Articles

What you need to know about fixed-term franchise agreements

Your Business January 2009
By Ian Jacobsberg & Sanusha Govender

Fixed-term franchise agreements run for a specific time period at the end of which they terminate automatically if not renewed or extended. The agreements can be terminated by either the franchisor or franchisee.

In South Africa, most fixed-term franchise agreements run for between four and six years. Previously longer term and "evergreen" agreements were popular, but these are seldom used today because experience has shown that franchisors need to update operations and their relationship with franchisees from time to time. The term can’t be too short, however, as this makes it impossible for franchisees to realise a return on their investment.

What happens at the end of the fixed term?
For the duration of the franchise agreement, franchisees are given the right to use the franchisor's intellectual property, know-how, business methods and trade secrets. These remain the property of the franchisor and, at the end of the term, franchisees have to stop using them and return all items, such as operating manuals and branded accessories, to the franchisor. Franchisees are left with their equipment (to the extent that it is not branded or part of the franchisor's intellectual property, for example a unique coffee maker) and whatever stock they have on hand.

In some franchise agreements, franchisees are also obliged to sell their equipment and stock to the franchisor either at a predetermined price or at current market value. If the franchisor doesn’t wish to buy the equipment, franchisees can sell it on to a third party.

In general therefore, the value of a franchised business at the end of the fixed term amounts to little more than the value of those tangible assets that the franchisees have acquired for use in the business. Because the franchisor owns the intellectual property, the "goodwill value" of the business will also be low once the agreement, and the franchisees’ right to use the intellectual property, comes to an end. However, this certainly doesn’t mean that franchisees don’t receive value when buying into a franchise, or "walk away with nothing" at the end of the period. Whether or not this will be the case depends on the terms of the franchise agreement.

Look out for the “duration” clause
As would be the case with most business relationships, the franchisor and prospective franchisees should outline what they expect and want from their association at the start.
 
Franchisees, for instance, should look closely at the “duration” clause in the franchise agreement before signing to assess whether they will be able to realise a return on their investment in the time set down. Take the following factors into account:

• Substantial expenses will be incurred when setting up the business, including the purchase of equipment, the fitting out of the business premises, training staff etc. It may, therefore, be some time before the business breaks even and starts to show a profit.

• On the other hand, franchisees benefit from the franchisor's expertise when setting up and training staff, and will attract customers based on the franchisor’s reputation and intellectual property. For this reason, a franchised business should reach break-even more quickly than an independent business, which will have to develop its own methods and build up a customer base without the benefit of the franchisor's reputation and goodwill.  

A proper evaluation of the “term” of the agreement must take into account the type of business, the brand/product, the location, the clientele and the demand for the product. Importantly, franchisees must also investigate the franchisor and whether he can be relied on to supply the support, know-how and goodwill needed to get the business off the ground.

The alternative
An alternative, which balances the interests of both parties, is to offer franchisees the option of renewing the agreement for a further fixed period. Franchisees would have to exercise this option several months prior to the expiration of the initial fixed term so that both parties can make the necessary arrangements. If the franchise is not renewed, for instance, the franchisor these will need to find a new franchisee, while the franchisee will look to sell their equipment.
Franchisees would usually be required to meet a number of conditions to renew the agreement, including adhering to all of their obligations in terms of the franchise agreement, achieving turnover targets, profits and operating standards. They will also need to renew the lease agreement for the premises for a period not less than the renewal period of the agreement.

A franchisor may also expect franchisees to follow any conditions inserted into the initial franchise agreement and could make the renewal subject to their acceptance of these new conditions. Another common stipulation is that franchisees must "revamp" the outlet to conform to any image or brand changes introduced after the initial agreement was signed.

In some cases, the franchisee will be required to pay a fee to the franchisor on renewal of the agreement. This fee would be intended to cover the administration costs incurred by the franchisor in relation to the renewal. If a renewal fee is payable at at all, it is usually a relatively nominal amount, as the franchisor will have incurred, and recovered, most of his administrative expenses, on the initial establishment of the franchised business.

When can a franchisor refuse to renew?
The only basis on which a franchisor could refuse to renew the franchise agreement would be if the conditions weren’t met. Franchisees, therefore, have the security of knowing that, as long as the business is run within the parameters set down by the franchisor, their position is secure. The franchisor can, however, refuse to renew if they are not satisfied with franchisee performance.

Franchise agreements can be complex, and franchisees who don’t fully understand all stipulations would be well advised to seek financial and legal advice.

Fixed-term contracts can work for both the franchisee and franchisor as long as both parties go in with their eyes open. Franchisees particularly must understand both the terms of the franchise agreement and what they can expect to get out of the business.

Talk to a specialist

Ian Jacobsberg

Partner
011 523 6091
E-mail Ian Jacobsberg