Investing in a franchise involves extensive research, and rightly so. Buying into a franchise is a lot of money, and you’re committing to time and labor for years to come.
For entrepreneurs who’ve never entered such a business deal, it can be daunting, beginning with the franchise agreement itself. In fact, the first question to ask is what is a franchise agreement?
What is a Franchise Agreement?
It may sound simplistic to ask that question, but the answer is multi-faceted.
In its most direct definition, a franchise agreement is a legal contract through which a franchisor grants a franchisee rights to operate a business under the brand’s trademark. In return, the franchisee shares the profits under specific terms for the length of the contract, also called the franchise term.
In this article, we’ll explore the layers of the franchise agreement to more fully answer what is a franchise agreement and give an idea of why it’s important to the franchisor and franchisee.
What Details Does the Franchise Agreement Cover?
The Federal Trade Commission (FTC) regulates the information a franchisor must provide to a prospective investor interested in becoming a new franchise owner with a trademarked brand. The requirements are extensive, and they’re discussed in a Franchise Disclosure Document or FDD.
How a franchise operates its business is typically overseen by individual state laws, so some states are more franchise-friendly than others. However, the information disclosed during the talks between the franchisor and franchisee is federally regulated.
Franchise agreements can vary in detail, but the FDD must contain specific information about the franchise as required by the FTC for the potential franchisee to make a fully informed decision.
What are the most common items contained in a franchise agreement?
- Definitions of the parties involved and other important distinctions, such as territories, authorizations, systems, trademarks, etc
- License rights
- The FDD
- Disclosures required by laws of the state or states operating in
- Performance standards
- Franchisor responsibilities, such as training, marketing, ongoing support, etc
- Franchisee responsibilities, such as trademark usage, insurance, financial and legal responsibilities, fees, and royalties
- Terms, termination clauses, severability, and arbitration
- Amendments and waivers
The FDD’s specifics are crucial to the decision-making process. These items are vital to answer the question, “What is a franchise agreement?”
What is Item 7 within a franchise agreement?
Item 7 typically lists the franchise’s estimated initial investment range for a single franchise location. This disclosure will list the expenses that make up the values of the investment range and subtotal the range at the end.
Some examples of expenses in an Item 7 Estimated Investment Range disclosure are:
- Initial franchise fee
- Franchise location rent and security deposit
- Construction and remodeling of franchise location
- Furnishings and decor
- Licensing and permits
- Utilities, security system
- Point of sale system, technology software, computers, and office equipment
- Staff training and payroll
These are the typical expenses to expect during the initial opening weeks and months of operation as the franchise location is working toward becoming fully operational. Below the summary table, the expenses listed will likely be discussed in more detail.
What is Item 19 within a franchise agreement?
Item 19 is the financial performance of the franchise’s average location. It’s how a potential franchise investor can see actual records of an existing location to determine if the brand’s performance lives up to its reputation. It’s important to note if these average locations are corporate-owned or owned by independent franchisees.
This is important because, for example, in the case of corporate-owned franchises, equipment expenses can be extensive, and the corporation is frequently more capable of outright owning this equipment than the average franchise owner might be. It can have an impact on the performance of the location and its operating expenses over the year.
The description of the details in the FDD’s Item 19 should explain what exclusions are made (examples may be wholesale sales or catering, in the case of a restaurant franchise, if applicable). The details will span a specified number of years and what types of demographic data apply, i.e. square footage of the location or urban versus rural.
Item 19 typically details the average gross sales of an existing location based on the listed criteria.
Other Important Items on the FDD
The FDD also goes into great detail about the stability of the franchise brand’s system, the territory size and protections afforded each franchisee, and any legal troubles in the brand’s history.
In addition, if applicable, there is a section listing current and former franchise owners with the brand. This allows potential franchisees access to people who have experience investing with this franchise, so they may cut out the middle man, so to speak, and ask about their experience directly.
What Protections Does the Franchise Agreement Offer?
Another important layer to the question, “What is a franchise agreement,” surrounds the protections provided. No contract should ever be considered if all parties involved aren’t benefiting in some way.
A franchise agreement protects the franchisor by ensuring the franchisee operates their location according to the business model laid out in the franchise training program and the specified provisions in the contract.
Should the franchisee stray from the processes of the brand’s business, the franchisor has steps they can take to ensure the franchise owner returns to the correct business model. If they don’t comply, other steps can be implemented to ensure the location is placed under leadership that will operate it accordingly.
Additionally, franchisees are protected because they’re assuming a financial risk in opening a new location. While they agree to operate the business the brand’s way, they keep a share of the profits and have leeway to make appropriate decisions as well. Examples are hiring choices, scheduling, and daily operations decisions.
Why Does the FTC Require a Franchise Agreement?
The FDD contains 23 specific items1 of information so that prospective franchisees may make informed decisions about investing in a franchise.
The franchise agreement is also in place to protect franchisors and ensure each franchise location operating under their brand adheres to their brand’s principles and operating guidelines. By having a franchise agreement between the parties, both have their interests protected, and franchises thrive.
Basic knowledge of franchise agreements is a key part of understanding franchising as a whole and how it can be a beneficial path to owning a business. At Garage Living, we support our franchisees by making sure they are as equally informed as we are in franchising to confidently work together.
Need more information on what is a franchise agreement? Contact us at Garage Living. We’re expanding our franchise and have everything you need to become the next Garage Living franchise owner!
1 Source: “Franchise Rule” FTC.gov