What Is a Franchise Agreement?

With careful planning and a solid local business strategy, opening a franchise can be a smart way to capitalize on an established brand with a proven business model. However, as with any investment, you need to keep a keen eye on your running costs, which means checking the fine print on your franchise agreement so that you know exactly what the parent company expects of you.

In this article, I will break down what exactly a franchise agreement is and what information the agreement should include. I’ll also discuss some red flags to watch out for in franchise agreements and give you some of my top tips for negotiating the terms with a franchisor. Let’s get straight to it!

Key Takeaways

• A franchise agreement is a legally binding contract between a franchisor and a franchisee, outlining the rights and responsibilities of both parties.
• The agreement covers key aspects such as fees, territory, operational requirements, and brand standards that the franchisee must follow.
• Franchise agreements typically include provisions for training, support, and marketing obligations from the franchisor.
• Terms of renewal, termination, and transfer of the franchise are clearly defined within the contract.
• Prospective franchisees should carefully review the agreement with legal and financial advisors before signing.

What Is a Franchise Agreement?

A franchise agreement is a legal contract that sets the terms between the franchisor and the franchisee. It spells out not only what the franchisor will provide, such as brand materials, support, and training, but also your obligations as a franchisee, from royalty payments to non-compliance penalties.

Signing a franchise agreement is one of the final steps you take when you purchase a new franchise. So, it is essential to thoroughly read through the agreement to ensure that you fully understand what is expected of you.

Many prospective franchisees ask me whether it’s normal for the franchisor to write the terms of the franchise agreement. While it is true that franchisors tend to write up the contract, franchisees do have a chance to negotiate the terms. In the end, as long as the terms are fair, a franchise agreement should be mutually beneficial, allowing the franchisor to protect its brand and for you to protect yourself and your investment.

What Is Included in a Franchise Agreement?

The franchise agreement is a highly important document. Once signed, you are officially a franchise owner. That said, before you jump the gun and sign the contract, I recommend going through the details of the agreement with a fine-toothed comb. Reputable franchisors might not intentionally pull the wool over your eyes, but many franchisees are caught out by overlooked fees and unforeseen local competition.

Here are some of the most important elements of a franchise agreement.

Grant and Term

Your franchise contract will likely state the territory in which you are permitted to use the franchisor’s trademarks and provide their services. Some franchise agreements give you exclusive rights to a particular territory – but many don’t. If you don’t have exclusive rights to a territory, you should remember that a competing franchise of the same brand could open in your local area, taking away from your customer base.

You’ll also find the details of your term length, which is usually offered in intervals of five to ten years. A franchise agreement with a short term might sound like the least risky option, but it’s worth bearing in mind that it usually takes at least a year (and generally longer) for a franchise to become profitable. That said, you should balance this against the drawbacks of a long-term agreement – tying into a long agreement might demand a significant financial commitment. Market demand for the franchise may change over time, so it’s good practice to avoid agreements that last more than 20 years.

Fees

Naturally, the franchisor will make most of their payment terms explicitly clear. After all, they don’t want to leave any wiggle room when it comes to their profits. Your franchise agreement will define the initial franchise fee as well as ongoing royalty fees or marketing payments you’re liable to pay to the franchisor. Most importantly, the agreement will include the royalty structure, which could be a flat fee paid periodically or a percentage of your revenue. More often than not, your royalty payments will be based on your revenue rather than your profits – something to keep in mind when checking through your franchise agreement.

Initial Training and Ongoing Support

In many cases, franchisors will provide training to the franchisees so that they can get up and running as quickly as possible. Moreover, the franchisor can ensure your staff upholds its strict brand standards. Your franchise agreement will define the parent company’s training and ongoing support commitments. It may also dictate how many people can undergo training without incurring additional fees and where the training takes place.

Marks and Brand Manual

This section of the franchise agreement explains your restrictions and rights regarding the franchisor’s trademarks. For example, most agreements stipulate that you must not use any branding related to your own entity as opposed to the franchisor’s brand. 

Your agreement also legally requires you to comply with the rules and regulations in your brand manual. The brand manual should clearly define how to operate your franchise in line with the franchisor’s brand guidelines. Unlike the franchise agreement, the brand manual will likely be updated periodically, and you’ll be required to comply with the updates as per the franchise agreement.

Site Selection and Development Schedule

Franchisors generally set certain rules, expectations, and standards regarding the franchise’s location and property. This helps the franchisor maintain their established reputation and maximize the chances of your business being a success.

In most cases, the parent company will state in the franchise agreement that you must obtain the franchisor’s permission before signing the lease on a property. It may also define terms such as development timelines and the responsibilities of the franchisor and franchisee regarding the build-out process.

Advertising

When reading your franchise agreement, pay close attention to your advertising rights. Although you may not initially intend to invest in marketing, your plans can change as the business starts to take shape.

In many cases, the franchisor will handle the advertising efforts, and you’ll be required to contribute to an advertising fund. Your franchisor will then decide how and where to allocate your contributions. That said, this isn’t always the case. Some agreements may require you to handle the advertising in your local area on behalf of your franchisor.

It’s also worth mentioning that some franchisors expect their franchisees to pay for a “grand opening” to kickstart marketing efforts in a new territory.

Disputes

As you’re probably aware, disagreements are far from rare in the world of business. Your franchise agreement will also lay out the procedures that help settle disputes and conflicts between you and your franchisor. It may spell out conflict resolution terms such as the choice of law, venue, damage limitations, and when and whether arbitration, mediation, or litigation is required.

If you are unsure about any of these dispute rules, I recommend having your attorney review the document and point out any red flags.

Indemnification and Insurance

The indemnification section of your franchise agreement explains that both you (the franchisee) and the franchisor agree to protect each other from certain costs or problems that may arise during your franchise term. For example, you may not be liable to cover legal fees if you are sued for something your franchisor did (such as supplying a bad batch of products). 

You’ll also find the terms of any insurance policies that you’ll be required to purchase. Most franchisors require franchisees to purchase general liability, commercial property, and worker’s compensation insurance policies. Additionally, many franchise agreements state that your insurance policy must include your franchisor as a covered party.

Transfers and Assignments

Your franchise agreement will dictate if and how you can transfer the agreement to another individual or entity, i.e., whether you can sell your franchise before the end of your lease and how you can do it. 

You’ll likely need approval from your franchisor before transferring your agreement. Whoever you wish to transfer the agreement to must prove they can uphold the franchisor’s brand standards. In most situations, you will also have to pay some fees and expenses to transfer the franchise agreement.

Termination and Post-Termination

You’ll find the terms of termination in your franchise agreement, which are the rules and processes for ending the business arrangement between you and your franchisor. Your contract will likely state the criteria for an immediate termination, where there’s no chance for remediation, or a termination with a time to fix, where you’re given a chance to rectify issues to prevent the termination (a very serious final warning, in essence).

Franchise Agreement vs. Franchise Disclosure Document

The franchise agreement represents the legal foundation for the relationship between you and your franchisor, while the franchise disclosure document (FDD) provides you with detailed information about the franchise before you sign the franchise agreement. 

The FDD includes information such as the franchisor’s financials, history, lawsuits, and overall performance. Essentially, the FDD lets you know who you’re getting into bed with. In the US, your franchisor must provide you with an FDD at least 14 days before you sign the franchise agreement.

You can think of the franchise agreement as a legally binding marriage and the FDD as the dating period. With the FDD, you get to know your potential franchisor inside and out, gaining insights into their reputation, background, and expectations. If you don’t like what you see with the FDD, you can get out before tying the knot. The franchise agreement finalizes your relationship. Once signed, it can be legally enforced, and breaching the terms can result in penalties.

Red Flags to Look Out for Before Signing a Franchise Agreement

Opening a franchise can be a smart investment strategy. However, like all investments, franchises have risks. Knowing what to look out for before signing your franchise agreement can significantly mitigate these risks. Make sure to ask your franchisor the right questions, too.

High Initial Fees

If your franchisor charges exorbitant initial fees compared to a competitor, you should find out why. It could be due to the franchisor’s unbeatable investment opportunity. Or, it might be more concerned with the franchisor attempting to generate most of its revenue from the initial fee. Well-known franchisors may charge high initial fees if they already have locations in most territories and don’t expect to see a high long-term return.

Most reputable parent companies don’t earn profit from these initial fees. The franchise fee helps cover the initial expenses of opening the franchise, while the ongoing royalty payments are where the franchisor really makes a profit.

Lack of Experience

Franchisors new to the game may offer attractively low royalty and start-up fees to potential franchisees. While this may represent a good opportunity, it’s worth remembering that the royalty fee is more than just a pesky expense – it’s what gives you access to a proven business model and a brand with a loyal customer base.

Turnover

In many cases, you might want to stay away from franchisors that seem to have more shops closing than opening. Also, double-check whether your franchisor has a high number of sold franchises that have yet to open. This is a major red flag as it can signal that this franchisor invests very little resources in the success of its franchises.

Litigation

Some franchisors constantly find themselves in legal disputes with their franchisees. Of course, there are countless occasions when franchisees have their agreements terminated for valid reasons. But if a franchisor is in the habit of terminating contracts, it could suggest they’re very good at finding problems when it works in their favor.

Territory

As I touched on above, territory rights are a major source of contention between franchisors and franchisees. If your finance agreement does not give you exclusive rights to a territory, there may be nothing preventing a franchise from the same brand opening in your neighborhood, which can cause your revenue to take a serious hit at no cost to your franchisor.

Item 19

Item 19 states the franchisor’s financial performance and is usually included in your FDD rather than your finance agreement. However, not all franchisors disclose an item 19, which is a red flag. The parent company may have legitimate reasons for withholding their financials, such as if they’re just starting out, but I recommend doing some additional research before signing the franchise agreement.

Non-Compete

If you sign a franchise agreement with a lengthy non-compete clause, you might be limited with regard to investment opportunities during or after operating the franchise. Make sure to read through any non-compete clauses to ensure they are fair.

How to Negotiate the Terms of a Franchise Agreement

The fact that franchisors usually write them can make the terms of franchise agreements seem one-sided. In some cases, they are, but franchisors have a business obligation to protect their brand. Many terms will likely be non-negotiable, such as your territory and term rights, operating rules, and brand guidelines. For large franchises, royalty fees are often fixed, but this is one area where you may have a tiny bit of wriggle room.

With the help of an expert or business attorney, you might be able to negotiate terms such as your franchisor’s support commitments, the initial investment fee, rights to an exclusive territory, and potentially periodic modifications to royalty payments based on performance. 

It’s worth noting that, as it likely goes without saying, franchisors are often highly resistant to amending the terms they wrote in your finance agreement. This is why I highly recommend hiring an experienced attorney with proven negotiation skills to help you finalize your franchise contract.

Ready to Start Looking for Franchises?

The foundation of any franchising relationship is the all-important franchise agreement. This document clearly outlines the terms, expectations, and protections for both franchisors and franchisees. Understanding the details of this contract is key to making an informed decision, as negotiating the right terms can set you up for success. Whether you’re new to franchising or simply refining your understanding, Franzy will guide you every step of the way. Our mission is to connect you with trusted franchisors and offer resources to help you navigate agreements with confidence.