Five Crucial Legal Tips for Start-up (and Other) Franchisors

1. Never Franchise an Unproven Concept.

This is not, strictly speaking, a legal point, but it has legal implications.  The bottom line is this: franchisees who are making money do not normally sue their franchisors; however, franchisees who are not making money frequently do. Accordingly, one of the keys to ensuring that you do not face a litany of franchisee law suits is to ensure you are selling a proven business concept that has been shown to create a reasonable return on investment.

2. Apply to Register Your Trademark A.S.A.P.

Start-up franchisors should apply to register their trademark(s) as early as possible.

In Canada, registration of a trademark gives the trademark owner the exclusive right to use that trademark across Canada. Without a registered trademark, a franchisor and its franchisees must rely on common law trademark rights, which must be enforced through "passing off" actions. A major limitation of the passing off action is that, in order to succeed, you must prove, among other things, that you have a valuable reputation in the trademark in the area in which the alleged passing off took place. If infringement occurs in a market in which the franchisor and/or its franchisees have not yet established the brand, the chances of success are low. Registration of a trademark avoids this problem and ensures that, in most cases, the franchisor can enforce its trademark rights anywhere in the country. 

While trademark registration is a must, the registration process takes considerable time from start to finish (12-18 months or more). While franchisors may begin granting franchises before their trademarks are registered, franchisees and their lawyers will typically want to see, at a minimum, that the franchisor has one or more trademark applications in process. Offering to grant a franchise without a registered trademark and without a trademark application pending will be a "red flag" for prospective franchisees who are paying attention.

3. Make Sure You Have a Properly Drafted Franchise Agreement.

In addition to having properly protected trademark rights, a franchisor must have a properly drafted franchise agreement. The franchise agreement is the central document in the franchise relationship. The franchisor relies on the franchise agreement to enforce payments owed to it, enforce system standards, make modifications to the system and generally to ensure productive and brand-appropriate franchisee behaviour. Although all franchise agreements tend to cover the same ground, they are not all created equal. Franchise agreements prepared by lawyers who do not have extensive experience in franchise law tend to suffer from significant problems.

One such problem is the use of what could be termed “soft” language, i.e., language that does not set out the franchisor’s rights comprehensively or explicitly enough. Since Franchise Agreements are “contracts of adhesion” (i.e., contracts that are presented on a “take it or leave it” basis) they are interpreted contra proferentum (against the person who presented the agreement). This means that if there is any wording in the agreement that could be interpreted in more than one way, a court will always interpret it in the way that helps the franchisee at the expense of the franchisor.

Franchise agreements are also interpreted in light of the franchisor’s duty of fair dealing. This duty limits the franchisor’s ability to act in its own self-interest in the performance or enforcement of the franchise agreement. That said, the duty of fair dealing cannot override the express terms of the franchise agreement. Accordingly, if the franchisor wants to reserve certain rights or benefits to itself under the franchise agreement at the expense of the franchisee, these rights and benefits should be set out in the agreement very explicitly. If it is not clear that the franchisor is exercising an express contractual right, there may be room for franchisee's counsel to argue that the franchisor is performing or enforcing a term in bad faith or in an unreasonable manner. The franchisor’s rights vis-à-vis supply chain matters require particular attention in this respect.   

Developments in franchise case law, which occur on an ongoing basis, must also be taken into consideration to ensure the enforceability of the agreement.

4. Be Careful What Amendments You Negotiate to Your Franchise Agreement.

As noted above, franchise agreements are typically viewed as “contacts of adhesion”, i.e., contracts the terms of which are presented on a take it or leave it basis. However, the reality for start-up franchisors is not that simple. In the early days of a franchise system, before the franchisor has a track record of success and significant brand recognition, it will likely be required to negotiate concessions or grant incentives, such as future development rights, to franchisees in order to sell franchises.

  

However, as much as possible, concessions should be limited to the financial aspects of the deal, i.e., reduced or deferred franchise fees, royalties or advertising payments. Changes should not be made to the standard legal terms and conditions of the franchise agreement. Not only do such changes weaken the franchisor’s ability to enforce consistent standards across the system, but allowing ad hoc variations in its franchise agreements means the franchisor will inevitably incur higher costs and a greater drain on its resources to administer franchisee relations in the future, e.g., once the franchisor has 50 or 100 franchises, all operating under materially different versions of the franchise agreement.

Incentives, such as rights of first refusal, options and future development rights should, as much as possible, be limited and scope, so as not to lock up undeveloped territory too tightly. If the franchisor grants rights of first refusal, for example, they should be limited by time and geography and otherwise drafted in such a way that, if the franchisee that holds the right of first refusal does not jump at the new opportunity as soon as it is offered, the franchisor will have a free hand to develop the territory with another franchisee.

Again, advice from an experienced franchise lawyer will do a long way towards avoiding pitfalls in this area.

5. Know and Properly Protect Against Your Potential Liabilities Under Franchise Disclosure Laws.

While the franchise agreement is key to governing the franchisor-franchisee relationship, the pre-contractual phase of the relationship poses arguably the most acute legal risk to the franchisor. Franchise statutes in NB, PE, ON, MB, AB and BC require franchisors to deliver a franchise disclosure document to prospective franchisees not less than 14 days before the prospective franchisee signs any agreement or pays any money. The disclosure document is, essentially, a long and detailed franchising prospectus, which must be tailored to each prospective franchisee.

If the franchisor fails to deliver a fully-compliant franchise disclosure document, the franchisee has the right to rescind (cancel) the franchise. Depending on the facts of the case, this right may remain available for up to two years from the date on which the franchisee signed the franchise agreement. 

Upon rescission (cancellation), the franchisor is required to repay all amounts it has received from the franchisee over the course of the relationship, repurchase all inventory, supplies and equipment at original prices and compensate the franchisee for any other losses it has incurred in establishing and operating the franchise. 

The amount payable under a rescission claim can be quite substantial and, as noted above, will often be enough to bankrupt a small franchisor. Moreover, certain individuals who are involved in running the franchisor are personally liable, along with the franchisor, to pay the franchisee’s damages. This means that the founders of a start-up franchise system will likely face the spectre of personal bankruptcy if a franchisee successfully rescinds its franchise agreement. 

As alluded to above, franchise case law makes it clear that a generic franchise disclosure document, which is not tailored to include transaction-specific information, will not satisfy the franchisor's disclosure obligations in most cases. Moreover, as more material information becomes known in the course of the deal-making process, it will often be necessary, in order to comply with provincial franchise legislation, to update the franchise disclosure document using a Statement of Material Change. 

Given the complexity of franchise disclosure requirements, franchisors, especially new ones, require considerable support from experienced franchise legal counsel in order to ensure their obligations are met and their exposure to statutory rescission (and other) claims is contained.

Conclusion

There are many other legal tips that could be offered to start-up franchisors.  However, a franchisor that acts on all five tips above will have gone a long way towards ensuring that its legal position in respect of its franchisees and others is as strong as possible.