Franchising is often considered by businesses wishing to expand. It’s a process of duplicating branding and a business model with a proven track record for success. Setting up and establishing a franchise system can be a sizeable task, and the Australian franchising industry is arguably the most heavily regulated in the world. There are some important things to first be taken into account when considering franchising your business. Each have their pros and cons.
The Franchising Code of Conduct (Code) sets out what constitutes a Franchise Agreement, together with other rules and regulations which must be followed. Compliance is actively monitored by the Australian Competition and Consumer Commission who can issue substantial penalties for non-compliance.
This means that franchising is a very structured industry, which can be appealing to both franchisees and franchisors because each will know what to expect.
There is an inherent power imbalance between franchisors and franchisees in a franchising relationship. The regulations are therefore weighted in favour of franchisees in order to ‘even-out’ this power imbalance. To a certain extent, prospective franchisors should therefore be prepared to be limited in what they can and cannot do.
The Code requires franchisors to maintain a current Disclosure Document, which must generally be updated annually. The purpose of a Disclosure Document is to provide prescribed information about the franchise system in order to assist a franchisee to make an informed business decision about whether or not to enter into the franchise. It contains information about the franchisor’s financial position, the fees a franchisee will expect to incur during the course of the franchise relationship and details of past and present franchisees.
Disclosure Documents are highly regulated. As such, those wishing to franchise a business model must be prepared to provide prospective franchisees with a substantial quantity of information about the franchised business and to ensure that this is kept up-to-date.
Franchising a business model can be appealing because of the high level of control a franchisor will hold over the operation of businesses by franchisees. This control is essential in order to maintain consistency across the franchise system. Franchisees must generally follow all of the franchisor’s systems, procedures and directions about how to operate the business. These can change from time to time.
The Code does however require a franchisor to act in good faith. This means a franchisor must act reasonably when exercising their control, placing certain limits on how far this control may go. There are also restrictions on directing franchisees to incur certain types of capital expenditure.
The relationship between a franchisor and franchisee contains complex dynamics. Franchisors should be prepared to encounter franchisees of all personality types. Some franchisees will be more amendable to control than others, meaning franchisees may not always be cooperative.
Consistency ensures the success of a franchise system and that the brand maintains its goodwill. This extends to products, services and branding.
A restaurant franchise can be used as an example, where customers can:
recognise outlets of that franchise from their distinctive signage;
enter any outlet that will have the same interior theme;
order from the same menu; and
enjoy food that tastes and looks the same because every outlet uses the same recipes, ingredients and packaging.
A well drafted Franchise Agreement will enable a franchisor to introduce changes to their franchise system which franchisees must comply with from time to time. Using the above example, a restaurant franchise can therefore require franchisees to change their menus and ingredients from time to time in order to keep up with market trends.
Franchisors will retain ownership of their brand. Franchisees are granted a ‘licence’ to use this branding for the duration of the Franchise Agreement, meaning they essentially rent the use of the brand during this time.
A franchisor’s brand is one of their most valuable assets and is one of the key reasons why a franchisee will want to be a part of the franchise system. Generally, the more franchisees who are part of the franchise system, the more valuable the brand becomes.
Provided the Franchise Agreement is properly drafted, and the Code is complied with, franchisors can change their branding at any time. Whether this is a change to the business name, logo or get-up, franchisees will generally need to comply with these changes. Again, this ensures consistency across the franchise system.
Franchisors should however be conscious that a brand can easily be damaged by the actions of a single franchisee. This is a reason for a franchisor’s need to have strict policies and procedures in place for how a franchisee can operate their business. Because of this, it’s important for a franchisor to following rigorous selection criteria for choosing franchisees.
Most franchisors will charge franchisees an upfront establishment fee to join the franchise system. If that fee doesn’t cover training, then a training fee may be payable in addition.
Throughout the duration of the franchise, ongoing fees and/or royalties will be payable to the franchisor in exchange for the ongoing right to trade under the franchisor’s brand. Selling franchises is therefore profitable for a franchisor.
In exchange for payment of fees, franchisees will expect a certain level of ongoing support. This can be development and promotion of the brand, training and operational assistance, maintenance of a website and/or operating a national call centre. In other words, franchisees expect to see value for their money.
Franchisors who simply charge for the use of the brand and who fail to demonstrate a commitment to assisting franchisees grow their businesses will generally face unhappy franchisees.
Franchisors will generally undertake their own marketing and promotional activities for the franchise system. This can either be funded through the collection of ongoing franchise fees/royalties from franchisees, or a standalone marketing fee.
If a separate marketing fee is charged, then there are certain regulations under the Code which must be complied with regarding marketing/advertising funds. This includes keeping a separate bank account, only using the money for legitimate marketing and advertising expenses disclosed to franchisees within the Franchise Agreement and the franchisor’s Disclosure Document, and preparation of annual statements. These statements must be audited unless 75% of franchisees vote otherwise.
Again, franchisees wish to see value for their money. Franchisors therefore can face criticism by select franchisees who do not consider that their particular business is given sufficient exposure in marketing/advertising campaigns.
The bulk buying power of a franchise system can be attractive to suppliers, who often negotiate rebates or commissions payable to the franchisor. As such, franchisors often direct all their franchisees to obtain products and services from designated suppliers.
This again assists in maintaining consistency across the franchise system.
A franchisor’s Disclosure Document must disclose the existence of any rebate or commission a franchisor has with suppliers. This ensures a certain level of transparency. Many franchisors will reinvest this rebate or commission back into the franchise system. Franchisees see reinvestment as positive because they can share in its benefit.
It is also quite common for franchisees to acquire certain products and services direct from the franchisor.
The larger the franchise system, the better the chance of the brand becoming a household name. This can be achieved through both advertising and franchisees offering premium quality products and services.
Whilst media coverage can be positive, it can also be negative. Whether it’s the acts of a select few franchisees or the franchisor themselves, media spotlight can be damaging to a franchise system. In recent years, this effect on franchise systems has been highlighted by media reports of franchisees underpaying staff, and franchisors treating their franchisees poorly.
Franchise Agreements are generally granted for a fixed time period known as a ‘term’ with multiple options for the franchisee to renew/extend it. This locks both the franchisor and franchisee into the business relationship for the term unless the franchisee decides to sell their business (or the franchisor sells the franchise system).
A fixed-term Franchise Agreement gives value to both franchisors and franchisees. Franchisors are guaranteed payment to franchise fees/royalties during this time period. A franchisee is guaranteed a continuing right to trade under the franchisor’s brand.
On the other hand, a fixed term can have its downsides. If a certain franchisee is ‘difficult’, then the franchisor continues to be locked into a hostile business relationship. If a particular franchisee’s business (or the franchise system itself) is ultimately not successful, then again, the franchisor continues to be bound by the Franchise Agreement.
Whilst a franchisor and franchisee can mutually agree to part ways, this cannot be forced where one party wishes to continue with the franchise relationship.
Liability for Franchisees
Franchising can be attractive because a franchisor is generally not liable for the actions of their franchisees, as opposed to a non-franchised business model where each business is owned by the founder. A franchisee will be legally responsible for the operation of their own business and will not be considered as an employee of the franchisor.
Despite this, a franchisor can in certain situations be liable to compensate a franchisee’s employees if there is a wage underpayment or another breach of workplace laws.
Whilst not being legally liable for a franchisee, franchisors can suffer other types of indirect liability such as reputational damage due to the acts of a single franchisee (or a select few).
Relevant to liability are Leases for site-based franchises. When establishing a franchise system, a franchisor will need to make a choice between:
allowing franchisees to hold the Lease in their own name; or
the franchisor holding the Lease and granting franchisees a licence to occupy the premises.
Whoever holds the Lease carries liability to the landlord for rent and compliance with the Lease.
When the Franchise Agreement ends it’s a lot easier for a franchisor to continue operating a business from the site if the Lease is in the franchisor’s name. On the other hand, a franchisor can face difficulties retaining the site if the franchisee holds the Lease and there is a dispute about enforcing a restraint against the franchisee.
Alternatively, a franchisor may not want to retain the site if it’s in a poor location and/or the business was not successful. In these circumstances, even if the Franchise Agreement ended early then the franchisor would continue to be bound to honour the Lease with the landlord.
As a compromise, some franchisors will allow a franchisee to hold the Lease on the basis that the franchisee and landlord sign a Step In Deed or Right of Re-entry Deed. This is an agreement that gives a franchisor the choice to take over the Lease in certain situations, such as where the Franchise Agreement terminates early.
Promises and Representations
Most well-drafted Contracts include an ‘entire agreement’ clause. This means that the terms within the Contract fully govern the subject matter, and any previous agreements or promises which are not included within the Contract are superseded.
Franchising on the other hand is different. Under the Code, a franchisor cannot contract out of verbal or written representations made to a franchisee. This means that if a franchisee was promised something, such as the ability to achieve a certain amount of profit in their business, then the franchisor cannot rely on an entire agreement clause to avoid this promise.
Franchisors must be careful about the promises and representations they make to franchisees before entering into a Franchise Agreement. Unless the franchisor has supporting evidence they can rely on, statements about things such as profit, suitability of a location, potential success of the business and personal opinions should be avoided.
There have been many court cases where franchisees have successfully sued a franchisor where the franchisee has relied on a promise or representation which hasn’t been fulfilled, and the franchisee has suffered loss and damage as a result.
Breach by a Franchisee
Despite the fixed term of Franchise Agreements, the Code gives franchisors rights to terminate a Franchise Agreement early in certain circumstances.
Examples of where a franchisor can immediately terminate a Franchise Agreement include if a franchisee enters into bankruptcy/insolvency, engages in fraud, abandons the business or loses a licence/permit required to operate the business.
Otherwise if a franchisee breaches a provision of the Franchise Agreement, a franchisor can only terminate if the franchisee fails to comply with a valid notice to remedy that breach.
Even though a franchisor has these rights, a franchisor must still act in good faith. This means that when exercising the right of termination, the franchisor must assess the circumstances and determine whether they are acting reasonably.
A franchisor can also face difficulties where a poor-performing franchisee repeatedly breaches the Franchise Agreement, but remedies those breaches. In these situations, the Franchise Agreement must continue to remain on foot.
It should be noted the Code does not currently give franchisees the right to terminate a Franchise Agreement if a franchisor is in breach. Subject to certain other rights a franchisee may have under law, such a right to terminate would need to be expressly contained in the Franchise Agreement.
When a dispute arises between a franchisor and franchisee, there are certain procedures that must be followed. There are 2 similar types of procedures that can be chosen, being the procedure set out in the Code or the procedure set out in the Franchise Agreement (if any).
If there’s a dispute, then the franchisor and franchisee must try to agree on how to resolve it. If it cannot be resolved within 3 weeks, then either party can call for a mediation. Each party must then attend the mediation and participate in good faith. The costs of the mediation are split equally. It is entirely optional for someone in a mediation to have a lawyer present, and in that case, that person must pay for their own legal fees.
This procedure can be a cost-effective way to resolve a dispute as compared to court proceedings. On the other hand, some franchisors consider that the procedure is open to abuse by some franchisees who can force a franchisor to attend a mediation over trivial matters.
Franchise Agreements generally include a restraint/restriction against competition, known as a ‘non-compete’ clause. This means that once the Franchise Agreement ends, the franchisee cannot compete with the franchise system for a certain time period in a specified area.
Restraint clauses need to be drafted very carefully because a restraint will only be enforceable to the extent it is reasonably necessary to protect the franchisor’s legitimate business interests in the circumstances.
The Code also places certain limits on when a restraint can be enforced.
It’s very important that a business model is properly structured from the outset to reflect your intentions.
If franchising isn’t right for you, then your business must be correctly set up so that it doesn’t fall within the Code’s definition of a Franchise Agreement. On the other hand, if you are intending to franchise your business, then this should be done after careful consideration and ensuring strict compliance with the Code and other regulations.
The team at Salerno Law are experienced in acting for both franchisors and franchisees in all aspects of franchising law. This includes assisting businesses structure and franchise their business model to establish a franchising system.
Get in contact if you need our assistance.
DISCLAIMER: This article is only meant to give you general information and should not be relied on as legal advice. Speak to one of our lawyers for more information.
Salerno Law is managed by Emma Salerno, Managing Partner and CEO, who has a wealth of experience from operating her own businesses across Australia as well as a range of in-house and commercial experience both in Australia and overseas.