AGREEMENTS AND ISSUES RELATED TO THE FRANCHISE SALES PROCESS
By Marisa D. Faunce and Christina M. Noyes
During the process of courting, qualifying, negotiating, and selling franchises to prospective franchisees, franchisors must take measures to ensure that they have appropriate legal documentation to protect the franchisor, the brand, and its proprietary operating system. In this chapter, we will explore the various contracts that should be a staple in every franchisor’s arsenal during the sales process.
I. CONFIDENTIALITY AND NONDISCLOSURE AGREEMENTS
Any franchisor that is actively engaged in the franchise sales process recognizes the danger of sharing too much information about the franchise system with prospective franchisees. A franchisor must take precautions to protect its proprietary information, from design and construction to supply chain to system operations. At the outset of any discussion with a prospect, a franchisor should have the prospect (and its owners and employees) sign a confidentiality agreement, also known as a nondisclosure agreement. In a confidentiality agreement, the prospect acknowledges that the information provided to the prospect during the sales process about the franchisor’s operating system is proprietary to the franchisor. Accordingly, the prospect agrees not to disclose any information covered by the agreement to a third party.
If the franchisor wants to have each prospect sign the confidentiality agreement, the franchisor must include the confidentiality agreement in its franchise disclosure document along with the other contracts that the prospect will sign if he or she chooses to purchase a franchise. Generally, a confidentiality agreement will not exceed one or two pages in length. The agreement should contain the following terms:
- A definition of the information that the franchisor deems to be proprietary, including information related to the franchise system, trade secrets, design and construction plans, software, operating manuals, marketing plans, vendor information, financial information and development projections
- A definition of the information that is excluded. Typically, the confidentiality agreement will not apply to information previously acquired by the prospect or that is generally available to the public
- An outline of how the prospect can use the information acquired and with whom the prospect can share the information, e.g., with a lender, financial advisor, accountant, attorney, and other investors in the prospect’s enterprise
- A covenant by the prospect not to disclose, copy, or transfer the confidential information
- The circumstances when the confidential information must be returned to the franchisor, e.g., when the prospect has determined that he or she will not purchase a franchise
- Types of disclosures that are permissible, e.g., court orders
- The length of time that the agreement is binding
- Enforcement procedures such as a choice of law and choice of forum, and an acknowledgement that the franchisor is entitled to injunctive relief if there is a breach of the agreement
Generally, the confidentiality agreement will be signed only by the prospect who is agreeing to maintain the confidentiality of the information provided. If the prospect is a business entity, the franchisor should consider having the agreement signed by the entity’s directors and officers, as well as co-owners, who will personally acquire the information. The franchisor does not typically sign the confidentiality agreement; however, if the prospect is a large multi-unit operator, then it is not uncommon to make the confidentiality agreement mutual since the franchisor will be acquiring access to financial and other proprietary information owned by the prospect.
The confidentiality agreement should be signed as soon as a franchisor has determined that the prospect meets its financial and operational standards to purchase and operate a franchise. In any event, it should be executed no later than the franchisor’s discovery day because of the significant amount of confidential information provided to a prospect during discovery day.
II. PRELIMINARY OR TRAINING AGREEMENTS
Franchisors wish to select a franchisee that will be a good fit for the brand. In evaluating a prospect, franchisors often make decisions based on a variety of information, such as the franchise application, personal interviews conducted by the franchisor’s staff, personality tests and other matrixes, and time spent with the prospect during a more involved discovery day. However, in certain circumstances, it may be desirable for a franchisor to observe a prospect operating in the field or in a training setting to determine whether he or she has the aptitude to learn the operational aspects of the business. In these cases, franchisors may opt to have their prospects sign a preliminary or training agreement before signing the franchise agreement. The franchisor will have an opportunity to observe a franchisee in the business directly during a preliminary period to determine whether the prospect’s operational propensities are measured out. This may serve as a better alternative than the common approach of providing for an early termination of the franchise agreement if a franchisee cannot successfully complete the franchisor’s training program. The franchisor may save its time, effort, and emotional investment, as well as reduce its potential liability if the franchisee has made investments in reliance upon the executed franchise agreement. Preliminary agreements also are useful in the transfer arena as the franchisor may want to evaluate a prospective franchisee’s operational skills before accepting the transfer application.
Franchisors should include the preliminary agreement in their franchise disclosure documents and the agreement should contain the following terms:
- A description of the training program, including its length, location, whether it is classroom or on-the-job training, and the criteria for successful completion of the program
- The franchisor’s ability to terminate the preliminary agreement and end the training program
- An acknowledgement that the prospect is not an employee or agent of the franchisor while he or she is attending the training program and that the franchisor will not be paying wages or benefits to the prospect
- Confidentiality and noncompetition provisions to maintain the confidentiality of the information provided by the franchisor during the training program (even if the prospect has executed a prior confidentiality agreement) to ensure that the prospect will not use the information gathered during the training program to a competitive advantage
- An agreement to return any materials provided at the end of the program
- Any training fees or other expenditures such as travel or living expenses that must be made by the prospect
- The ramifications of failing to complete the program successfully (typically, the removal of the prospect from consideration for a franchise)
- The franchisor’s obligations if the prospect successfully completes the program. For example, the franchisor may commit to signing a franchise agreement with the prospect upon successful completion of the program. Alternatively, the franchisor may state that it has no obligation to offer the prospect a franchise and that such a decision will be made at the franchisor’s sole discretion
- An acknowledgement that the prospect has no obligation to purchase a franchise at the end of the program
- Enforcement procedures such as a choice of law and choice of forum, and an acknowledgement that the franchisor is entitled to injunctive relief if there is a breach of the confidentiality and noncompetition provisions of the agreement
III. TERM SHEETS, LETTERS OF INTENT, AND MEMORANDA OF UNDERSTANDING
Once a prospect has been approved by a franchisor, the parties may find it desirable to outline the details of the proposed transaction in a nonbinding term sheet, letter of intent, or memorandum of understanding. The differences among these documents are slight. All three generally are nonbinding documents that outline the deal terms. A term sheet is the least formal of the three and outlines the terms of a deal in bullet point or list format. A letter of intent and a memorandum of understanding are more formal in that they outline the terms of the deal in a letter or agreement format. For ease of reference, we will refer to this type of document as a “letter of intent.”
Franchisors may use letters of intent for a variety of transactions, including situations in which a prospect is going to develop and operate a single unit or multiple units, purchase company-operated units and enter into an area development agreement to develop additional units in a specified territory, and international deals. The letter of intent confirms the parties’ understanding with regard to the transaction and serves as a guide for the attorneys who will be compiling the execution copies of the agreements. It will include information related to the proposed unit location or development area, the scope of the franchisee’s protected territory, development schedules, the franchisee’s entity and guarantor information, and payment terms. In certain situations, the franchisor may charge a fee to cover the cost of preparing deal documents and posting foreign counsel fees. One reason to consider using a letter of intent in the franchise context is that lenders may want to review a letter of intent before approving a loan. This document will enable the prospect to start the financing process while the parties work out the final terms of the deal. If a franchisor uses a letter of intent for every franchise sales transaction, the form of the letter of intent should be included in the franchise disclosure document.
The letter of intent is usually nonbinding because otherwise the parties would simply move on to the definitive agreement. This means that the terms that are outlined in the letter of intent are still subject to negotiation as the parties move toward the final documentation. The following language will protect a franchisor from claims that it is obligated to enter into an agreement based on the terms of the letter of intent:
This Letter of Intent is not a binding document. Until Franchisor and Applicant have executed an actual Development Agreement or Franchise Agreement, either party may discontinue negotiations at any time for any reason.
In the international context, it is more likely that the letter of intent will be binding to the extent of the franchisor’s ability to retain the deposit.
In the letter of intent, the franchisor may agree that it will not offer the development opportunity to another prospect while the parties are working out the terms of the deal. Accordingly, the franchisor should clearly state how long the letter of intent will remain in effect. For example:
This Letter of Intent will remain in effect for forty-five (45) days from the date of this letter (the “Term”). Upon the expiration of the Term, if Franchisor and Applicant have not entered into an actual Development Agreement or Franchise Agreement and the parties have not agreed to extend the Term, this Letter of Intent will become null and void.
Letters of intent for a multi-unit development deal typically contain the following terms:
- The scope of the development territory
- The franchisor’s agreement not to sell a franchise for a particular area during the term of the letter of intent
- The development schedule, which should outline the number of units that the prospect will develop and the time period for the development of each unit
- Entity information related to the prospect and its owners, if that information is available
- Identity and contact information for personal guarantors
- Any minimum purchasing obligations or other criteria for operation of the units
- Fee structure and payment terms
- Training requirements
The following additional terms should be addressed in the letter of intent for a single-unit development deal:
- The scope of any exclusive territory
- Site selection and construction schedule
- The projected opening date
- Operating principals or managers and related training requirements
- Address of the proposed unit
- Type of unit (e.g., kiosk, free standing or nontraditional)
IV. RIGHTS OF FIRST REFUSAL AND FIRST OFFER AGREEMENTS
Many franchisors prefer to work with franchisees that will develop and operate more than one franchised unit since economies of scale and the ability to deal with one franchisee in a region is desirable. As a franchisor analyzes a particular geographic territory to determine how many units the region can support, it may discover that its multi-unit developer or its existing franchisee in the region is not yet ready to commit to developing the total number of desired units. However, the franchisee would like the first opportunity to develop additional units in the area if the franchisor plans to offer those rights to a third party. A right of first refusal agreement provides that if a third party submits a proposal to develop franchised units within the defined territory, the existing franchisee would have the right to match the offer made within a defined time period.
Rights of first refusal are often granted in conjunction with the grant of area development rights. In that situation, franchisors should carefully consider whether they want to hold a territory up from development by other developers while the right of first refusal is still alive. The parties also need to clarify whether the right of first refusal would apply only to the proposed development of franchised units or the franchisor’s own plans to develop company-operated units in the region.
A right of first refusal agreement should contain the following terms:
- The time period in which the holder of the right of first refusal must either match the third-party offer or lose the right of first refusal
- The territory to which the right of first refusal applies
- The term of the right of first refusal, which is often the term of a development agreement
- Any fees that will be paid to obtain or exercise the right of first refusal
- The terms of the ultimate franchise or development agreement that would be entered into by the parties
- Any additional requirements to exercise the right of first refusal
- Whether the franchisor’s development of company units is included in the right
- Whether the franchisee must be in good standing under its existing franchise agreement to retain the right
A right of first refusal agreement may be a standalone agreement or it may be inserted into a franchise agreement or an area development agreement. An example follows:
During the term of this Development Agreement, Franchisee will have the right to match any proposal made to Franchisor by a third party seeking to purchase a franchise or development opportunity in Franchisee’s designated Territory. Provided that Franchisee is in compliance with the terms of this Agreement, then Franchisor shall notify Franchisee of the third-party offer in writing (the “Notice”). The Notice shall provide details regarding the development of the proposed Franchised Store that will be material to Franchisee’s analysis of whether or not to exercise the Right of First Refusal. Franchisee will have thirty (30) days after receipt of the Notice (“Exercise Period”) to notify Franchisor that it intends to exercise the Right of First Refusal and match the terms of the offer as described in the Notice. In order to exercise the Right of First Refusal, Franchisee must: (1) provide timely written notice to Franchisor (“Acceptance Notice”); (2) not be in default of any Franchise Agreement or any other agreement with Franchisor; (3) pay Franchisor’s then-current initial franchise fees and execute Franchisor’s then-current form of Franchise Agreement to govern the development and operation of the Franchised Store within thirty (30) days after the date that Franchisor receives the Acceptance Notice.
In many circumstances, after a franchisor receives a formal offer from a new prospect who wants to develop a unit in the restricted territory, a franchisor may be reluctant to have to provide the holder of a right of first refusal with the opportunity to exercise its rights. In addition, many prospects may lose interest in the opportunity while the franchisor is waiting for the holder of the right of first refusal to determine whether they want to exercise their rights under the agreement. Accordingly, great care and consideration should be given before granting such a right. As an alternative, a franchisor may choose to offer its existing franchisee a right of first offer agreement through which the franchisor will agree to offer the development opportunity to the holder of the right first before it offers the opportunity to a third party or develops the unit itself. In contrast to the example above, a right of first offer agreement will contain the following:
During the term of this Agreement, if Franchisor intends to develop or grant to any third party the right to develop a Franchised Store in Franchisee’s designated Territory, Franchisor shall notify Franchisee of its intention in writing (the “Notice”) and grant Franchisee a right of first offer to develop a Franchised Store in the Territory. The Notice shall provide details regarding the development of the proposed Franchised Store that will be material to Franchisee’s analysis of whether or not to exercise the Right of First Offer.
The right of first offer should specify that if the franchisor or the third party fails to develop the additional unit within a specified period of time, then the right of first offer would then revert to the franchisee, who would be given an opportunity to exercise the right when the franchisor again indicates its intent to develop additional units in the franchisee’s territory.
It may be desirable to tie a right of first offer to the sale of company operated stores as well as additional franchised stores in a franchisee’s neighboring territory as set forth below:
During the term of your Development Agreement, if Franchisor, in its sole discretion, decides to sell any of its Company-operated Stores in Fairfax County, Virginia (“Offer Area”) to a franchisee or if Franchisor decides to open the Offer Area for franchise development, then (provided that Franchisee is not in material default of this Agreement or any other Agreement with Franchisor or its affiliates) Franchisor shall provide written notice to Franchisee and offer Franchisee an opportunity to purchase these Company-operated Stores and enter into a development agreement to develop a specified number of additional Franchised Stores in the Offer Area (the “Notice”).
V. LEAD REFERRAL AGREEMENTS
An important aspect of selling franchises is obtaining leads for potential franchisees. Franchisors can elect either to have in-house sales agents or to outsource their sales activities to third-party referral sources, which may include other franchisees in the system as well as business brokers, lenders, consultants, realtors, business coaches, and the like. Both approaches have advantages and disadvantages. In-house personnel generally have a great deal of knowledge regarding the franchise system because they are continually exposed to existing franchisees as well as prospective franchisees. However, franchisors may find the salary costs to maintain a dedicated sales force, along with the payment of benefits and employment taxes, to be too costly. Franchisors may choose to engage a variety of internal and external sales agents as their needs change and their systems evolve.
The role of lead referral sources varies from system to system, but generally lead referral sources provide the names of potential franchisees to the franchisor’s sales department without further involvement in the sales process. The lead referral agent will usually make sure that the lead meets the franchisor’s minimum operational and financial requirements before referring the lead to the franchisor. The franchisor will then review and approve the leads and work with the prospects during the franchise sales process. Lead referral programs may be structured in a variety of ways and should be documented in formal agreements that specify the conditions where a franchisor will be responsible for paying a commission fee on the referrals that it receives. Commissions vary from hundreds of dollars to a percentage of the initial franchise fee. To earn a commission, lead referral sources may provide many leads and may act in an unscrupulous manner by inventing leads. Even genuine leads may be found to be not a good fit for the system, or the lead may not progress to executing a franchise agreement for its own business reasons. A franchisor may wish to limit payment of a commission fee to only those circumstances when the referral advances to a certain step in the sales process, such as attendance at a discovery day or the execution of a franchise agreement. In these situations, the referral fee is often a percentage of the initial franchise fee paid.
Some referral sources maintain copies of the franchisor’s franchise disclosure documents, work very closely with the prospective franchisees, and provide the disclosure documents to their clients for evaluation. Other franchisors may simply have a program that gives a limited fee to anybody who refers a prospect to them, including existing franchisees, based on how far a referred prospective franchisee advances in the sales process. For referrals that have the basic qualifications but do not progress, then the fee, if any, is minimal; it results in more of a marketing effort by the franchisor to maintain a good relationship with a potential referral source. These types of referral programs are different than a franchisor electing to pay for each Internet lead through a specific Web site in a lead-generation agreement.
Franchisors that use referral sources or outside sales brokers and that register their franchise offerings with the franchise registration states are required to disclose the following statement on the state cover page of their franchise disclosure documents:
We use the services of one or more franchise brokers or referral sources to assist us in selling our franchise. A franchise broker or referral source represents us, not you. We pay this person a fee for selling our franchise or referring you to us. You should be sure to do your own investigation of the franchise.1
It is important for franchisors to know if the referral source is also representing the franchisor’s competitors, and if so, how the referral source will determine which prospects are sent to which brand. If a franchisor wishes to have a referral source not work also with competitors, then the franchisor might need to increase the commission payment. If it works with franchise competitors, then a clear-cut geographical allocation would be best as it is certain and determinable. If the only determination is the fee that the referral source will obtain, then the referral source will be tempted to steer the potential franchisee toward the franchise system that will generate the highest commission.
The lead referral agreement should contain the following terms:
- The appointment of the lead referral source and whether the franchisor reserves the right to appoint additional referral sources
- Whether the lead referral source is dedicated to a particular franchisor or whether the referral source may handle leads for competing franchise systems or in specific franchise categories
- The territory where the lead referral agent may solicit leads
- The length of the term of the appointment
- The services to be provided by the lead referral source (e.g., generating leads and submitting qualified leads to the franchisor, providing background information regarding the franchisor, collecting application material from prospects, and maintaining records)
- Any prohibited actions (e.g., the lead referral agent cannot make any financial performance representations, approve a prospect, accept money from a prospect, or enter into a binding contract on behalf of the franchisor)
- Any restrictions on advertising materials that may be used to generate the leads
- The compensation to be paid for the receipt of qualified leads
- Confidentiality, indemnification, default, termination, and enforcement provisions
Generally, franchisors are not required to disclose their lead referral programs or the identity of their referral sources in their franchise disclosure documents, except for the broad disclosure on the state cover page.2 However, franchisors should carefully structure their lead referral programs to ensure that the lead referral source does not qualify as a third-party broker. In that case, the franchisor must comply with the federal and state laws related to franchise sellers as discussed below. In addition, if the franchisor implements a referral program pursuant to which its existing franchisees can receive payments for referring prospects, then the franchisor should have its legal counsel evaluate the referral program to ascertain whether the franchisor should disclose the program in the franchise disclosure document. Although the exact details of the referral program need not be mentioned, the franchisor might elect to do so if the amount is significant. The franchisor’s operations manual should fully describe the program, including how and when a franchisee may earn the referral fee, how the franchisor will ascribe a lead to a particular franchisee, and track that lead through to the closing on the sale.
VI. LEAD GENERATION AGREEMENTS
Lead generation systems generate potential leads through online Web sites and then immediately transfer the leads to franchisors without engaging in substantive conversations with the prospective franchisees. If the lead generator stays involved with the potential franchisee throughout the entire process, then they are acting as a referral source as discussed above. Franchisors need to document how the lead generation process will work as well as when and how the lead generator earns his or her payment in the lead generation agreement. Some lead generation systems have a simple screening process and then charge the franchisor for lists of leads that the franchisor then has to pursue. The payment structure is typically set up for a certain dollar amount per lead. One issue to be addressed is that leads may be provided to the franchisor from different lead generators. In these circumstances, the franchisor may wish to implement a system that provides for payment only for the first originated lead in accordance with a time-stamped receipt or other type of time-sensitive delivery system.
A lead generation agreement should contain the following terms:
- The exact criteria for the lead to meet before it is transferred to the franchisor
- The process the lead generator will use to evaluate the prospect (e.g., Will the lead generator only capture the information electronically from searches, or will it require the prospect to complete an application?)
- Whether the leads may be “sold” to more than one client, and disclosure of competing systems
- The commission structure (e.g., either “click per lead,” upon any transfer of contact information, or only upon validation by the franchisor of the prospect’s qualifications)
- The minimum number of qualified leads to be provided and the timeframe for the leads to be provided
- Whether any amount can be held back until after the franchisor inspects the leads
- Confidentiality, indemnification, default, termination, and enforcement provisions
The primary disadvantage with a lead generation approach is that the franchisor will spend a great deal of time further evaluating the leads. The leads may only meet the most basic of criteria. In the worst instances, the potential lead may have only clicked on a general informational page online relating to franchisees and might have had contact information obtained without a real understanding that he or she would be contacted by a franchisor. It is recommended that the franchisor only agree to purchase a small number of leads to verify the quality and provide for either a refund or a payment hold back if a specific percentage of the leads do not meet the established criteria.
VII. FRANCHISE BROKER AGREEMENTS
Franchise brokers vary in their level of involvement with the franchise sales process. Franchise brokers prescreen prospects, and often, as part of this process, assist the prospect in determining which franchise system offers the best fit with the prospect’s capabilities and objectives, provide information about those systems in which the prospect is interested, and arrange for meetings with the representatives of the franchisor. Franchise brokers generally work on a commission basis and are deemed to have earned the commission upon the prospect’s payment of the initial franchise fees and execution of the franchise or area development agreement.
Franchise brokers generally market and sell franchises for multiple franchise brands and enter into separate agreements with each franchisor that they represent. Oftentimes, the broker agency will provide a form agreement to the franchisor for review. Some franchisors prefer to adopt their own form of broker agreement to ensure that the proper protections are in place before engaging the broker. Since most franchise brokers are personable and enthusiastic people, franchisors need to clarify the broker’s responsibilities and to protect the franchisor, the franchise system, and its intellectual property.
The main terms to consider including in a broker agreement are set forth below and certain provisions are discussed in more depth following this summary:
- The specific authority limits on the broker’s actions (e.g., authority to offer, negotiate, or close the sale)
- The franchisor’s required pre-approval of a particular broker if the broker is part of a larger national brokerage firm and any specific requirements on the broker’s background, such as restrictions on prior bankruptcy, litigation, or criminal matters
- Length of the term and whether there are any renewals (short-term agreements are more flexible and are often preferable)
- Territory and market limitations
- The broker’s responsibility for compliance with franchise disclosure laws, including abiding by state broker registration laws and providing the franchise seller disclosure forms that a franchisor requires for state franchise registrations (see Section VII.C. of Chapter 3)
- Approval and review of any sales materials used by the broker
- Any sales quotas (e.g., terms of a particular area, targeted ranges of prospects, targeted ranges of contract executions or number of franchise openings, as well as the notice of default and opportunity to cure provisions if the sales quota levels are not reached)
- Consequences of not meeting the sales quotas
- Rights reserved to the franchisor on the qualification and approval of prospects
- The amount of representation (e.g., full-time representation or limited representation)
- Compensation and the identification of the lead origination
- Confidentiality and rights to use the franchisor’s trademark
- Indemnification of the franchisor for the broker’s improper actions and of the broker if sued by an unsatisfied franchisee
- Default, termination, and enforcement provisions
A franchisor may enter into a broker agreement with a sales group or with an individual broker. If the franchisor engages a sales group, the agreement should specify the broker who will serve as the franchisor’s primary contact and how much time that sales agent will devote to the franchisor’s system. A broker agreement should first appoint the broker to solicit qualified prospects for the franchise system. The agreement should specify whether the broker has any authority to negotiate the terms of the franchise agreement that the franchisor will sign with the prospect, or whether the broker’s responsibilities cease after determining whether a prospect meets the franchisor’s financial and operational standards. The agreement should reserve to the franchisor the final acceptance and approval of a prospect at its sole and absolute discretion. If a franchisor specifically reserves this discretion, it can minimize the chances that a broker might claim it was due a commission for introducing a prospect the broker deemed qualified and that the franchisor unreasonably rejected.