While franchises are typically great businesses to invest in, you need to be careful of these five franchise killers that could be lurking in your franchise agreement.
A franchise presents a fantastic opportunity to own a successful business by piggybacking on a recognized brand name with a proven operating system. With a franchise, you obtain access to an established network of loyal customers, strong market share, and a solid base on which to rapidly grow your business.
But what starts out as the perfect business opportunity can quickly falter and fail if you don’t pay enough attention to the clauses in your franchise agreement. After years of helping people get out of completely unfair franchise relationships, I’ve seen countless smart and talented business owners driven into bankruptcy by franchise structures that were destined to fail.
In this quick guide, we’ll beam a flashlight on five clauses that can seriously threaten (or even kill) your franchise and what to do about them if you come across something similar in your next franchise investment.
1. Royalties and costs
The Problem With Franchise Royalties and Costs
If you’re seriously considering a new franchise offer, take a step back and ask: how much money am I really going to make from this franchise? A franchise is almost no different from running a business that’s solely yours, except that you have to pay added fees that are unique to a franchise relationship.
For instance, franchisors typically require you to pay a yearly or monthly royalty on your revenues. You may also have to pay added costs related to training, marketing, and other technical or management fees. When all this adds up, you may find your take-home profits are far less than you might anticipate compared to owning the business yourself.
In practice, profit margins in a franchise may range from 10-15% or higher for product-based franchises, while service-based franchises can expect much higher profit margins (closer to 30%). However, that profit base as a whole can erode easily in the face of these hidden fees and charges that you might not be aware of.
On the other hand, paying your monthly or annual franchise fees, royalties, marketing fees and management fees can simply be looked at as the cost of business for receiving a proven, successful business model and brand.
How To Avoid Issues With Franchise Royalties and Costs
First, Take a microscope and a pen to your franchise disclosure document where the franchisor must provide you with a rough estimate of your total initial costs and ongoing costs to operate the franchised business. I like to add this up in excel so that you can later crunch some numbers based on generating different monthly revenue figures, as described below.
From there, turn to your franchise agreement and highlight every clause that takes money out of your pocket to continue to operate the franchised business. Identify your guaranteed exposure (i.e., money sums you have to pay from time to time), sum it all up, and run these costs against your expected revenue and profit margins.
If the math doesn’t look good or you’re feeling that this is a little more riskier than you had hoped, start by having a conversation with the franchisor about your profitability concerns. A good franchisor would have analyzed the local area (population, age, demographic, etc.) before thinking about selling the location to you. This additional information could help alleviate concerns around not generating enough revenue to cover costs.
In addition to the above, you can push for revised clauses that would give you more of a profit runway. For example, maybe the royalty fees or marketing fees are too high for you to make enough profit for yourself. If the franchisor won’t budge, it may be best to walk away.
2. Contract Duration (Term)
Contract Duration: A Key Asset To Your Franchise
The first thing you should understand is that a longer contract duration is an asset to you. While there’s the possibility that the franchisor’s brand may turn out weaker than you expect, it is more likely than not that you’ll benefit immensely from the franchisor’s strong, established market presence. Therefore, any clauses that tend to unfairly limit or abruptly cut short your franchise duration may be unfavorable to you.
When it comes time to exit or sell the business, a longer remaining contract term is a great selling point for any incoming buyer. Buyers want to be sure that they too can reap the benefits of using the franchisor’s brand long into the future, and not just for a short period of time.
In our experience, there are three key questions to ask and answer when it comes to assessing the Term of a franchise agreement:
- How long is your contract duration? We’ve seen franchise agreements with contract terms as short as two to three years. That’s a red flag. You will want an initial term of 5 years at minimum, because you will likely need at least two years to recoup your setup costs and begin to collect real profits.
- Do you have a fair renewal clause? This is a must! Don’t spend your blood, sweat and tears building a franchise business that would just go back to the franchisor after a short five years. Push for a renewal clause if you don’t have one. In fact, it’s even better if you can push for multiple renewals!
- Is your remaining Term conditional? Is it tied to anything unfair, like your lease? This is dangerous because your franchisor is usually the main leaseholder while you’ll be subleasing underneath them. If they terminate your sublease for any reason, you’ll automatically lose your franchise and investment. This is actually a real situation we’ve come across as well.
How To Avoid Building Someone Else's Empire
You should look critically at duration provisions in your franchise agreement and ask questions if anything seems unclear or unfair. Better yet, speak with a franchising lawyer to gain better clarity on your rights and how to protect them.
When you start looking at your contract term, renewal rights, conditions to renewal and termination clauses, it can all get very tricky, very fast!
3. Termination clauses
Can My Franchisor Kick Me Out Of My Franchise?
Termination clauses govern how the franchising arrangement comes to an end. In practice, franchise agreements include a number of penalties tied to any breaches of the agreement or the franchise policies and procedures. Often, these penalties may result in termination and expensive penalty fees.
For instance, failing to adhere to the standards detailed in the franchise agreement may carry a termination penalty. Likewise, any delay or default in royalty payments may have graduated penalties that eventually lead to termination.
Understanding the nature of these termination provisions and when they will operate is critical. Are they fair or not? Do they provide a cure period or are they designed to be held over your head for every minor mistake?
How Franchisees Can Protect Themselves From Being Terminated
Look carefully at the ‘fine print’ a.k.a. the Termination section of your Franchise Agreement. If any termination clause fails to give sufficient opportunity to cure the default (this means a period of time to fix the problem), you should push back – hard.
Otherwise, what we often see is that anytime your relationship with the franchise gets a little rocky, they’ll be looking to the contract to find any way to kick you out. That’s why we always recommend that you strike first and make sure that your arrangement is fair from the beginning.
4. Exit and transfer rights
How Can I Exit or Leave My Franchise?
An implied right in making any investment is the freedom to decide when you’ve had enough. If you decide, for any reason, that the franchise isn’t meeting your business objectives, you should be able to walk by taking your profits and selling the business to someone else.
However, in practice we see that many franchisors don’t allow exits or transfer. If they do, there are often a ton of transfer fees and burdensome requirements to meet before you are allowed to exit the franchised business. These types of arrangements effectively lock franchisees into the franchise agreement, forcing them to stick with the franchise through the duration of the contract and continue to pay their monthly royalty payments.
Another approach that we’ve seen is where franchisors allow exits, but only with their consent. The problem here though, is that many franchisors reserve the right to give or withhold consent arbitrarily – so the franchisor can say no without any justification. Where this is the case, the reality is that you’re effectively stuck.
So this begs the questions, what happens if your location ends up less successful than you had expected? How do you continue paying royalties AND paying yourself if the franchised business is just not making any money?
How To Avoid Being Locked Into a Franchise
What you need to do is negotiate for a fair right to sell or exit the franchised business if things don’t work as you expect. Ideally, the contract should have an exit and transfer clause that allows you to sell or transfer when reasonable conditions are met – such as requiring you to find a buyer to have relevant business experience and good financial standing.
Therefore, when you’re assessing the fairness of your sale or transfer rights, you should pay particular attention to the conditions that you must meet before the franchisor will approve the transfer or sale. As long as the conditions are fair, then you’ll have yourself a solid exit clause!
5. Renovation clause
A Sneaky Trick Franchisor's Use To Remove Franchisees
In more than one instance, we’ve seen a popular burger chain franchisor in Toronto try to push a franchisee out of the location because they wanted to take it over for themselves. When the franchisee refused, the franchisor threatened to force her into bankruptcy by triggering a renovation clause that would result in more than a $100,000 in costs to the franchisee. Unfortunately, the franchisee was forced to give in.
The lesson? Be careful of renovation clauses because they can throw a wrench in your long-term plans. Typically, these clauses require a franchisee to maintain the location to a certain standard. For example, you’ve probably seen your local McDonalds get redecorated at least a few times in your lifetime. Since most renovations or interior overhauls carry large cost implications to you, they can get very uncomfortable if you haven’t budgeted for it or, in the worst case scenario, push you into bankruptcy.
How To Avoid Unfair Renovation Clauses in Your Franchise Agreement
Watch out for renovation clauses in your franchise contract. The most important thing that you want to look out for is how often you can be required to renovate. Personally, we like to see at least a 5 year buffer between each renovation. That way, you can have a very predictable timeline between each renovation so that you can start saving and budgeting for the large expense.
Also watch out for other things in the agreement that could trigger large additional costs like renovations and can be used against you in the same way. You need to budget and prepare for these costs. Better yet, avoid them in your agreement and negotiate them out in advance!
A franchise can be a beneficial business arrangement, but there are many pitfalls to watch out for. One way to avoid the painful experience of building a new franchised business and then having to stress about your success is to hire an experienced franchise lawyer to review and negotiate your franchise agreement before you make a hefty investment you later regret.
For more information on how to negotiate the best franchise contract possible, download our Ultimate Franchise Negotiation Package for persons looking to purchase a franchise business.
If you’re currently in the process of obtaining a new franchise and you’ve gotten stuck at one of the points that we mentioned here, reach out to us here or call us at (416) 580-0345 and we’ll walk you through the best way to negotiate a fair franchise agreement in your favor!