By Laura E. Liss, Attorney, Brown and Kannady, LLC.
While many franchisor-franchisee relationships function well and both sides benefit from the contractual franchise relationship, others do not. Franchisors may seek to terminate a franchise agreement for cause based on a franchisee’s non-compliance with the franchise agreement, whereas franchisees are not typically granted but a whisper of a termination right and almost never is termination “for convenience” or for lack of earning an anticipated return permitted. Franchise agreements are often for five to ten years, so a natural exit via an expiring contract may appear too far away on the horizon.
For a franchisee without a contractual exit strategy facing a franchised business that is losing money, or a family health problem taking he or she away from the business, or another problem making franchised business ownership and operation infeasible, many franchisees struggle with how to proceed. Many believe there is no exit strategy because often when asked about exiting the franchise system, the franchisor’s operations staff will try to encourage the franchisee to stay or otherwise remind the franchisee that there is no natural exit to pressure the franchisee to remain in the system.
Instead, two main avenues exist to exit a franchise system.
First, depending on how the business’ performance is (i.e. if it is profitable) and how long the franchisee can wait to terminate the agreement, finding a buyer for the franchised business is often the best exit strategy because it allows the franchisee to recoup some, all, or more than its investment. Unless the franchisor knows of a prospect interested in acquiring the franchisee’s business or unless another local franchisee wants to expand by taking on the exiting franchisee’s business, it can often take six months or more to find an interested and qualified buyer, which may rule out the exit-via-sale option out based on the timing needs.
If this timing is feasible, however, the franchisee should begin preparing the business for sale by verifying its financials (and better organizing them if necessary), gathering documentation a buyer would likely request during a due diligence review, and evaluating if it would like to engage the services of a business broker to assist with the marketing and sale process before bringing the sale to the franchisee’s attorney to review.
Alternatively, if an exit-via-sale is not feasible for whatever reason(s), and the franchisor is uninterested in reacquiring the franchised business, the franchisee should seek to negotiate an exit via mutual termination of the franchise agreement. Even if the franchisor will consent to the termination, this will be a slow process typically because the franchisor dislikes losing a franchisee and has no obligation to agree to the termination.
The original franchise agreement’s terms coupled with the lack of obligation to agree to the termination gives the franchisor the ability to make the mutual termination very one sided. Post-termination obligations routinely placed on the franchisee include confidentiality, non-competition with the franchised business and within a radius around the business location and other branded locations, non-solicitation of customers and employees, an obligation to fully de-brand the premises, and often the obligation to sell the franchisee’s assets to the franchisor at their depreciated value (not fair market value). Franchisees should be reminded that these franchise obligations will most likely apply to them, even in a mutual termination setting.
When negotiating the mutual termination agreement, these obligations will be re-affirmed, and the franchisor or its attorney will typically prepare the first draft of the termination agreement. Importantly, the franchisee or its attorney should seek to obtain a full release from liability of the franchisee and personal guarantors by the franchisor. Commonly, the franchisor will decline to release the franchisee and guarantors for any acts or omissions that occurred prior to the termination based on the risk that the franchisor does not know the extent to which the franchisee may have damaged the brand or caused other harm for which the franchisor would want to seek compensation.
Given the prevalence of this position as an “industry norm” and the franchisor’s negotiating leverage, most franchisees accept that they and guarantors will not be released for this period. Franchisors will usually agree to release the franchisee for acts or omissions after the termination date, except for post-termination obligations and indemnification. Other than the release language and post-termination obligations, most other parts of the termination agreement should be made mutual through the negotiation.
To incent the franchisor to agree to the termination, many franchisees will offer to pay the franchisor some amount of money upfront or over one to two years after the termination agreement is signed. This figure will commonly be based on all or some of what the franchisor could have theoretically earned as royalties from the franchisee’s sales over some agreed hypothetical future period. While this may be hard for a struggling franchisee to pay this amount, many choose to do so because it is less than the cost of litigation with the franchisor over a failed store and less than the costs of continued operating expenses (rent, employee wages, inventory, etc.).
Franchisees seeking a termination should expect to work with the franchisor to the extent the franchisor is amenable. Despite a franchisee’s unhappiness with the franchise system or other life difficulties, transfer or mutual termination are typically the clearest paths out of the system and onward to the future the franchisee seeks.
This article was previously published in the Colorado Bar Association Business Law Section Newsletter.