For many franchisees, the purchase of their first franchise is just the beginning of a larger business venture. These franchisees crave the opportunity to expand their businesses, after getting their first franchise up and running. If your business plan includes expansion, you must understand the methods available for achieving your goals prior to signing a franchise agreement. You also must make certain your chosen method of expansion is well documented and secure. A few of the more common vehicles for franchise expansion are as follows:
Become an Area Developer: One method of securing the right to expand is by entering into an “Area Development Agreement” with the franchisor. Area Development Agreements provide franchisees with the right to open additional franchises within a designated area, thereby developing and furthering brand recognition in that area. Area Developers are typically granted the exclusive right to develop their territories, which means that they are protected from encroachment by other franchisees and Area Developers.
However, development rights are not suitable for all franchisees. That is because in addition to affording the franchisee with development rights, most Area Development Agreements also set forth a legalobligation on the part of the franchisee to open a certain number of franchises in the area within a given period of time. Failure to open the additional franchises in accordance with the agreed schedule can result in the termination of the Area Development Agreement, the reduction or elimination of the franchisee’s territory or even the termination of the franchisee agreement itself. In such instances, franchisors can also seek damages against the franchisee as a result of the termination. For these reasons, area development rights are not suitable for everyone.
Obtain a Right of First Refusal: For many franchisees, obtaining a right of first refusal is a more suitable method of preserving expansion rights. When a franchisee is given the right of first refusal, the franchisor and franchisee designate a certain area where the right will apply. The area is typically adjacent to the franchisee’s existing territory. If the franchisor receives interest from a third party wishing to open a franchise within the reserved area, the franchisor must notify the franchise. The franchisee then has the right to step into the third party’s shoes and is afforded a certain period of time (typically 30-45 days) to enter into a new franchise agreement in place of the third party. If the franchisee chooses not to take the new franchise, the franchisor is then permitted to grant the franchise to the third party.
Rights of first refusal are beneficial to franchisees because they help franchisees protect the areas contiguous to their current franchise territory. Franchisees with these rights need not worry that the surrounding areas will be sold out from under them. There are no obligations to expand, and the franchisee can always decline to purchase a franchise that is presented. In this regard, rights of first refusal are less risky than Area Development Agreements.
However, rights of first refusal have negative aspects to them as well. For one thing, franchisors typically charge an up-front fee to franchisees for these rights. Fees can vary depending on the size of the reserved area and the length of the right. Another problem with rights of first refusal is that they create uncertainty. Franchisees have no way of knowing if, and when, an interested third party might express interest sufficient to trigger the right of first refusal. Theoretically, a third party could express interest shortly after the franchisee signs his first franchisee agreement. In such a situation, the franchisee could be forced to sign a second franchise agreement (and pay another franchisee fee) prior to getting the first franchise profitable. If the franchisee declines to purchase the new franchise, the third party would then be free to operate in the franchisee’s desired market. Making matters worse is that franchisees cannot control the franchisor’s actions. A franchisor could theoretically make extra efforts to sell franchises within the franchisee’s reserved territory, knowing that if a potential buyer is found, the franchisee will likely be coerced into opening another store to keep the third party out. If the franchisee opts to purchase the new franchise, the franchisor can then direct the interested third party to another location, thereby procuring two new franchises in short order.
Rights of first refusal must also be carefully drafted so they are only triggered when the third party is committed to moving forward with a franchise. Otherwise, a franchisee could be faced with making a decision to purchase another franchise where the third party has merely expressed minimal interest. Failure to properly draft the right of first refusal can result in uncertainty and trouble.
Obtain an Option to Expand: An option is another tool designed to provide franchisees with the right to expand. When a franchisee is granted an option, the franchisor agrees to remove a specific territory from the market. The franchisee receiving the option then has the right to “exercise” the option to purchase another franchise in that territory within a specific period of time. While options typically require the payment of an up-front fee (to purchase the option), they are a great way to preserve the right to expand. The franchisee has the right to develop the territory, but is not legally obligated to do so.
Franchisors are typically hesitant to grant options, because they put limits on the franchisor’s ability to expand into certain territories. A territory that is off the market cannot be developed, and presents a problem for growing franchise systems. So an option may not be available. Also, options can get expensive, depending on the length of time and the size of the reserved area. As with rights of first refusal, options must also be carefully drafted, to assure that the franchisee is getting exactly what he pays for. A simple drafting error can end up causing trouble down the road.
As set forth above, there are many ways a franchisee can expand the franchised business. While it is certainly possible to negotiate the above methods after the franchisee signs the initial franchise agreement, the most appropriate and effective time to memorialize expansion plans is prior to signing. After the initial franchise agreement is signed, the franchisor is under no obligation to negotiate further. In such cases, a franchisee could find him or herself locked into one franchise with limited or no ability to expand. It is therefore essential that franchisees with expansion goals engage in careful planning before committing to their first franchise.
ABOUT BRIAN LOFFREDO
Brian is a commercial litigator with more than fifteen years of experience representing clients in the franchise industry. Brian routinely assists clients during the licensing and franchise/FDD review process, as well as with the resolution of franchise-related disputes, including those involving terminations, territorial disputes, fraud, disclosure/relationship law violations and breaches of contract.
In addition, Brian represents and counsels clients in the construction industry on matters involving litigation, construction defects, licensing and compliance, collections, mechanic’s liens, payment bond and Miller Act claims, contract drafting, and compliance with home improvement laws and other construction industry laws.
Brian also has extensive experience representing financial institutions with workouts, collections and residential / commercial foreclosures.