Buying a Franchise: Understanding the Legal Principles Covered in the Franchise Agreement

When you buy a franchise, you will be presented with a franchise agreement and its related contracts. Here’s an overview of some of the legal principles you can expect to see covered in these documents—principles that will guide your life as a franchisee.

7 key areas of the franchise agreement

1. Transfer

You will not be free to sell your business to any purchaser of your choosing at any price. Get used to the idea that as a franchisee, you are not a completely independent business owner. The franchise agreement will impose a series of conditions.

Essentially, the buyer must meet the same qualifications you did coming into the program, and the price you receive cannot threaten the continuing viability of the business. If the agreement has a Right of First Refusal, you may have to allow the franchisor to match any purchase offer before you can sell. And there will probably be a transfer fee designed to cover the franchisor’s expenses in training the new owner and getting him or her up to speed.

2. Termination

Expect to find in the agreement a dozen grounds for the franchisor to terminate the relationship, and not one articulated reason allowing you to terminate it. Talk to your lawyer about this area. There may be applicable state law that will limit the franchisor’s termination grounds to being “reasonable” or amounting to “good cause.”

Some investors find the termination language to be quite threatening to the security of their investment. Your best hedges: Find a franchisor whose management style you trust to be reasonable, check whether the franchisor uses mediation/arbitration to resolve disputes (see “Dispute Management,” below), and check the volume of franchisee/franchisor disputes revealed in Item 3 of the company's Franchise Disclosure Document (FDD).

3. Releases

You won’t see any release language in the franchise agreement itself, but releases are popular with franchisors at the times of renewal and transfer. A release has a profound effect on your legal rights: It is a promise, for consideration, to waive any right you may have to bring a legal claim against the franchisor for past problems. Make sure any release you sign is mutual.

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4. Personal guarantee

It is common for franchisees to hold their franchise rights in the name of a legal entity, such as a corporation or, more commonly, a limited liability company, rather than in their personal names. Franchisors generally allow this approach, and some require it, although they insist that the franchisee sign a personal guarantee of the obligations of the entity. This is a legal contract that fully exposes the owner, personally, to pay royalties, fees, vendor bills, and other debt of the corporate franchisee if the franchisee cannot.

This might seem to nullify the principal reason for creating the limited liability company in the first place: a liability shield. At least regarding liability of the business’s obligations to the franchisor, that’s correct; it will remove all liability shielding.

5. Dispute management

This is a code for Alternate Dispute Resolution (“ADR”), which is code for mediation/arbitration instead of courthouse litigation. There is a running debate in the franchise legal community over whether mediation and arbitration provide advantages over traditional litigation, and whether it is appropriate for parties to a contract to commit to arbitration well before a dispute arises. The issue of pre-dispute commitments to ADR has even reached the U.S. Congress.

I serve as a Commercial Arbitrator with the American Arbitration Association and believe in the problem-solving power of mediation and arbitration. I think that pre-commitment lets both parties know going into the relationship how disputes will be resolved, but there are strongly held views on all sides of the debate. Know what dispute resolution approach is adopted in your franchise agreement, and talk to your attorney about it.

6. Indemnification

Most franchise agreements contain language by which the franchisee protects—or “indemnifies”—the franchisor against claims that might arise from the franchisee’s business. This is particularly important in a franchise relationship where the franchisee is operating under a trademark owned by the franchisor.

Indemnification language will apply, for instance, if a slip-and-fall incident occurs at the franchisee’s premises, a customer is injured, and the customer sues the franchisor. The franchisor will invoke the indemnification provision, and the franchisee, or more practically, the franchisee’s insurance company, must reimburse the franchisor for expenses incurred in defending the suit.

7. Insurance

Franchisors insist that the franchisee carry a full plate of business insurance; you will find the requirements detailed in the franchise agreement. Insurance coverage is of vital importance to the interests of franchisors and franchisees alike, and it will surely threaten the continuation of the relationship if a franchisee does not maintained required coverage.

Before you sign . . .

This is only a sampling of the legal features of the typical franchise relationship, but it’s vital that every franchise investor understands them. Before you sign anything, you should go over them with your own lawyer to make sure you are fully comfortable with the legal architecture of your franchise investment.

About the Author:

Andrew Caffey is one of the nation’s leading franchise legal specialists and he represents franchisors across the United States. Caffey served as General Counsel of the International Franchise Association, a member of the Governing Committee of the ABA Forum on Franchising, and Chair of the ABA Forum on Franchising. He also is a member of the bar in Maryland and the District of Columbia, and a member of the Panel of Neutrals of the American Arbitration Association. Caffey has appeared on numerous franchise programs and is a frequent speaker and author on subjects of franchise and business opportunity regulation.