In the self-storage business, most people will tell you that identifying the best location and evaluating market demand are critical factors to success. When considering a franchise model, however, you should also carefully review and negotiate the terms of your agreement.
There are many reasons a business can fail, but franchise owners sometimes say their contract bound them to terms that made it difficult to achieve the level of success they envisioned. In fact, the franchisee failed to understand the long-term consequences of his contract provisions. Thankfully, this can be overcome with thorough due diligence and careful negotiating.
The Negotiating Game
Your soon-to-be business partner may tell you there’s no room for negotiating in the franchise agreement, but that isn’t always true. Don’t be dissuaded from trying to get terms that are favorable to your business, whether you’re pursuing a new franchise or a renewal. You may be pleasantly surprised.
First, do your due diligence by talking with existing franchisees. Most will freely tell you which changes they were able to negotiate. You can also learn from them how the agreement has developed over time and what critical issues have been addressed by renewals or amendments. These are important because they help you understand what the franchisor values and how it sees the business progressing. Franchisors like to see their franchisees do well, but they love to see themselves do better.
While there are several items on which you should focus, pay particular attention to the following:
The defined terms related to royalties and other fees charged by the franchisor. Pay careful attention to the scope of fees the franchisor can collect. These terms can be vague, leaving openings for the franchisor to charge additional fees in the future that weren’t contemplated when the agreement was signed. For guidance, look at older disclosure documents (FDDs) and versions of the agreements executed by other franchisees. Consider negotiating for caps on fees, or at least caps on increases over time.
Personal guarantees from the franchisee’s principals. Establishing a corporation or limited-liability company to operate a franchise won’t shield you from personal liability if you sign a personal guarantee. Negotiate to limit the duration of guarantees or seek a release of personal guarantees over time based on the strength of your business results.
Preserve the size of your territory. Scrutinize the language that defines the size and scope of the area dedicated to your franchise, whether in terms of geographic size, population or otherwise. Preserve your rights for expansion, and make sure your franchisor can’t give away your growth plans to another franchisee. Secure options or rights of first refusal for expanded or new territories.
Search the franchisor’s litigation history. Regardless of what’s in the FDD or franchise agreement, ask your lawyer to search for prior or pending lawsuits between the franchisor and its franchisees. While any business will have occasional disputes, a legion of litigation generally signals a lot of unhappy partners. Read the complaints and consider the specific areas of dispute. Keep those in mind during your negotiations.
A franchisor’s willingness to negotiate varies but is rarely non-existent. What may seem like contractual overkill on the front end can become critically important if a problem ever arises and can help guarantee success down the road.
Also, ensure all negotiations are documented in writing. Too many franchisees have gotten into disputes with their franchisors years down the road. Memories about what was discussed, what certain terms were intended to mean, and what the respective parties thought they meant and agreed upon fade over time. Our greatest tools for litigation or successful dispute resolution have been the written, back-and-forth communication that clarifies what was meant by the parties during negotiations.
Plan Exit Strategies
Many franchise agreements provide the franchisor with a unilateral right to purchase a franchise at a certain time, for a certain price, based on a multiple of profit or some other formula. Therefore, you may succeed in building a great business only to have to sell it to your franchisor for less than it’s worth or what you spent to build it.
There’s usually little or no disclosure in the FDD about the economic impact of the franchisor’s repurchase rights, so give careful thought to your long-term business plan. Consider startup costs, mandatory maintenance and improvements, costs to achieve projected growth and profitability, and whether you can afford to take any money out of the business along the way. Then, consider at what point the franchisor can exercise a right to buy back your franchise.
Again, talk with other franchisees. Pay close attention to this issue as you develop or revise your business plan. Finally, try to negotiate (or renegotiate) for a greater purchase price or profit multiple and, more importantly, a long operation period before the right to purchase can be exercised.
Franchise agreements frequently contain a “right of first refusal” provision that requires you to offer your franchise to the franchisor before you can freely sell it to someone else. This may make your business less appealing to a third party and, thus, less valuable.
For example, a buyer may have to wait for the franchisor’s right-of-first-refusal period to expire, impacting the timing of any sale. The right of first refusal may also require the buyer to execute a new franchise agreement as opposed to taking over yours. Therefore, all your negotiating success may not be passed on to your buyer unless you also negotiate the ability to transfer your agreement. Try negotiating the right to sell to another existing franchisee, a member of your existing ownership group or a family member without triggering the right of first refusal.
When it comes to entering a franchise relationship, if you do the work up front to maximize your options, you’ll likely maximize your success in the end.
Scott M. Ratchick is an attorney in the commercial litigation and corporate, securities and finance practices at Chamberlain Hrdlicka in Atlanta. His practice focuses on issues relating to complex commercial, franchise, and securities litigation and shareholder and business disputes. He may be reached at 404.588.3434 or firstname.lastname@example.org.