From the IFA's Legal Symposium

Franchisors have been reluctant to deviate from their standard form because uniform contracts have many benefits for them, said Karen Satterlee, vice president and senior counsel, global franchise development, for Hilton Worldwide. Uniform contracts ease management of brand identity, enable franchisors to change the system in a lock-step fashion when necessary, simplify contract administration, provide equal treatment of all franchisees, and can be written to minimize the risk of adverse outcomes in litigation, she said.

However, those virtues will have to be balanced with the business imperatives of working with the new breed of franchise purchasers. “In order to grow, franchisors must close deals, and that may not be possible without some level of negotiation,” Satterlee said. “As a result, franchise agreements have become more complex.”

These new franchisees might be private equity investors that are seeking to operate many franchise outlets or to control large, exclusive territories. They might be individual owner-operators who have extensive franchising experience and have built a management team to operate additional outlets or to purchase franchises in another brand. “To get a sophisticated franchisee to the table, a franchisor must recognize that they have strong business skills and have [access to] a good lawyer,” said Mark Friedman, senior vice president, general counsel and secretary for Pinkberry.

Given their sophistication and their substantial investment in the brand, these types of franchisees will expect to have a voice in the development of the brand, Friedman said. Franchisees that are backed with bank capital will seek greater security for that capital by having stronger protection against termination or nonrenewal, and the banks will insist that they have first rights to the franchisee's assets.

Franchisees backed by investors look at the expected return on their investment differently than does an individual who is aiming to earn an income from one or two units, added Ann Hurwitz, a partner with Baker Botts, L.L.P. in Dallas. “Think about a very successful area developer franchisee,” she said. “You want them as a partner; they are a great steward of your brand. But they are going to look at how they can get their equity back out of the franchise when it's time to sell.”

Investor-franchisees change the dynamic other ways, too. For example, they will bring in minority owners of their franchise as a way to raise capital. The investor is spreading his risk and getting a return on his investment ' perfectly legitimate business decisions. But few standard franchise contracts account for this activity. “A franchisor would respond that it needs to know who it is doing business with,” said Hurwitz. “Maybe the compromise is that the franchisor accepts that another operator is added, if the rules in the contract define who it can be and how large a stake in the venture can be sold.”

Another complication can arise if the parties in an investor group need to dissolve their partnership. “How do you fire a person who has a 20% interest as an owner-operator?” asked Hurwitz. “If the majority owner is absentee and the minority owner is the operator, who is trained to take over if the minority owner leaves?”

Often, private equity firms have investments spread across multiple companies in the same industry. From their perspective, it's smart business, as they seek to build synergistically on the knowledge they have gained in that field. But from a franchisor's perspective, that could represent an investment in a direct competitor. “A standard franchise agreement will include non-competition clauses, and the franchisor has a legitimate interest in protecting against competitors,” said Friedman. “The sophisticated franchisee wants to deploy its capital where it has investment expertise.” He recommended adjusting non-compete clauses on a case-by-case basis when those conflicts occur.

Other issues on which sophisticated franchisors are likely to seek to negotiate contract terms include: franchisees' ability to cure violations without being terminated; fees for renewals; territorial rights (both geographic and in development of nontraditional outlets); requirements that the franchise owner is also the operator (given that most investor-owners have created management teams to run the actual operation); and performance guarantees.

Negotiating for Nontraditional Outlets

Selling franchises in non-traditional venues brings a different set of challenges to the standardization of the franchise contract. Often the venue itself has strict operational rules that are enforced by a master concessionaire ' itself a large company with layers of management. The franchisor must accept the venue's and concessionaire's rules if it wishes to open a unit, and those rules could be in conflict with the franchisor's brand model and contract.

Satterlee cited a quick-serve restaurant franchise operating in an airport as an example. The airport probably has high traffic early in the morning. The restaurant brand might not have breakfast items to meet that demand, but a franchisee might suggest adding a breakfast menu. “What foods match the franchise's brand, how much do you charge, what are your brand standards ' these are some of the questions that must be resolved,” she said. “From a franchisor's perspective, this can set a dangerous precedent, as other franchisees might want to get into the breakfast business.” Also, if the breakfast items are popular, a dispute can arise about who owns the intellectual property.

Franchises operating in a nontraditional venue might balk at paying into the advertising fund, said Friedman. They could argue that they have a captive audience at a college or airport, so they are not really benefiting from traffic generated by advertising. “Clearly they are not getting the full benefit of the brand's marketing program, so maybe you cut them a break on the fee,” said Friedman. “However, we have learned [at Pinkberry] that some local advertising will drive traffic for those venues, so I will require our franchises to do some advertising.”

Other issues that can arise for nontraditional venues include: length of term of initial franchise contract (for which specialty venues often prefer shorter terms than franchisors); venues that require use of their point-of-sales system instead of the franchisor's; dispute mechanisms; jurisdiction for dispute resolution; and non-compete restrictions on the master concessionaire for the venue.

Types of Negotiated Contracts

Given the likely need to negotiate contract provisions, the IFA Legal Symposium presenters outlined three different approaches to negotiating and drafting the contracts. The most conservative is to negotiate from the universal contract form. In this way, the franchisor can probably minimize the number of changes to the contract. However, the presenters indicated that this tactic is not likely to develop a good working relationship with the franchisee, and the administrative challenge of managing unique contracts can be immense. In their written paper, the presenters used as an example a franchisor that agrees to a variable-royalty arrangement for a franchisee in a nontraditional location. But the coding system in the franchisor's database only accepts a fixed-percentage royalty. “These are not inconsequential issues, and it is possible that some deals would cost more to make the system work around them than they are worth from a brand or financial standpoint,” they wrote in their paper.

A second drafting technique is to develop multiple franchise contracts, each of which is standardized to deal with a particular type of franchise unit. For example, a fast food restaurant might have its basic FDD, but create a slightly different FDD for restaurants set up on college campuses, airports and other nontraditional sites. This will make negotiations with franchise buyers more efficient, as well as accommodate the most common demands from concessionaires. Some franchisors have tried to create alternate FDDs for private equity franchisees, but these tend to raise fairness issues. “While a franchisor may be able to explain to a franchisee's satisfaction that product offerings had to be negotiated in an airport setting, it is less easy to explain why any given franchisee can't benefit from the transfer provisions that a franchisor granted a private equity fund,” the presenters noted in their paper.

A third approach is to attach addendums to each FDD that identify any deviation from the standard contract, instead of producing a new franchise contract for each deal. The addendum consolidates all changes into one section of the document. “In [my experience,] ' approaching contract modifications through the use of addendums was a god-send when Hilton Worldwide decided to enter 17,000 franchise documents in a new document database,” Satterlee said. “This contrasted with our negative experience in coding management agreements that varied on a contract-by-contract basis, without structure as to how edits were made over time.” The addendum approach is especially convenient when a franchisor, such as Hilton, operates across numerous brands in the same industry, Satterlee added.

Kevin Adler is the associate editor of FBLA . He can be contacted at [email protected].

In the last several years, private investment groups and wealthy, experienced business owners have showed increased interest in purchasing franchisees. At the same time, food and retail franchisors have moved more deeply into developing units at nontraditional locations, such as airports, colleges and hospitals. These twin developments have been, for the most part, highly positive for the franchising industry.

However, both trends have raised one major challenge for franchisors: negotiating contract terms that deviate from their standard FDD. In order to come to agreements with attractive franchisee prospects or to reflect the unique circumstances of nontraditional venues, franchisors have often had to abandon their take-it-or-leave-it attitude about their form contract. Moving on to the next candidate or the next venue in a tough economy isn't a recipe for brand growth. How franchisors can both satisfy their needs for standardization while meeting the circumstances that arise with sophisticated investors and in nontraditional venues was the subject of a session on advanced contract negotiating and drafting techniques at the IFA's 46th Annual Legal Symposium in May.

Negotiating with Sophisticated Franchisees

Franchisors have been reluctant to deviate from their standard form because uniform contracts have many benefits for them, said Karen Satterlee, vice president and senior counsel, global franchise development, for Hilton Worldwide. Uniform contracts ease management of brand identity, enable franchisors to change the system in a lock-step fashion when necessary, simplify contract administration, provide equal treatment of all franchisees, and can be written to minimize the risk of adverse outcomes in litigation, she said.

However, those virtues will have to be balanced with the business imperatives of working with the new breed of franchise purchasers. “In order to grow, franchisors must close deals, and that may not be possible without some level of negotiation,” Satterlee said. “As a result, franchise agreements have become more complex.”

These new franchisees might be private equity investors that are seeking to operate many franchise outlets or to control large, exclusive territories. They might be individual owner-operators who have extensive franchising experience and have built a management team to operate additional outlets or to purchase franchises in another brand. “To get a sophisticated franchisee to the table, a franchisor must recognize that they have strong business skills and have [access to] a good lawyer,” said Mark Friedman, senior vice president, general counsel and secretary for Pinkberry.

Given their sophistication and their substantial investment in the brand, these types of franchisees will expect to have a voice in the development of the brand, Friedman said. Franchisees that are backed with bank capital will seek greater security for that capital by having stronger protection against termination or nonrenewal, and the banks will insist that they have first rights to the franchisee's assets.

Franchisees backed by investors look at the expected return on their investment differently than does an individual who is aiming to earn an income from one or two units, added Ann Hurwitz, a partner with Baker Botts, L.L.P. in Dallas. “Think about a very successful area developer franchisee,” she said. “You want them as a partner; they are a great steward of your brand. But they are going to look at how they can get their equity back out of the franchise when it's time to sell.”

Investor-franchisees change the dynamic other ways, too. For example, they will bring in minority owners of their franchise as a way to raise capital. The investor is spreading his risk and getting a return on his investment ' perfectly legitimate business decisions. But few standard franchise contracts account for this activity. “A franchisor would respond that it needs to know who it is doing business with,” said Hurwitz. “Maybe the compromise is that the franchisor accepts that another operator is added, if the rules in the contract define who it can be and how large a stake in the venture can be sold.”

Another complication can arise if the parties in an investor group need to dissolve their partnership. “How do you fire a person who has a 20% interest as an owner-operator?” asked Hurwitz. “If the majority owner is absentee and the minority owner is the operator, who is trained to take over if the minority owner leaves?”

Often, private equity firms have investments spread across multiple companies in the same industry. From their perspective, it's smart business, as they seek to build synergistically on the knowledge they have gained in that field. But from a franchisor's perspective, that could represent an investment in a direct competitor. “A standard franchise agreement will include non-competition clauses, and the franchisor has a legitimate interest in protecting against competitors,” said Friedman. “The sophisticated franchisee wants to deploy its capital where it has investment expertise.” He recommended adjusting non-compete clauses on a case-by-case basis when those conflicts occur.

Other issues on which sophisticated franchisors are likely to seek to negotiate contract terms include: franchisees' ability to cure violations without being terminated; fees for renewals; territorial rights (both geographic and in development of nontraditional outlets); requirements that the franchise owner is also the operator (given that most investor-owners have created management teams to run the actual operation); and performance guarantees.

Negotiating for Nontraditional Outlets

Selling franchises in non-traditional venues brings a different set of challenges to the standardization of the franchise contract. Often the venue itself has strict operational rules that are enforced by a master concessionaire ' itself a large company with layers of management. The franchisor must accept the venue's and concessionaire's rules if it wishes to open a unit, and those rules could be in conflict with the franchisor's brand model and contract.

Satterlee cited a quick-serve restaurant franchise operating in an airport as an example. The airport probably has high traffic early in the morning. The restaurant brand might not have breakfast items to meet that demand, but a franchisee might suggest adding a breakfast menu. “What foods match the franchise's brand, how much do you charge, what are your brand standards ' these are some of the questions that must be resolved,” she said. “From a franchisor's perspective, this can set a dangerous precedent, as other franchisees might want to get into the breakfast business.” Also, if the breakfast items are popular, a dispute can arise about who owns the intellectual property.

Franchises operating in a nontraditional venue might balk at paying into the advertising fund, said Friedman. They could argue that they have a captive audience at a college or airport, so they are not really benefiting from traffic generated by advertising. “Clearly they are not getting the full benefit of the brand's marketing program, so maybe you cut them a break on the fee,” said Friedman. “However, we have learned [at Pinkberry] that some local advertising will drive traffic for those venues, so I will require our franchises to do some advertising.”

Other issues that can arise for nontraditional venues include: length of term of initial franchise contract (for which specialty venues often prefer shorter terms than franchisors); venues that require use of their point-of-sales system instead of the franchisor's; dispute mechanisms; jurisdiction for dispute resolution; and non-compete restrictions on the master concessionaire for the venue.

Types of Negotiated Contracts

Given the likely need to negotiate contract provisions, the IFA Legal Symposium presenters outlined three different approaches to negotiating and drafting the contracts. The most conservative is to negotiate from the universal contract form. In this way, the franchisor can probably minimize the number of changes to the contract. However, the presenters indicated that this tactic is not likely to develop a good working relationship with the franchisee, and the administrative challenge of managing unique contracts can be immense. In their written paper, the presenters used as an example a franchisor that agrees to a variable-royalty arrangement for a franchisee in a nontraditional location. But the coding system in the franchisor's database only accepts a fixed-percentage royalty. “These are not inconsequential issues, and it is possible that some deals would cost more to make the system work around them than they are worth from a brand or financial standpoint,” they wrote in their paper.

A second drafting technique is to develop multiple franchise contracts, each of which is standardized to deal with a particular type of franchise unit. For example, a fast food restaurant might have its basic FDD, but create a slightly different FDD for restaurants set up on college campuses, airports and other nontraditional sites. This will make negotiations with franchise buyers more efficient, as well as accommodate the most common demands from concessionaires. Some franchisors have tried to create alternate FDDs for private equity franchisees, but these tend to raise fairness issues. “While a franchisor may be able to explain to a franchisee's satisfaction that product offerings had to be negotiated in an airport setting, it is less easy to explain why any given franchisee can't benefit from the transfer provisions that a franchisor granted a private equity fund,” the presenters noted in their paper.

A third approach is to attach addendums to each FDD that identify any deviation from the standard contract, instead of producing a new franchise contract for each deal. The addendum consolidates all changes into one section of the document. “In [my experience,] ' approaching contract modifications through the use of addendums was a god-send when Hilton Worldwide decided to enter 17,000 franchise documents in a new document database,” Satterlee said. “This contrasted with our negative experience in coding management agreements that varied on a contract-by-contract basis, without structure as to how edits were made over time.” The addendum approach is especially convenient when a franchisor, such as Hilton, operates across numerous brands in the same industry, Satterlee added.

Kevin Adler is the associate editor of FBLA . He can be contacted at [email protected].