.

How can you market your franchise business?

There are a number of ways on how to recruit prospective franchisees, particularly by having an understanding on how franchisees research and select franchise. Here are some ways that might ensure successful marketing by the franchisor;

  • Since franchisees mostly use franchisor’s websites to search for franchise, Franchisors needs to ensure that their website can be easily found and navigated online.
  • A franchisors must also ensure that its franchise offerings are more attractive compared to that of its competing business, particularly, the initial fee, continuing fees, turnover and profitability
  • A prospective franchisee can also undertake research on general franchise websites such as the national franchisor associations, attend seminars on franchising as well as being keen on franchise system on local advertising.

Don’t Confuse It With Licensing Agreement!

The owner of that Canadian restaurant is wondering if maybe by achieving the license to use only McDonald’s trademark, its restaurant will be as popular as McDonald’s. But it should be noted that a mere trademark won’t give the new restaurant the high quality it’s seeking.

That’s why you should avoid confusing licensing agreements with franchises. There are several differences between these two, but the key point is that licensing agreement grants the licensee only the right to use the licensor’s trademark. That’s why you can see Disney characters on everything from notebooks to sleeping bags to T-shirts and clothing.

On the other hand, by a franchise agreement, the franchisee would gain the right to learn and then operate the franchisor’s operating procedure of know-how and use its trademark. 

However, the major similarity between the two business systems is that both involve a business relationship where the franchisor and/or the licensor cannot divest itself of the responsibility to control the quality of the goods and services offered, hence quality control is vital in both as it ensure compliance with the standards set out in the operations manual.

So in the above question, the suitable legal agreement for that restaurant would be a franchise. By entering into this legal agreement with McDonald’s, the new restaurant will be able to use McDonald’s trademark and also its secret recipe. Therefore, the customers of this restaurant in Canada can feel the same as other McDonald’s customers regardless of where they are having their meals.

6 Things You must have in your Franchise Agreement

Use of Franchisor’s Intellectual Property including Trademarks: As a franchisor, trademarks, patents, and copyrights are the cornerstones that set your business apart and shield your brand. Hence, it is vital to articulate and oversee these rights within the agreement. For example, the specific trademarks, service marks, or logos a franchisee can use should be listed in this section. If either party intends to limit the use of the given trademark within an assigned territory, the contract should specify this. The agreement should also define what IP is licensed to the franchisee, particularly how the franchisor’s trademark can be used.

Similarly, it is important to stipulate the franchisee’s responsibilities in upholding and safeguarding your intellectual property rights. This encompasses their commitment to maintaining the quality and standards associated with your brand and an advertising commitment to proactively prevent infringements or unauthorized uses of your IP.

The agreement should also address the repercussions of any breaches or infringements on your intellectual property rights. Consequences may range from terminating the franchise agreement to seeking financial compensation or legal remedies to enforce and safeguard your rights.

It is also crucial to recognize that your IP rights may change the franchise relationship. New products, services, or processes might emerge, trademarks may undergo updates, or patents might expire. Hence, the franchise agreement should encompass provisions for managing changes to your intellectual property and specify how these updates will be communicated and integrated into the franchisee’s operations.

Term and renewal of the Franchise 

The franchisor might want to limit the duration the franchisee is allowed to use the given rights. In a franchise agreement, the franchisor and franchisee must comprehensively comprehend the initial and renewal terms. This section of the agreement offers a concise overview of these aspects. For example,

Initial Term

The initial term denotes the period wherein the franchisee is granted the right to operate the business, utilizing the franchisor’s trademarks, systems, products, and services. Typically spanning 5 to 10 years, this duration allows the franchisee ample time for business establishment, investment recovery, and potentially achieving a return.

Renewal Terms

Upon the conclusion of the initial term, there is often an option to renew the agreement for an additional term. The franchisee should be aware of the renewal notice period and any applicable renewal fees for extending the agreement.

Financial Obligations: Franchise fees (Initial fee, continuing or royalty fee and Other Payments): Paying fees is the franchisee’s primary obligation in exchange for the rights it receives. These fees may be paid one time (initial fees) or periodically (ongoing fees or royalty). 

For franchisees, comprehending financial commitments like franchise and royalty fees is paramount to planning and operating a successful franchise. A thorough review of relevant documents ensures full awareness of commitments under the franchise agreement.

Franchise Fee: Upon entering a franchise agreement, an initial financial commitment is the franchise fee. This one-time upfront payment to the franchisor grants the franchisee the right to operate under their brand and use their business model. Typically covers:

  • The use of the franchisor’s trademarks, logos, and signage.
  • Initial training and support.
  • Assistance in setting up your location or territory.
  • Access to proprietary business systems and processes.
  • Royalty Fee

These ongoing payments to the franchisor, calculated as a percentage of gross revenue, contribute to ongoing support and the right to use the brand name. Royalty fees, collected weekly, monthly, or quarterly, cover:

  • Continued use of trademarks and branding
  • Ongoing support and training
  • Access to marketing materials and campaigns

Since there are various fees a franchisee may pay, it’s necessary to consult with a qualified legal professional at LegaMart lawyer before making yourself obliged to them by signing the contract.

Obligations and Duties of both the Franchisor and Franchisee

There are a few common obligations that normally all franchisors have. Among these obligations are: preparing the franchisee with the required training for operating the business and adequate participation in that.

  • Franchisor and Franchisees rights

Franchisors hold distinct rights within the franchise agreement. They can establish standards, systems, and procedures the franchisee must adhere to. The franchisor may impose conditions for continued franchise operation, focusing on maintaining quality standards and adherence to brand guidelines. Regular inspections are within the franchisor’s rights to ensure compliance, with the authority to terminate the franchise agreement if established requirements are not met.

On the other hand, the franchisee possesses specific rights outlined in the franchise agreement. These include utilizing the franchisor’s intellectual property. Receiving comprehensive training and support from the franchisor, covering ongoing guidance, marketing materials, and access to updated operational manuals. 

Mutual Responsibilities

Both parties, the franchisee and franchisor, share obligations outlined in the franchise agreement. Acting in good faith and maintaining open communication channels to address concerns is a joint responsibility. The franchisee is obliged to comply with the franchisor’s systems, procedures, and standards. Both parties must adhere to confidentiality clauses protecting sensitive information.

Advertising,Marketing and Insurance requirement costs 

Within a franchise agreement, advertising and marketing assume a pivotal role in upholding brand coherence and reaching the intended audience. The franchisee should be aware of the franchisor’s advertising commitment and applicable fees that the franchisees are required to pay to facilitate such costs. On the other hand, there should be a defined minimum insurance coverage that a franchisee is required to have prior to entering into the franchise legal agreement.

The franchisor should furnish the franchisee with essential marketing resources, tools, and training to facilitate the effective promotion of the franchisee business. Therefore, franchise agreements commonly stipulate a requirement for franchisees to contribute to a regional or national advertising fund. Managed by the franchisor, this collective fund supports expansive marketing endeavors, such as television, radio, and online advertising campaigns that bolster the overall brand. 

Termination

The termination clause is a vital aspect of any franchise agreement, defining the conditions and processes for ending the agreement by both parties. A comprehensive franchise agreement incorporates provisions for termination, allowing either party to initiate it under specific circumstances. A franchisor might seek termination if there’s a breach of agreement terms, while a franchisee may pursue it due to insufficient profits or a perceived weakness in the business model.

Mutual termination can occur post the initially agreed term, accompanied by restrictive covenants lasting one to five years after agreement termination. These covenants restrict the franchisee from using gained knowledge to open a competing business. The wording of these clauses is critical, as overly ambiguous or extreme terms may render them unenforceable, potentially harming the franchise’s interests.

When termination is necessary, following proper procedures is crucial:

  • Notice: Provide clear and timely notice in writing, adhering to the agreed notice period.
  • Default and cure provisions: Follow the agreement’s cure period, allowing time for the defaulting party to rectify the breach.
  • Exit plan: After termination, adhere to the franchise agreement’s outlined requirements for ceasing operations, including returning manuals and property and discontinuing the use of the franchisor’s brand.

Seeing how clauses and interpretations are applied can give you a better understanding of franchise agreements. Here is an illustrative example of a franchise agreement

These Elements Are Not Exclusive

Remember that contractual franchise clauses are not limited to the ones mentioned above. These elements were exclusive to the franchise, but a few general features are common in almost every contract. Such as the choice of applicable law or the forum selection clause, which according to Alessandro Oliverio, is crucial for dispute settlement. 

So after finding the franchise agreement and the suitable contract for you, it’s vital to use legal advice before entering it.

What are the types of fees payable in franchising system?

The following are the three types of fees that are payable in a franchising; –

  • An initial fees: this is an up front lump sum fee that is paid by the franchisor, it is also referred to as a franchise fee.
  • On going fees: This are royalties paid based on a percentage of the agreed turn over.
  • Other fees: they include, renewal fees, advertising fees and administration fees 

Licensing vs Franchising: 4 Key Differences

difference between license and franchise

  1. Degree of Control: The franchisor has significant control over the business of the franchisee and the operation of the business. However, in a licensing agreement, the licensor can exert little control over the licensee’s business. The licensor can lay out the process of using intellectual property, but they cannot stipulate different aspects of the licensee’s business.
  2. Business Model: Franchising agreement deals with providing services, and licensing is related to goods and products. 
  3. Legal Regulations: The franchise and the licensing agreement are governed by standard agreement contract law. Generally, a franchise agreement is governed by federal regulations and specific state laws within international business. It is stringent and complicated, consisting of various moving parts. Licensing agreement is a simple agreement that consists of protected images and marks. 
  4. Process: Licensing involves the one-time transfer of rights in exchange for a fee. No training and support are provided by the licensor. On the other hand, the franchisee agreement contains the duties and responsibilities of both parties in a brief manner. Franchisees assist in setting up a new business, extending an existing one, and increasing brand recognition. 

Licensing vs Franchising: Which one is better?

In the early stages of business, licensing is an effective tool as a large amount of revenue is generated, and the business gets fast recognition. Licensing helps you in instant marketing, production and allocation, which other companies have spent decades strengthening.

This is the best option for businesses looking to make more profit with less costs while running independently. However, as the business expands, licensing can result in legal problems and also gets surrounded by limitations. 

If you want your business to build momentum and increase the market share of the brand, then it’s time to plunge straight into a franchisee agreement. Many businesses opt for this route, as it aids in establishing the brand and increasing online visibility. In addition, it is better because businesses can learn new skills from the franchisor and manage their business simultaneously. 

To Sum Up

The franchise agreement is a great tool particularly for a small business to grow faster while replicating a successful business. This is because, most franchisors opt to provide enough support and the franchisee may capitalize on the said grant of franchise as a small business through an ongoing training to ensure it perform its obligations under the franchise. Considering the elements mentioned above and, of course, the knowledge of how franchise agreement works and with the help of a franchise lawyer, you’ll be able to build a franchise relationship that will promotes your business in the long run.

In addition to the strategic benefits offered by franchise agreements, businesses exploring growth avenues should also consider the significance of well-structured design-build contracts. This form of contract not only streamlines the construction process by integrating design and construction responsibilities but also plays a crucial role in ensuring the success of expansion initiatives.

Frequently Asked Questions

What Are Different Types of Franchise Fees?

There are a variety of fees that the franchisee is supposed to pay. These include initial franchise fees, royalty fees, national and local marketing fees, and technology fees.

What Law Applies to Franchise Agreements in the USA?

The Federal Trade Commission (FTC) governs franchising legal requirements in the United States. So to conclude a valid franchise agreement in the USA, you should resort to the Franchise Rule. 

Where Can I Find the Best Franchise Opportunities?

The International Franchise Association has the largest directory of available franchise opportunities online.

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