WIPO/SMEs/SIN/07/5

page 2

E
WIPO/SMEs/SIN/07/5
ORIGINAL: English
DATE: September 2007
WORLD INTELLECTUAL PROPERTY ORGANIZATION / INTELLECTUAL PROPERTY OFFICE OF SINGAPORE / INTERNATIONAL ENTERPRISE SINGAPORE

SINGAPORE-WIPO REGIONAL WORKSHOP ON the role of intellectual property in enhancing competitiveness and growth of small and medium-sized enterprises in the franchising sector

organized by the

World Intellectual Property Organization (WIPO)

in cooperation with
the Intellectual Property Office of Singapore (IPOS)

and

with the assistance of
the International Enterprise Singapore

Singapore, September 18 to 21, 2007

Topic 5
SUCCESSFUL FRANCHISING: KEY TERMS OF A FRANCHISING AGREEMENT

Document prepared by Mr. Gurmeet Singh Jakhu, Partner,
Hamilton Pratt Business and Franchise Solicitors, Birmingham


I. BASICS OF FRANCHISING

The terms “franchise” and “franchising” are used in a variety of ways, sometimes for arrangements which have no real connection with commercial or “business format” franchising – for instance television, legal aid or train franchises. Equally some commercial franchises do not call themselves a franchise, preferring instead to refer to their arrangements as partnerships (not to be recommended!), licenses, or by some other term. In the UK having a clear definition of franchising is not terribly important, at least, from a legal perspective, because there are no laws which apply specifically to franchises and therefore trying to establish whether you are or are not a franchise is not, generally speaking, something which arises very often. In other countries such as Italy, Canada, USA and Australia which do have franchise specific franchise laws knowing whether your commercial arrangements are franchises is very important.

Although not legally significant it’s a good starting point to have a clear understanding of what is or is not a franchise. Business format franchising contains four essential elements:

- the franchisor allows the franchisee to use a name which is associated with the franchisor;

- the franchisor exercises continuing control over the franchisee;

- the franchisor provides assistance to the franchisee; and

- the franchisee has periodically to make payments to the franchisor.

These elements are reflected – although the language makes it difficult to decipher - in the European Franchise Federation definition of franchising (which has been adopted by the British Franchise Association (“the BFA”)) and is set out below:

“Franchising is a system of marketing goods and/or services and/or technology, which is based upon a close and ongoing collaboration between legally and financially separate and independent undertakings, the Franchisor and its Individual Franchisees, whereby the Franchisor grants its Individual Franchisees the right, and imposes the obligation, to conduct a business in accordance with the Franchisor’s concept. The right entitles and compels the Individual Franchisee, in exchange for a direct or indirect financial consideration, to use the Franchisor’s trade name, and/or trade mark and/or service mark, know how, business and technical methods, procedural system, and other industrial and/or intellectual property rights, supported by continuing provision of commercial and technical assistance, within the framework and for the term of a written franchise agreement, concluded between parties for this purpose.”

The definition is wide enough to include “man and a van” operations as well as multi million pound hotel franchises but franchising is different from other arrangements for distributing products or services such as:

Distribution. A manufacturer or sometimes wholesaler appoints an independent third party to market its goods. The independent third party purchases the goods on his own account and trades under his own name. His business name will usually have no connection with the name of the wholesaler or manufacturer. Nor will the supplier regulate the way in which the distributor operates his business other than, perhaps, to oblige the distributor to reach minimum turnover levels, to undertake advertising, to maintain minimum stocks both of goods and spare parts and to provide servicing. These provisions are much less extensive than the obligations which a franchisor seeks to impose on its franchisees. Further, in franchising there is almost always a requirement to pay the franchisor an initial and continuing fees. The continuing fees contains the franchisor’s profit. In a distribution arrangement the supplier’s profit arises from the difference between the price at which he manufactures or which he pays for the goods and the price at which he is able to sell the goods to the distributor.

Franchising is different from distribution but franchise agreements do have many of the features of a distribution agreement from which franchise agreements developed.

Agency. Agents do not purchase products in their own name. All contracts are made either directly by the supplier and the ultimate customer or by the agent on behalf of the supplier. A supplier imposes relatively few restrictions on his agent and these normally relate to the agent’s powers to incur liabilities on behalf of the supplier. Some franchises do, however, contain an agency-principal relationship. This frequently occurs in parcels delivery franchises where contracts with customers are generally entered into by the franchisor but delivery and collection is effected through franchisees.

Licensing. Intellectual property rights (such as trade marks) or know how are frequently licensed to another manufacturer to enable that manufacturer to produce and/or sell goods. Whilst most franchise agreements contain a license to use the franchisor’s trade mark, brand names and know how, franchise agreements are unlikely to relate to the manufacture of products, and a franchisor will seek to regulate the way in which the franchisee operates his business in much more detail than a simple license agreement which normally regulates only quality control issues. That having been said, some “low cost” franchises are little more than licenses.

In practice these clear distinctions between franchising and other distribution arrangements are sometimes, for perfectly good commercial reasons, blurred but mostly the “purer” the form of franchising which is adopted the greater the chance of success.

II. ADVANTAGES/DISADVANTAGES OF FRANCHISING

Any number of reasons is put forward as to why franchising has substantial advantages, but broadly the perceived advantages of franchising for a franchisor are:

- the availability of finance for growth;

- harnessing the motivation of franchisees; and

- speed of network expansion.

These advantages will not arise “automatically”. These elements only occur when a franchisor does it right.

Availability of finance - The leading UK banks all have franchise units which seek to provide finance to franchisors and their franchisees.

Where banks are prepared to make funds available to franchisees, the general rule of thumb is that they will match pound for pound every pound provided by a franchisee. For highly rated and successful franchises banks may be prepared to lend on ratios of 1:2 or even 1:3. In exceptional cases banks have been known to provide 100% of the finance to franchisees wishing to take up an established franchise.

Franchisors must give themselves the best possible chance of securing finance for their franchisees. To do this they need to know what banks look for when deciding whether to lend to franchisees. Broadly, banks look for the following:

- is there a proven demand for the products or services?

- has the franchisor sufficient business, financial and managerial resources to develop a franchise network adequately?

- are the profit margins sufficient for both a franchisor and a franchisee to operate viable businesses? A split for each outlet of 70/75% for the franchisee and 25/30% for the franchisor of the net profit before drawings, interest payments, taxation and depreciation is a good starting point.

- is the franchisor a member of the national franchise association or planning to join?

- the period of the loan should not generally exceed the initial term of the franchise agreement.

- has the franchise agreement been prepared by a recognized and experienced franchise lawyer?

- does the franchisor have sufficient procedures in place to track the performance of franchisees and, in particular, are there early warning systems to alert a franchisor if things go wrong? Ideally, these systems should be IT based.

- how “choosey” is the franchisor in selecting franchisees and what are its profiling and selection procedures?

- initial fees should cover the franchisor’s costs but should not include any significant profit element for the franchisor, and the on going fees should provide an equitable split based on the 70/75%/25/30% ratio referred to above.

- the training programs provided by franchisors should not only relate to technical matters but should also include marketing, financial and business management. This is an area which is usually considered to be important.

- the franchisor has a recognized brand and ideally a registered trade mark.

- the franchisor should be constantly seeking to innovate and improve its products or services.

- the on going services provided to franchisees in relation to marketing, purchasing, training and field support has to be of a high quality and the management service fee should be based on the level of such support.

Motivation - The argument is that franchisees have a stake in their own business and this will be motivating because they will know that the effort that they put in will have a direct impact on their remuneration. This may not be true of employees and may not even be true of employees who have their remuneration linked to their performance. Unfortunately, the evidence suggests that a number of prospective franchisees fail to distinguish between operating their own franchise business and having a job.

Provided that the recruitment criteria and procedures are rigorously enforced there is certainly anecdotal evidence to support the view that franchisees perform better than employees. One leading UK optician which has been franchising for a considerable period of time and which initially franchised its more marginal outlets in terms of size or location found that franchisees were able radically to improve the performance of these outlets. McDonald’s UK has recently announced that it intends substantially to reduce the number of company owned outlets in the UK and to franchise them on the basis that the evidence is that their franchised outlets perform better. This is undoubtedly true when the right franchisees have been recruited but will not be true if recruitment criteria aimed at selecting only those with drive and enthusiasm are not rigorously enforced.

Speed of network expansion - The suggestion that franchising enables rapid expansion is, of course, linked to the availability of finance which, as already discussed, may not be readily available to new franchisors or those with a significant number of franchisee failures.

Further the cost of launching a franchise can by high. A recent survey has indicated that the average cost of launching a franchise in the UK is now £166,000, broken down as follows:

£
Lawyers, Consultants and Accountants / 10,600
Staff and Franchisee recruitment costs / 21,800
Advertising, Marketing and Market Research / 24,700
Pilot Scheme / 11,600
IT / 19,200
87,900

Great care needs to be taken with these figures which will undoubtedly vary from franchise to franchise. Many believe that the figures substantially overstate the cost of launching a franchise and certainly the figures include the proverbial “kitchen sink” but prospective franchisors do tend to underestimate the costs involved. What you can say with certainty is that launching a franchise is not a cheap exercise!


Franchising does, of course, also have disadvantages for a franchisor as follows:

- Whilst the franchise agreement will impose substantial restrictions and obligations on franchisees, it is important to remember that franchisees are independent third parties who will be seeking to maximize their profits, sometimes at the expense of the franchisor. It is important for the franchisor to keep a very close eye on franchisees because one “rotten egg” may well affect the good name and reputation of the entire franchise network.

- Part of the franchisor’s profit element is used in supporting an additional entity, the franchisee, in the distribution chain.

- In involving third parties in their business, franchisors have to divulge substantial know how and information concerning their business. The franchise agreement will contain restrictions on the franchisee’s ability to make use of this information for his own purposes, but such provisions are usually difficult and expensive to enforce.

- The skills required to get the best out of franchisees and provide the back up required are different from those involved in operating a business through employees.

III. IS THE BUSINESS FRANCHISABLE?

In order for a business to be capable of being franchised it has to be capable of being replicated, must be able to last for so long as there are franchisees and the franchisee must be able to operate the franchise profitably.

Whilst it is possible for a franchise to be launched successfully on the basis of simply an “idea” this is not to be recommended. Certainly franchisors who launch a franchise without pilot testing, will find it difficult to recruit franchisees.

Essentially all businesses are franchisable except for the following:

- creative businesses – those businesses which require particular skills whether of an artistic or creative nature which cannot be easily taught. In other words it is most unlikely that a design business which requires the flair of a designer could be replicated and franchised. That having been said there are existing successful networks of franchised hairdressers in the UK under which franchisees are required to recruit stylists, so provided that the franchise does not depend on the franchisee himself being taught skills which, in practice, he is unlikely to have or is unlikely to be able to learn in a relatively short period of time even creative businesses can be franchised.

- technical businesses – are unlikely to be franchisable because in the great majority of franchises a relatively short period of induction training is provided by the franchisor. Whilst in some high cost franchises such as McDonald’s very extensive training over a long period of time is provided, this is very much the exception to the rule. If a franchise requires a high level of technical expertise in a highly technical area this is unlikely to be franchisable unless the franchisor takes on franchisees who already have that technical expertise or the technical aspects are referred back to the franchisor so that, in effect, franchisees are salesmen or the interface with the customer. The BFA may have some doubts as to whether this type of franchise is a genuine business format franchise which would satisfy its criteria.