When a prospective franchisee is looking at purchasing a franchise operation, they are buying various rights. These include the intellectual property behind the franchise system, the support of the franchisor on an ongoing basis to assist in a successful business and, more often that not, the right to sell the goods or services that are the subject of the franchise within a specified territory.
Just what may define a territory differs from franchise system to franchise system. Territories come in many shapes, sizes and styles. The most common of these are set out as follows:
Exclusive territories
When a franchise is being sold with an exclusive territory this means that the franchise agreement will contain details of an exclusive area in which the franchisor will not set up another franchise to compete with the franchisee that holds that territory. In many cases a map is attached to the franchise agreement to highlight the exclusive area of the franchisee. Depending on the type of franchise this could be anywhere from a specific address or premises, such as a certain shopping mall or defined suburbs, through to cities or even wider geographical areas. The theory behind such territories is that a franchisee can establish their business without the threat of someone else within the same franchise system setting up in competition with them. Of course, this does not prohibit competitors from outside the franchise system competing with their business.
Non exclusive territories
Non exclusive territories often define the area that franchisees are allowed to trade within, but they allow the franchisor to sell franchises to other prospective franchisees within that territory also. Such systems effectively allow franchisees to sell their products or services within that territory but they have restrictions on them trading outside of it. The freedom of the franchisor to sell other franchises within that area is retained in the belief over time that the territory could sustain an increase in the number of franchisees. The franchisor reserves the right to sell additional franchises at the appropriate times.
In such circumstances the franchisee must trust the franchisor not to over-saturate the market with franchises so that their franchise business will become diluted to the extent that it does not provide an appropriate return. An astute franchisor will not over-saturate the market because such action will lead to dissatisfied franchisees, which in turn leads to major disputes within the franchise system. Disharmony in a franchise system causes a loss of focus for all concerned and can lead to a loss in profitability.
A prospective franchisee needs to be wary of a franchisor that is looking for a quick profit by way of the sale of new franchises into non exclusive territories, especially if that market already has a number of participants. Meeting as many existing franchisees as possible and discussing the system with them is advisable to ensure that not only are they comfortable with the franchise system generally but that they are comfortable that the market can sustain another franchisee. The better franchisors focus on earning income through the operation of the franchise and the royalties generated through franchisee sales rather than cannabalising franchise territories by selling new franchises into them for an upfront fee, when the addition of a new franchisee will not increase the level of franchisee sales at all.
Changes to territories
Many franchise agreements, even those that provide for exclusive territories, give the franchisor the right to change the territory or alternatively start up a new franchise within the territory should circumstances arise that will allow the territory to sustain another franchise operation. Such circumstances may include a change of demographics within the franchise territory or a development in the technology used by the franchise system that makes it a market leader and in turn results in a much greater demand for the product or service being offered within the franchise system. It is not uncommon to see a right given to the franchisee which requires the franchisor to offer the franchisee the first right of refusal to purchase the new franchise operation commencing within the territory. That way the franchisee would have the opportunity to expand its business and keep the territory exclusively for itself. In successful franchise systems franchisees often tend to exercise such rights when expansion opportunities come along, and where franchisees take the opportunity to invest further in a system this can often be taken as a strong sign of a successful and well run franchise.
Franchisors often also reserve the right to sell a new franchise into a franchisee’s territory where the franchisee is under performing or failing to meet preset minimum key performance indicators. This is understandable from a franchisor’s perspective as it cannot afford to have what could otherwise be a high performing territory failing to produce appropriate levels of income because of the lack of franchisee achievement. In such circumstances a franchisee would normally have received feedback and warnings from a franchisor that it’s performance is not up to the required standard. It should also have been given training, assistance and/or advice from the franchisor to try to turn the direction of the business around and it will be aware that the introduction of a new franchisee to the territory is one of a number of possible consequences that may be faced if performance does not improve.
Types of territories
When people think of territories they tend to think of geographical areas. In the majority of cases that is how territories are derived. However, depending on the type of franchise system and how business is attracted, territories can be split up using a variety of methods. A good example of this is where business is derived via the telephone, for example pizza franchises that provide home delivery. In such cases territories may literally be divided up between franchisees by allocating different telephone exchanges between them, with calls routed through the different telephone exchanges going directly to the franchisee concerned.
Problems with territories
One of the major problems that can occur with exclusive territories is when a franchisee attracts business from outside of its allocated territory. Some franchise agreements recognise that this may occur and they attempt to deal with this issue in advance. Solutions range from an absolute prohibition on trading with a customer from outside the territory, to allowing such a transaction to occur but requiring the franchisee to make a payment to the franchisee of the territory that the customer came from.
Such problems often occur in franchise systems where there is a service being offered to customers on a mobile basis, for example gardening and lawn mowing services where a franchisee receives a referral and attracts business from outside of its agreed territory. The problem can also arise when a franchisee has an existing client within its territory and that customer moves premises outside of the territory but wishes to continue using the services of their existing provider rather than contracting the franchisee for the territory that they have moved to.
A good franchise agreement will have clear guidelines to deal with such issues and rules dealing with the allocation of work. It is not uncommon to see a provision in franchise agreements where customers contact a franchise system through a toll free number so that the work is always referred to the franchisee that has control of the territory, but they can be referred to other franchisees if the franchisee for the territory is too busy to meet the service guidelines of the franchise or that particular customers requirements. Such situations must be clearly defined and consistently adhered to so as to avoid disputes between franchisees.
In scenarios where issues can arise between neighbouring territories there are often strict controls on how advertising can be carried out so that one franchisee is not seen to be attempting to attract business from the territory of another franchisee. There are often controls on whether an individual franchisee can have its own website. It is more normal for there to be one website for the whole franchise system that is controlled by the franchisor.
Issues have also arisen with the recent growth of internet sales. This has caused disputes within franchise systems as this source of sales has opened up opportunities for franchisors that may not have been originally contemplated. Whilst many franchise agreements may provide an exclusive geographical or other type of territory for a franchisee, older franchise agreements may never have even contemplated online sales. Many franchise agreements that do provide for online sales actually reserve the right for the franchisor to sell products or services online. An ideal scenario from a franchisee’s perspective would be for some type of payment to be made to the franchisee of a territory if the franchisor makes a sale by internet to a potential customer within that territory. This however can be difficult for a franchisee to monitor.
The writer has recently been involved in a franchise system that was able to revolutionise the way a service was delivered through the use of the internet but, unfortunately for the franchisees, the delivery of online seminars and advice to customers by the franchisor caused the loss of a significant revenue stream for them, which affected the viability of their businesses. The franchise agreement allowed the franchisor to use the internet, but as the agreement had been prepared ten years ago, the use of the internet by the franchisor in the manner that caused the issue had not been contemplated by any of the parties as it was only the recent expansion of broadband capability throughout New Zealand that enabled them to offer the online services that saw the franchisor competing with its franchisees. Whilst many franchise agreements contain a disputes resolution procedure, it relies on the goodwill of the parties concerned to try and reach an amicable solution. There is currently no general duty in New Zealand for franchisors and franchisees to act in good faith towards each other so such disputes often result in one party being detrimentally affected whilst the other receives a windfall.
Summary
Every franchise agreement is different, and the rights and privileges obtained under the agreement will differ in each case too. It is extremely important to minimise unpleasant surprises and to properly understand exactly what rights a prospective franchisee is purchasing when buying into a franchise system, including knowing the issues surrounding the territory being purchased. Taking advice from a specialist franchise lawyer and liaising with as many existing franchisees as possible are the best ways to understand your rights and to gauge the robustness of the franchise system and the behaviours of the franchisor. They will also give you an indication of the general satisfaction of franchisees with the franchise system. Remember though that having an exclusive territory does not prevent the franchisee from facing competition from any person in the same line of business who is not part of the franchise system.
Mark Sherry is a partner at Harmans Lawyers in Christchurch. He is a franchise specialist. Telephone (03) 352 2293 or email mark.sherry@harmans.co.nz
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