Preparing a Franchise System for Growth

1. Non-compliant franchise disclosure document (FDD)

FDDs are not generic “one size fits all” documents. A legally compliant FDD must disclose the unique business relationships and legal material facts that exist in a franchise system and those that are unique to each location. The information disclosed in the FDD must comply with franchise legislation in the provinces in which the franchisor operates. It needs to be current, accurate, specific, clear and complete. Some common errors or omissions include:

• failure to disclose location or site-specific information, including the lease and its key terms;
• providing additional documents to a prospective franchisee that are not contained in the FDD;
• including financial information that constitutes a “financial projection”, without complying with the statutory requirements of projections, and
• inaccurate or out of date disclosure about the franchise system, such as the franchisor’s affiliated companies, the current and past locations in the system, site-selection and other features of the franchise business.

Sometimes, the original batch of the first few franchisees in the system did not receive proper or any disclosure. Depending on the time that has passed since those franchisees signed their franchise agreements, the failure by the franchisor to comply with its disclosure obligations may result in significant legal risk to the franchisor and the franchise system.

The consequences of rescission claims can be drastic. Even one successful rescission claim by a franchisee can be financially devastating to the franchisor and the goodwill of the franchise system. A rescission claim can result in liability to a franchisor and its individual principals for compensating the franchisee for their entire investment and losses in setting up and operating the franchise business. That risk comes with personal liability.  The director of the franchisor is required to sign the franchisor’s certificate in the FDD. That attracts significant personally liability for rescission damages.

To address these problems, the franchisor and its legal counsel should assess all disclosure compliance problems with existing franchisees and assess how to best address them, such as by preparing legally compliant FDD and settlement packages.

2. Getting control of headleases

There are often problems with leases during this phase of growing pains: leases of the original batch of franchised locations are often held by the franchisees, rather than the franchisor or its affiliate. This can be a serious impediment to maintaining long term control of desirable locations, if the franchisees of those locations are terminated or leave the system and start a competing operation from the same location.

To rectify this problem, the franchisor should put a strategy in place to gradually assign all those leases to the franchisor or its affiliate, whenever contractually feasible.

3. Poorly drafted franchise agreements

Some of the key clauses of the franchise agreement may be legally ambiguous or otherwise unenforceable. For example, restrictive covenants, such as non-competition restrictions, are often too generic and fail to include required legal components for them to be enforceable in court. Another common area includes territory descriptions that may be vague and unenforceable.

Before starting the aggressive growth of the franchise system, it is advisable to fix and update the franchise agreement so that all key provisions and legally enforceable and in line with how the franchise system operates at the present.

4. Change in franchisor’s ownership

It is not uncommon to see a franchisor that grows out of the startup phase go through ownership changes, typically when one principal buys out the other. This is an opportunity to the exiting principal to reap the rewards of the hard work of building the franchise system during its startup phase and move on, and for the remaining principal to take the franchise system to the next level.

Changes in the ownership of relatively young franchise systems can result in discontent among some franchisees, sometimes even leading to violations by franchisees of their contractual obligations under their franchise agreements. The franchisor will need to address these potential problems with defaulting franchisees by enforcing standards and obligations.

Conclusion

Franchise systems about to start the rapid growth stage face exciting opportunities and often legal challenges that require attention from experienced legal counsel. Engaging specialized franchise legal counsel is essential for franchisors looking to successfully navigate this phase and build a strong foundation for their expanding franchise system. With the support of an experienced franchise lawyer, franchisors can safeguard their legal interests, protect their brand reputation, and set themselves up for sustained growth and success in the competitive franchise industry.

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The information contained in this article is provided for informational purposes only and does not constitute legal advice. Readers should not act on this information without seeking professional legal advice from a lawyer experienced in this area. The content in this article may not reflect the most current legal developments, and the application of law can vary in different provinces and territories. As such, the information in this article is not guaranteed to be complete, correct, or up to date. The author and the publisher of this article disclaim all liability for any actions taken or not taken based on any or all of the contents of this site.

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