How did it all start? 

Although the origins of franchising can be traced back to medieval Europe, the beginning of the modern franchise business model is attributed to an entrepreneur named Isaac Merrit Singer, founder of I.M. Singer & Company and the first person to patent the modern sewing machine. Sewing machines existed before Singer, but his machines could make 900 stitches per minute, far more than any other sewing machine of that time. Singer granted dealers the right to sell his product in specific locations, and thus, in 1863, his company launched a franchise system. 

 Almost 30 years later, Martha Matilda Harper, a salon owner, developed a franchise chain of over 500 salons. She trained her franchisees and supplied them with all the necessary products to deliver high-quality services. 

The franchise business model became particularly popular in the mid-1900s in the U.S. when fast food restaurants and retail outlets adopted this model. The move of families to the suburbs created a need for the development of franchise chains in fast food and retail. The franchising industry flourished—from auto parts, fuel sales, and petroleum products to hotels and handyman services—everyone wanted to create their own franchise chain. 

At one point, franchising gained a bad reputation as many franchises that emerged were not operating diligently, and many of them went bankrupt. Due to such practices, investing in a franchise began to be seen as a speculative venture. 

The rapid growth of franchising led to the establishment of franchise associations such as the International Franchise Association (IFA) and the European Franchise Federation (EFF) and the formulation of codes of conduct. 

What exactly is franchising? 

The International Franchise Association defines this business model as a contractual relationship between a franchisor and a franchisee, where the franchisor offers or commits to maintain a lasting interest in the franchisee’s business, mostly concerning know-how and training, and the franchisee commits to operate under a common name, appearance, or procedure belonging to the franchisor, paying an agreed fee and independently investing the initial capital in the business. 

We have already written about the basics of the franchise agreement in a previous article, and you can read the definition of the franchise agreement here. 

Let’s simplify this explanation and present the basics of franchising before focusing on the contractual clauses, which are the core of this article. 

Who are the contracting parties? 

In this legal transaction, there are two parties—the franchisor and the franchisee. The franchisor is the one who owns the brand, whether it’s a trademark or service mark, as well as the visual identity. The franchisor is recognizable in the relevant market and can transfer their business concept to another entity. 

Now, we come to the franchisee—a business entity that is independent, meaning they operate in their own name and at their own account, but they are granted rights to the trademark or service mark, as well as business rules, from the franchisor. The franchisee pays an agreed fee to the franchisor, which can be in the form of a basic fee paid continuously or an entry fee paid once upon signing the franchise agreement. 

What is a franchise agreement like? 

The franchise agreement is interesting because it originated as a creation of autonomous law, and most domestic legal systems do not contain specific provisions for franchising. It is a complex contract that spans several legal areas, such as contract law, commercial law, competition law, intellectual property law, and may include aspects of labor law, tax law, insurance law, private international law, and norms related to consumer protection. 

For example, in 2021, the Commercial Appellate Court, in decision Pž No. 69/20, confirmed the status of a franchise agreement as an unnamed contract in the field of autonomous commercial law. According to the ruling, two or more business entities cooperate in a way that the franchisor, as the owner of the exclusive rights to use the firm, trademark, symbol, product, and services, grants the franchisee the right to use them in exchange for a fee. 

Are there different types of franchises? 

Franchising is divided into three main categories—by type of activity, by type of know-how, and by business organization. 

A franchise by type of activity includes distributive, service, and manufacturing franchises, as well as mixed franchises. 

By know-how, franchising is divided into product distribution franchises and business format franchises. 

 Know-how includes various knowledge and experience related to business, which can be of a commercial or technical nature. 

Finally, a franchise by business organization includes direct, multiple, and master franchises, as well as regional representation. 

Why is a franchise agreement useful? 

This contract is concluded by parties with different economic powers, facilitating entrepreneurship development and providing the economically weaker party with a safer way to enter the market. 

Regardless of economic power, both parties benefit from this contract. The franchisor has additional income from the franchise fee and the ability to keep potential market competitors under control. Participating in a franchise system helps in business expansion without the need for significant personal investment. 

As for the franchisee, there are various advantages—they remain an independent business entity but are involved in a well-established and market-recognized business model, receiving training and ongoing assistance in their operations. 

What are the risks of a franchise agreement?

Despite the numerous benefits, there are serious risks in a franchise agreement, which can mostly be avoided by approaching the contract signing with care and understanding all that the legal transaction entails. 

The franchisor always faces the risk of difficulty in controlling the standards and operations of the franchisee, while the franchisee has, in addition to the obligation to pay the franchise fee, the need to comply with all contractual provisions and understand that they have limited decision-making freedom. 

This can be illustrated by an example from our case law- in the ruling of the Higher Commercial Court, Pž No. 9674/05 from 2005, it was noted that the relationship between the contracting parties in this type of contract depends significantly on how their rights and obligations are regulated by contractual provisions. Namely, if the contracting parties agree that the franchisee bears all the costs of operation, maintenance, and depreciation of the facility and inventory, the contract must be upheld, and the franchisee cannot transfer these costs to the franchisor, nor can they claim in the case of the franchisor’s bankruptcy that these costs be established by the court as their claim from the bankruptcy estate. 

From this example, it is clear why it is necessary to approach the signing of a franchise agreement with greater care. 

Here is another example from our case law- in the ruling of the Higher Commercial Court, Pž 6351/95 from 1995, the court confirmed the importance of contractual provisions in unnamed contracts in commerce. The ruling states that the lower court correctly found that the franchise agreement was terminated because the conditions for termination specified in the contract were met, as the defendant did not fulfill their obligations in the agreed manner. Namely, it was agreed that the contract could be terminated before the agreed term if the economic interest of the cooperation ceased. The plaintiff stated that the expected economic interest was not realized, which was also confirmed by the expert’s findings. 

The most common clauses in franchise agreements 

 Franchise agreements come in many forms and variations, but here we will consider some common clauses. While no franchise agreement is the same, most contain the provisions listed below. 

Additionally, what a franchise agreement should cover is described in the European Code of Ethics for Franchising. 

Duration and territorial scope

Franchise agreements are usually concluded for a specific period, considering whether the potential economic interest will be realized. Both parties must ensure that the duration of the franchise agreement aligns with their business plans and capabilities, considering how much time is needed for the franchisor to recoup their investment. 

The franchisor should ensure that the franchisee is granted territorial exclusivity without encouraging internal competition. The franchisee should pay particular attention to territorial provisions, as they are often linked to minimum sales quotas required to maintain territorial exclusivity. 

Training and business support 

The prerequisite for the franchisee’s successful business is training provided by the franchisor. This clause describes the location, duration, number of participants, etc. Additionally, the contract often defines the concept of supplementary services and ongoing support that the franchisor provides to the franchisee. 

Obligations of the contracting parties 

An essential part of any contract is where the obligations of the contracting parties are defined. For example, the franchisor declares that they have the legal right to use the name and trademark and that they have successfully managed the business concept for a certain period before establishing their own franchise chain. 

It is also usually stated that the franchisor recognizes franchisees as independent business entities and grants them the right to use know-how, and that they will provide initial training and continuous commercial and/or technical support. The franchisor typically commits to preventing any misuse or unauthorized transfer of know-how and, if necessary, to invest in resources required for brand promotion. 

On the other hand, the franchisee commits to cooperate loyally with the franchisor, to be responsible for human resources and financial assets, and to contribute their efforts to business growth. Furthermore, it is often stated that the franchisee agrees to allow the franchisor to check the quality of products and/or services as well as the brand image, and to keep confidential information, including know-how, secret. 

Please note that these provisions are given as an example to provide an idea of what a franchise agreement looks like. These contracts are complex and require expert knowledge as well as adaptation to the business concept and the specifics of the contracting entities. It is irresponsible, and impossible, to describe such a contract in detail in one educational text. 

Franchise fee and other payments 

The franchise agreement precisely defines the type and amount of fees to be paid and the method of payment, whether in a lump sum or continuously, and by what percentage. The contract outlines all payments that need to be made for the franchise business to operate, including the initial inventory and all necessary supplies. 

Intellectual property

One of the most important aspects of this agreement is the trademark for which the franchisee pays a fee to use. Attention must be paid to the restrictions regarding their use; for example, it may be required that the franchisee does not use the trademarks in the name of their company and must adhere to the rules imposed by the franchisor. 

In international practice, a so-called brand manual is often mentioned. This is a document provided by the franchisor to the franchisee for operational purposes. It should be noted that this is a living document, subject to periodic updates. 

On the other hand, franchisees will usually want to protect themselves in case a third party files a lawsuit for intellectual property infringement. 

Selection of business location 

The agreement may include provisions regarding the selection of an appropriate location for the franchise business to meet the franchisor’s standards. For example, the franchisor may require approval of the location before the franchisee signs a lease agreement. 

Along with location selection, there may be provisions regarding modifications or renovations; the franchisor might require the business premises to be renovated during the contract period, and the franchisee should protect themselves by ensuring this doesn’t occur during periods of slower business or impose excessive costs. 

Promotion and marketing

Marketing activities are crucial for brand recognition in the market, acquiring customers, and maintaining the desired image for all franchisees. The franchise agreement may specify a minimum amount to be invested in marketing, either as a percentage of revenue or as fixed amounts to be invested over a certain period.  

Termination of agreement 

A franchise agreement typically includes, like any other contract, a termination clause. It is important to understand the language of the agreement and all the consequences of termination, which also points to the importance of understanding contract law. 

As an example, we cite the reasoning in Supreme Court ruling 92/2001, which states that upon the expiration of the agreed term of the franchise agreement, the franchisee is obligated to return all assets provided by the franchisor and to cease using any words, elements, trademarks, logos, distinctive signs, or company name obtained under the franchise agreement in their business. 

Dispute resolution clause

Franchise agreements usually include a clause regarding the choice of governing law and the venue for dispute resolution. It is often required that the contracting parties attempt to resolve disputes through mediation or arbitration as methods of alternative dispute resolution. 

In any case, attention must be paid to the choice of governing law and forum; if you are interested in why the choice of governing law is important in contracts with a foreign element, we recommend reading this article. 

 

 

Note: This text does not constitute legal advice but rather the personal opinion of the author.