Franchise Disclosure Document – Item by Item Analysis (Part four of a series)

Business Law Notes

Winter 2011 Edition


(Part four of a series)

By M. Blen Gee, Jr.

ITEM 12 – Territory.

One of the most important questions that you want to ask is will you have a protected territory. Increasingly, many franchisors do not provide territorial protection for their franchisees. Other franchisors will give some protection to a franchisee in an area that is too small. Encroachment on a franchisee’s territory is a major area of abuse in franchising, and Item 12 of the FDD should be examined carefully.

Remember, as a franchisee your goal is to maximize profits. However, since the franchisor is typically paid a percentage of gross sales, far too many franchisors are less concerned about their franchisee’s profitability than making certain that gross sales, and therefore royalties, are as high as possible. In many franchise systems this leads to saturation and then oversaturation of the franchisee’s market by placing too many outlets in the same territory. For this reason, for most franchise systems, adequate territorial protection from encroachment is essential, and a prospective franchisee should seriously question a franchise system that does not grant the franchise a reasonable territorial restriction .

Some franchisors may tie the territorial protection to performance standards, such as minimum gross sales or achieving target scores under a system developed by the franchisor. You should be certain that any such performance standards are easily achievable. Otherwise, you may find that your sales are less than expected and, rather than assist you in improving sales, the franchisor points at your poor performance as a ground for placing another franchisee in your territory, making it impossible to ever achieve the required performance standards or maintain profitability.

If the franchisor refuses to provide you with a protected territory, one helpful, though inadequate remedy, would be to negotiate a “right of first refusal.” This would allow you to protect your territory from possible encroachment by agreeing to open a second franchise in the proposed location of a potential new franchisee in your territory. The obvious problem with a right of first refusal is that opening a new store will over-saturate your market; you will be substantially increasing your financial risk by incurring the cost of opening a new store in a market that you know will be over-saturated. On the other hand, by having two stores reasonably close to each other, you may be able to take advantage of economies of scale that would allow you to operate both stores more cheaply and profitably.

If you are granted an exclusive territory, it is essential that the territory be large enough to provide you with an adequate number of customers. The franchisor will have some incentive to provide you with a reasonable territory so that you will be successful. However, remember that the franchisor’s principal interest will be to maximize gross sales. By providing you with an unreasonably small territory, it can be certain it saturates the market by surrounding your small territory with other franchisees.

Depending on the nature of the franchise opportunity, mail order and internet sales by the franchisor can be a major encroachment issue. In some industries, the franchisee may find that he spends a great deal of time, energy and expense introducing a prospective customer to a product, and then the customer returns to his home and buys the product on-line.

A typical but worrisome clause allows the franchisor to sell into your market or authorize others to sell into your market under different trademarks. It is unclear how often franchisors actually license competing franchisees under other brands. However, the practice of reserving the right to do so is very common.

ITEM 13 Trademarks.

The grant to you to use one or more trademarks is an essential element of franchising . Typically, the franchisor has adequately protected its existing trademarks and infringement of the trademarks by third-parties is not a problem. However, occasionally infringement occurs where the franchise is a start-up franchise or lesser known. You should promptly report any infringement to franchisor in writing and follow-up to make sure that the franchisor takes any necessary legal action to prevent the infringement. It is probably a breach of the franchise agreement not to notify the franchisor of any known infringement. Frequently, the franchise agreement will state that the franchisor has no duty to you to take actions against persons infringing on the trademarks. However, in practice, most franchisors will vigorously protect their trademarks.

It is common for franchisors to change trademarks, trade names, logos, color schemes, etc. For you as a franchisee this means new signs, new stationary, new ads, etc. all at your cost. In most cases, these expenses are unavoidable. It is important for the franchise system to stay modern and competitive. However, a poorly run franchise system may force the franchisee to make excessively frequent or expensive changes.

In addition to your franchise agreement, the franchisor’s trademarks are protected by Federal and state law. In the event that you terminate your franchise, you must promptly cease using all of the franchisor’s trade names and trademarks. This is true even if you have validly terminated your franchise agreement because of breaches by the franchisor.

ITEM 14 Patents. Copyrights and Proprietary Information.

Typically, all advertising produced by the franchisor is protected by copyright law, and you cannot use it without the franchisor’s consent. Probably the most important document that you will receive from the franchisor is the operations manual. This manual is protected by the copyright laws. Further, the typical franchise agreement provides that you may not make copies without consent and that the operations manual is only loaned to you; it remains property of the franchisor. Upon termination of your franchise agreement, the operations manual should be returned to the franchisor. As with trade names and trademarks, once you terminate your franchise agreement, you cannot use any materials provided to you by the franchisor, and these should be returned to the franchisor or destroyed. If the documents are destroyed, you should send a letter to the franchisor indicating that all copyrighted materials have been destroyed. Although not required to be listed in section 14, frequently the franchise agreement will recite that any patents, creative materials such as advertising copy, artwork or other proprietary information that you develop become the property of the franchisor.

>> Read part five of our Franchise Disclosure Document series

About our author:


M. Blen Gee, Jr. is an honors graduate of the University of North Carolina School of Law. His areas of concentration include business and corporate law, including sales of businesses; business litigation, including arbitration and mediation; franchise law; automobile dealer law; and insurance company insolvency. Mr. Gee has earned the highest peer-review rating for professional excellence and ethical standards by the national publication Martindale Hubbell.

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