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As background to this article, I would like to reference the recently distributed Asian American Hotel Owners Association (“AAHOA”) publication that listed their 12 points for fair franchising. (AAHOA is an influential hotel group.) This publication addressed the Association’s view of an appropriate franchise relationship and what the corresponding agreements should include. Stanley Turkel, a prominent franchise specialist, wrote a follow up article, “Fair Franchising Is Not An Oxymoron: No. 2 AAHOA’s 12 Points of Fair Franchising,” that elaborated on each of the publication’s points.
Using these two resources as background, this month’s column will address some of the AAHOA points with an eye toward providing the franchisor with effective standards to promote a franchisee receptive system.
Point No. 1 - Termination of the Franchise for Business Reasons.
A. The Problem. Many franchise agreements have no provision for a struggling franchisee to terminate its franchise prior to the expiration date. The agreements are very one-sided (pro-franchisor) as the franchisee has little ability to effectively terminate. This situation recently occurred for a client of ours who had been losing $100,000 per year on a single unit for a period of ten years. Our client approached the franchisor (probably a little late) concerning a termination of its franchise agreement, and the franchisor refused. We have seen this happen many times.
B. The Solution. In order to maintain a good franchisor/franchisee relationship, the franchise agreement should provide the franchisee with the option to exit the system if certain reasonable sales and profitability expectations are not met. (For example, the franchisee is unable to make a profit for a period of two to three years or comparable sales are in the neighborhood of 60 to 70 percent of the system-wide average.) The criteria to provide objective standards for termination may be difficult but can certainly be accomplished.
C. Franchisor’s Point. In nearly all franchise systems the franchisor is entitled to receive the franchisee’s financial statements. A franchisee’s financials that show a consistent loss of money should be an immediate signal to the franchisor that this franchisee needs help. Perhaps having a grace period of two to three years for the struggling franchisee may be a good bargaining point for both sides.
D. Conclusion. A struggling franchisee should not be burdened with a liquidated damages clause whereby the franchisor can, in effect, collect the present value of future royalties. The franchise agreement should provide for some type of reasonable transition (such as six to nine months of royalties) if a franchisee wants to terminate after several years of nonprofitability. This solution gives the franchisor some economic cushion without continuing to burden the franchisee.
Point No. 2 - Modification of Development Schedules. A major issue in today’s market is the franchisee’s inability to perform under a development agreement. In most cases, the lack of performance is not due to a lack of desire.
A. The Problem. The three major reasons franchisees do not develop are: (i) the unavailability of sites; (ii) the slow performance of the developed sites; and (iii) the cost of sites. We have many clients who have developed five or six franchise units and by the time the franchisee completes the last unit, none of the units are profitable. At that point the franchisee realizes the underlying issues.
B. The Solution. The development agreement should have a self-controlling provision that states if units come online and their sales growth is slower than anticipated, the development schedules can be modified to slow down required development. There should be an automatic trigger recognizing the business matters. Additionally, if there is a system-wide downturn, the development agreement should have an automatic stay provision where no development is necessary until comparable sales have returned to positive levels.
Point No. 3 - Disclosure and Accountability.
The Problem and Solution. The AAHOA stated the franchisor should provide a full disclosure of the collected royalty fees, expenditures and any type of hidden costs. The franchisor’s records should be audited annually concerning the collection and disbursement of marketing and advertising dollars. These are good steps toward accountability.
Point No. 4 - Relationships with the Franchisees.
The Problem and Solution. Good franchise systems provide for the ability to establish an advisory council, marketing and advertising committees, and, in general, full involvement of the franchisee in the development of new products and services. These items should be specifically provided for in the franchise documents and not just given lip service.
Point No. 5 - Cooperation with Financing Sources.
A. The Problem. A major problem I have seen over the years is a franchisor’s lack of desire to cooperate with its franchisee in obtaining financing. Many franchisors have a list of franchise finance contacts but the process usually stops with that list. Franchisors need to recognize the current credit crunch and take active steps to help their franchisees secure financing.
B. The Solution. Some key financing solutions would be to: (i) give the financing source the rights to sell the franchise units as an ongoing business; (ii) do away with unnecessary assignment of leases; (iii) notify the financing source of any problems the franchisee may have that will lead to a potential default; (iv) have a realistic approach for removal of the operator in the case of default due to poor performance; and (iv) recognize modern financing structures (such as the use of private equity, mezzanine financing, seller financing and other creative approaches, including the use of hedge funds with high leverage situations but low amortization and good fixed charge coverages).
Point No. 6 - Dispute Resolution.
The Problem and Solution. In general, Franchise Agreements are antiquated concerning dispute resolution. Most franchise agreements provide for an arbitration process but prior to arbitration, the franchisor should provide for nonbinding mediation where issues can hopefully be resolved quickly and maybe even without lawyers. Further, if the franchisor is going to take action, the arbitration venue should be where the troubled location is or the franchisee’s place of business. (Far away venues are burdensome and do not facilitate settlement.)
Point No. 7 - Transferability.
A. The Problem. Most transfer provisions are vague and allow the franchisor tremendous latitude in the transfer process. The process of transferring franchises has become arduous and fraught with so much uncertainty that sometimes a selling franchisee gets frustrated and decides not to sell. With the growing number of older franchisees, this transfer issue is becoming more critical.
B. The Solution. The UFOC needs to clearly delineate the approval process for a franchise transfer so the selling franchisee understands what is necessary to receive the franchisor’s approval. This means providing the exact form for financial and operational approval of the transferee and a list of all necessary supporting documents. The timeframe for franchisor approval should be quick because when a franchisor takes excessive time to evaluate the potential new franchisee, the business deal unravels and the transaction expenses (particularly legal fees) escalate.
Conclusion.
Recognizing the current business environment, the above items are just a few key points for the franchise community to consider. The goal for the industry should be to work toward mutually fair positions for both the franchisee and franchisor.
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