How to Avoid Legal Loopholes in Franchise Agreements

Entering into a franchise agreement can be a lucrative opportunity for aspiring business owners, but it’s crucial to navigate the potential legal pitfalls effectively. Franchise agreements are typically drafted to benefit the franchisor, and without proper due diligence and legal advice, franchisees can find themselves in unfavorable positions. 

This article, with insights from Nicolas Tang, founder and managing director of Farallon Law Corporation, and Kodie Bennion, partner at Johnston Clem Gifford PLLC, outlines key strategies to avoid legal loopholes in franchise agreements.

Conduct Thorough Research

Before signing a franchise agreement, comprehensive research is essential. “Do your research by looking up the franchisor and market,” said Tang. “Investigate the franchisor’s history, reputation and financial stability. Understanding their track record can provide insights into their reliability and the potential risks involved.”

Evaluating the demand for the franchise in your target location, competition and consumer preferences is also crucial. “This information can strengthen your position during negotiations and help you identify any market-related risks,” said Tang. “Review the Franchise Disclosure Document (FDD) as well, as it contains detailed information about the franchise system, fees, obligations and risks. Carefully reviewing this document can help you identify key points of negotiation and potential red flags.”

Bennion agrees, noting that it’s essential to go into the process with open eyes. “One thing I can’t reiterate enough — these agreements are written by a law firm hired by the franchisor to benefit the franchisor,” he said. “Even if they are one of the good actors, the agreement itself may not reflect that.” 

Understand Key Clauses and Provisions

Franchise agreements contain numerous clauses that can significantly impact your business. Key areas to focus on include:

Non-Compete Clauses

“Ensure that non-compete clauses are reasonable in scope and duration,” Tang said. “These clauses should not unfairly limit your future business opportunities.”

Mandatory Arbitration Clauses

“While arbitration can be faster and more cost-effective, it may also limit your ability to seek legal remedies and may favor the franchisor,” Tang said.

Exclusivity, Termination and Renewal

“Pay attention to the level of specificity in the agreement regarding exclusivity, termination and renewal terms,” said Tang. “Vague or generic language can create uncertainties and allow for varying interpretations.”

Renewal and Sale Clauses

Bennion emphasizes the importance of renewal clauses and the ability to sell the franchise. “Often, franchisees who built a successful business but are ready to retire find severe restrictions on the process,” he said. “They see their franchise as a retirement plan, but there are often significant hurdles.”

Marketing Spend Clauses

Bennion points out a common issue with marketing spend clauses: “There is usually a fee most franchises have to pay for joint marketing,” he said. “One problem is that there is often no control over how franchisors spend the money, so they may be spending it in markets that don’t benefit the people who are paying the fees.”

Changes in Ownership

Franchise agreements often grant franchisors significant control over various aspects of the business. “Older franchisee groups may find that a new owner exercises control in ways the original franchisor did not,” Bennion said. “You need to look beyond how the franchisor acts and understand how they are allowed to act.”

Negotiate Terms and Conditions

Effective negotiation can lead to more favorable terms. Tang suggests focusing on:

Royalty Fees

“Negotiate the percentage of sales required to be paid as royalties to the franchisor,” he said. “Lower royalty fees can help increase profitability.”

Territory Rights

“Negotiate the exclusivity of your territory to ensure you have sufficient market space to operate without direct competition from other franchisees,” said Tang.

Training and Support

“Ensure that the franchisor provides adequate training and ongoing support to help you succeed in your business,” Tang said.

Engage Legal and Financial Advisors

Overall, the importance of professional advice cannot be overstated. “A lawyer specializing in franchise law can help you navigate the complexities of the franchise agreement, identify potential legal loopholes and ensure that your rights are protected,” said Tang. “Legal professionals can review the agreement for ambiguous language, vague provisions and any clauses that may be unfavorable to you, such as non-compete clauses and mandatory arbitration clauses.”

Financial advisors play a critical role as well. “An accountant or financial advisor can help you understand the financial obligations, such as initial investment, ongoing royalty fees and additional costs like marketing fees or technology expenses,” Tang said. This analysis is important for determining the profitability and sustainability of the franchise opportunity.

Finally, Bennion recommends seeking advice from independent franchisee foundations. “They can be the best resources for understanding how things really work,” he said. “Given how serious of a document this is, I would always recommend hiring a professional to read it over.”

By taking these steps, prospective franchisees can protect their interests and set the foundation for a successful franchise business.

Every great franchisee had help buying a franchise. Want to learn more about how 1851 helps franchisees find the right franchise opportunity? Visit www.1851growthclub.com and start your journey.