Ready to Commit? About to buy a business but intimidated by the franchise license agreement? We explain what to look for before you sign on the dotted line.
By Jeff Elgin
Opinions expressed by Entrepreneur contributors are their own.
One of the most misunderstood aspects of franchising relates to the term of the franchise agreement. The question I often hear is, "If I'm paying a fee to buy the franchise, how can it be for only a limited period of time?"
To understand the answer, you must understand what a franchise agreement actually is. A franchise agreement represents a license to use a specific business operating system employing registered brands and trademarks for a specific period of time in exchange for a specified payment structure. The license agreement also typically contains a number of restrictions relating to the acceptable methods of employing the operating system and using the brand.
In this sense, a franchise agreement is like the lease for renting an apartment. The lease contract contains the terms of use of the apartment, the economic payments required of the renter to keep the lease in good standing and the term of the rental agreement.
When you execute a franchise agreement, you are not "buying" or taking any form of ownership in the franchise. Every franchise agreement contains specific clauses that make clear that all ownership rights to the brand, trademarks and proprietary business operating systems remain with the franchise company.
To the extent that you must make investments in personal or real property in association with the franchised business, you usually will own such property based on your investment. However, many franchise agreements also condition the ownership of such property by containing provisions that require the property be sold to the franchise company upon termination of the franchise agreement, often at its depreciated value.
Regarding the term of the franchise agreement, most contain an initial term and then one or more renewal periods. The initial term is typically either five, 10 or 20 years.
Most franchisors prefer to use shorter terms of agreement with multiple renewals. The reasoning is twofold:
- First, virtually all franchisors require that the renewal be on the "then current" form of the franchise agreement. This means that if the terms of the franchise agreement have been changed since the original agreement, any renewal would incorporate the changes. This provision may be significant, since these changes could include things like a higher ongoing fee structure or more restrictive requirements concerning the operation of the business.
- Second, franchisors want to make sure the physical plant of the business is operating on whatever is the current basis for new units opening in the system. This could mean something as simple as making sure the carpets and other wear items are replaced so the unit is freshened up at each renewal point in time. It could also mean that a much larger investment is needed because of something like a new requirement for freestanding units rather than in-line retail shopping mall space.
The important thing to remember is that there is no assurance of what will be required when it is time to renew the agreement. For this reason, most franchisees prefer a longer initial term and fewer renewals when looking at the terms of the franchise agreement.
Franchise agreements typically do not discuss what happens after the initial and any renewal terms have expired. The fact is that there are no guarantees to you at all under most franchise agreements when this time is reached. The franchisor could require you to exit the business entirely, they could offer another renewal period, they could allow you to execute an entirely new franchise agreement and pay a new initial franchise fee, or any other possibility.
The best assurance you have, in relation to what will happen when the entire term has expired, is common sense. Let's revisit our lease agreement to illustrate this: Landlords are looking for renters who will be good citizens, treat the property with respect and maintain it well, and pay their bills on time.
This is basically what a franchise company is looking for in you. If you have been a good citizen as a franchisee, have operated well and according to the system and paid your bills on time, the franchisor will very likely want to keep you as a franchisee after your initial and renewal terms have expired. They'll likely offer you terms acceptable to you in order to induce you to remain in the system. If, on the other hand, you've been a real pain in the neck (but not bad enough to warrant default and/or termination), they will probably use this opportunity to get rid of you.
Your options, should you lose the franchise rights at the end of your term of agreement, are usually very limited and not very appealing to you. For this reason, the safest course for you is to evaluate any franchise opportunity under the assumption that your business will be worth nothing at the end of the initial and renewal terms.
Use your assumptions of the total investment you will make, in terms of both time and money, to calculate what you will be putting into the business over the term of the agreement. Then calculate what you think the business will return to you in profits, above the return of your initial monetary investment, over the total term of the franchise agreement.
If you believe, based on this analysis and these assumptions, that the franchise opportunity is a good one for you, do it. If you don't believe it would be a good opportunity for you unless the term of the agreement is changed to allow you more time, then insist on this change (which you likely won't get) or else skip this one and look for a different and better opportunity for you.
