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Drafting an effective franchise agreement - Part 3

Written by : Thomas M. Pitegoff
2009-11-15

Term and renewal

The term of the franchise agreement and renewal rights directly affect the value of the franchise. The term of most franchise agreements ranges from five to twenty years, and most franchise agreements grant to the franchisee the right to renew the agreement under certain terms and conditions.

Term

In order to determine the appropriate initial term for a particular franchise system, the franchisor must consider a number of factors that relate to the business plans of the franchisor as well as the marketability of the franchise. In essence, the duration must meet the goals, objectives and desires of both the franchisor and the franchisee.

A short term can maximize the franchisor's flexibility. If the franchisee is not suited to the system, the franchisor may want to look for a better franchisee upon the expiration of the agreement. The franchisee, on the other hand, often wants the security of a longer term. At a minimum, the franchisee will want to be sure that the initial term is long enough to enable the franchisee to recoup his or her initial investment and obtain a reasonable rate of return on such investment. Some franchisors may prefer a long term to discourage franchisees from leaving the system and operating competing businesses without making royalty payments, particularly in those states in which the franchisor will be unable to enforce post-termination covenants against competition.

The shorter the term, the less the franchisor will be able to charge as the initial fee. One reason is that the value of a short term agreement is simply less than that of a long term agreement. Also, upon renewal, the franchisee may be required to make a substantial investment to upgrade and refurbish the premises. The shorter the term, the sooner the franchisee may be required to upgrade and refurbish. The franchisor may have to pay for this flexibility with a lower initial fee. A low fee may be attractive to some prospective franchisees. It may be especially helpful to a franchisor in an unknown market or in a new franchise system.

Cutting across these considerations is the competition factor. The prospective franchisee will be looking at the term offered by competing franchise systems per investment dollar. The competition may be franchises in the same business or in completely different businesses, depending on whether prospective franchisees are looking to enter the type of business being franchised or whether they are looking for the appropriate franchise to buy.

Renewal and Extension

The term "renewal" can have a number of possible meanings. For purposes of this paper, renewal means adding another term after expiration, for such length of time and in such manner as the agreement specifies, on the same terms and conditions as the expiring term. By "extension", we mean the right to enter into a new agreement upon the expiration of the term or renewal term of the agreement. The new agreement would be on the terms then being offered to new franchisees.

While some franchise agreements do not allow for renewal or extension, most allow for one or the other or both. The least desirable approach from the franchisor's point of view would be an agreement that gives the franchisee the right to renew the agreement from term to term indefinitely, because it would lock the franchisor into one form of agreement as long as the franchisee desires. An agreement that allows either party to terminate at the end of any term is better for the franchisor, but is not common in franchising because of the need to take the initial fee into consideration. More typically, the agreement will be for one term, with perhaps one renewal term, with a right of extension if the franchisee so desires, upon the terms of a new franchise. Variations on this approach might include offering an extension for one half of the initial fee then being charged to new franchisees, or for no initial fee at all.

Conditions for Renewal or Extension

The grant of an extension is commonly made subject to certain conditions. Renewals may be made subject to similar conditions. For example, the franchisor may require that the franchisee:

  1. give notice of his or her election to extend;
  2. be in compliance with the terms of the franchise agreement during the initial term;
  3. do all remodeling, modifications, upgrades and investments needed to ensure that the franchise is in compliance with the franchisor's then current standards and specifications;
  4. execute the franchisor's then-current form of franchise agreement and ancillary documents which may provide for different or higher royalties and advertising fees as well as other material changes;
  5. relocate if the lease terms are not satisfactory or the existing location is no longer suitable;
  6. obtain an extension or renewal of the lease if the existing location continues to be suitable;
  7. pay a renewal fee;
  8. execute a general release.
Some franchisors charge another full franchise fee upon renewal or extension. Others simply charge costs incurred in connection with the renewal or extension. Still others forego the requirement of a renewal or extension fee altogether.

The franchisor might also want to reserve the right not to renew or extend the agreement in the event that the franchisor, in its discretion, chooses to withdraw from the market area in which the franchise is located. The franchisor might want to draft this type of provision in accordance with Section 20025(e) of the California Franchise Relation Act, which provides that the franchisor may refuse to renew if it withdraws from distributing its products or services through franchises in the geographic market served by the franchisee provided that

  • the franchisor does not seek to enforce a post-termination covenant against competition;
  • the franchisor's failure to renew is not for the purpose of transferring the franchised business to the franchisor's account; and
  • if the franchisor sells or transfers the franchisee's business premises occupied previously by the franchisee, the franchisee is given a right of first refusal.

    Another approach to extension is that used by McDonald's. McDonald's gives its franchisees an opportunity to cure any deficiencies so that a new franchise may be offered. If the franchisee does not correct the deficiencies within a specified period, McDonald's sends a notice of nonrenewal well in advance of expiration. During this period prior to expiration, the franchisee has the right to sell the franchise to an approved successor franchisee, who will buy the franchise for the remainder of the term plus a new 20-year term. See Roseli, Inc. v. McDonald's Corp., Bus. Franchise Guide. Single Term Agreements Some franchise agreements are for one single term and do not allow for renewal or extension.

    At the end of the term, the parties will either enter into a new agreement or the relationship will expire. This type of agreement is very similar to a commercial office lease for a fixed term with no renewal right. An agreement of this type may make sense in franchising where the franchisor allows the franchisee to continue in business at the same location under a different identity after the expiration of the agreement. The agreement will be worth far less to a franchisee when there is a post-term noncompete requirement.

    Statutory Restrictions Regarding Term and Renewal

    Some states require the franchisor to permit renewal unless the franchisor has "good cause" not to renew.5 It is likely these laws would allow an agreement that clearly and explicitly provides that there will be no renewal to expire in accordance with its terms, although this is not at all certain. Courts have not squarely faced this issue, probably because franchisors, as a practical matter, allow good franchisees to renew and there is always arguable cause for nonrenewal in other cases.
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