One of the unavoidable questions that many franchisors face at the time of granting a new franchise is the chronology that must, or can, be followed between the recruitment of the franchisee and the selection of a location for the franchised business.
Ideally, it is preferable that the franchisee and the location be selected at the same time so that the franchise agreement and the lease may be signed simultaneously.
In this way, before signing the franchise agreement and the lease, both the franchisor and the franchisee have a clear idea of the start-up costs of the franchised establishment (rents, deposits, rent allowances, construction costs, etc.) and have already agreed together on the chosen location (including its site).
Experience shows, however, that such synchronicity is often difficult to achieve.
In some cases, an interesting location is found long before the franchisor has been able to find a franchisee to occupy it and, conversely, in other situations, a suitable franchisee is selected before a suitable location has been found.
Several strategies have been developed by franchisors to deal with such situations, including (i) the signing of an offer to lease conditional on obtaining a franchisee to operate a franchised business in that location, (ii) the signing of a territory reservation agreement (with or without a deposit), (iii) the signing of an offer (or application) for a franchise (again, with or without a deposit), (iv) the establishment of a bank of prospective franchisees awaiting premises, and, (v) the signing of the franchise agreement before the location of the franchised establishment has been found.
Some franchisors go so far as to lease (or purchase), build, fit out and, in some cases, even operate the franchised establishment themselves (or through a subsidiary) before selling it on a turnkey basis to a franchisee.
These methods all have advantages, but they all raise certain issues, challenges and risks.
In this bulletin, we will consider one of these methods; the signing of the franchise agreement before the location has been found.
This method has long been used by, among others, large franchisors of small fast-food restaurants who wish to develop their networks as quickly as possible.
It obviously requires the franchise agreement to include some provisions dealing specifically with the fact that the location has not yet been found at the moment the franchise agreement is signed, including :
- Clauses dealing with the responsibility (franchisor, franchisee or shared) for the search and selection of the location;
- A timeline, and a deadline, for the search, selection and approval of the selected site, as well as for the negotiation and execution of an offer to lease and a lease (or, sometimes, an offer to purchase and a deed of sale);
- Clause to provide for the adding of the location in the already signed franchise agreement;
- Provisions dealing with the situation where a suitable location is not found or a lease or purchase agreement cannot be entered into within the agreed time frame;
- Provisions dealing with the situation where the franchisor and the franchisee do not agree on the choice of a location, or on the terms and conditions of the lease or purchase of the location;
- Provisions dealing with how the initial franchise fee will be treated if no location is found, or obtained, within the agreed time period, and in the event of disagreement as to the choice or cost of a location.
These provisions must be clear and, above all, comprehensive in order to cover all possible scenarios.
Even with such provisions in the franchise agreement, once a location has been chosen, questions will also arise with respect to (i) the territory of the franchisee (whether for the purposes of exclusivity, right of first refusal, delivery or local advertising) since, in most cases, this territory surrounds the location, (ii) the territorial scope of the non-competition covenants in the agreement (which also generally cover a territory around the franchisee's location), and (iii) the termination date of the initial term and, if applicable, of each renewal period of the franchise agreement (since it is often appropriate to provide for an termination date that coincides with the termination date of the initial term and renewal periods of the lease).
Another challenge that arises where a franchise agreement is signed before a location has been found is the disclosure to be made by the franchisor to its prospective franchisee. It will indeed be very difficult for the franchisor to provide clear and complete information as to the costs relating to the premises of the franchised business (construction costs, fit-up costs, rents, other leasing costs, business taxes, etc.) and, in some cases, as to the potential revenues of the franchised business (which may depend in part on the location, size and configuration of the site).
In the Canadian provinces with franchise legislation, this has long been a major challenge, culminating in the Court of Appeal for Ontario judgment in Raibex Canada Ltd. v. ASWR Franchising Corp. rendered on January 25, 2018.
In that case, a franchisee sought to rescind its franchise agreement on the basis that the franchisor had failed to provide the franchisee, prior to the signing of the agreement, with the information required by the regulations under the Ontario Franchises Act ("the Arthur Wishart Act (Franchise Disclosure), 2000, S.O. 2000, c. 3") regarding the costs of construction and development of the franchisee's site, as well as rental fees, which the franchisor had been unable to do because the site had not been selected at the time the agreement was signed.
In the first instance, the Ontario Superior Court of Justice had recognized the franchisee's right to rescind the agreement for this reason.
Fortunately for this franchisor (and for all other franchisors who sign franchise agreements prior to finding the location of each new franchise), the Court of Appeal for Ontario allowed the franchisor's appeal and recognized that the franchisor could not be expected to provide, prior to the signing of the franchise agreement, information that it obviously could not know at that time as it did not know yet the location that would be selected for the franchised business.
However, to render its decision, the Court of Appeal for Ontario took into consideration that, in this case, (i) prior to signing the franchise agreement, the franchisee was well aware that the location of the proposed franchise had not been selected (and this was clearly disclosed to the franchisee in the franchise disclosure document provided by the franchisor prior to the signing of the franchise agreement), and (ii) the agreement set out a clear procedure whereby the franchisor and the franchisee agreed to cooperate in the selection of the location of the proposed franchise, (iii) the franchisor had agreed to use its best efforts in selecting the location, which, in the opinion of the Court of Appeal for Ontario, required the franchisor to take into account the interests of the franchisee in making that selection, and (iv) if the franchisee did not accept the location selected by the franchisor, the franchisee had a contractual right to terminate the franchise agreement and obtain a refund of the money paid to the franchisor.
It is therefore uncertain whether another court would come to the same decision in different circumstances (in particular, if the franchisor retains a large degree of discretion in the choice of the site, if the amounts paid by the franchisee are not refundable if a site is not found or if the site chosen by the franchisor is not acceptable to the franchisee).
Another issue relates to franchisee training and the disclosure of confidential information about the network, its operations and plans.
Is it safe for the franchisor to train the franchisee before being assured that the franchisee will operate a franchised business? Is there not a risk of training a future competitor or providing confidential information to someone who will ultimately never operate a franchised business?
In Québec, this is complicated by the fact that article 1435 of the Civil Code of Québec requires that, in a contract of adhesion, any external clause (a term which, in franchising, includes the operations manual) must "be expressly brought to the attention of the […] adhering party" (the franchisee) before or at the time of the signing of the contract, failing which the external clause is null and void with respect such adhering party (the franchisee). Thus, even where the franchise agreement is signed before the location is found, the franchisor is still required to make its operations manual known to the franchisee and, therefore, to take the risk of such disclosure in the event that, in the end, an acceptable location is not found or is not acceptable (particularly in terms of costs and conditions) to the franchisor or franchisee.
For these reasons, signing the franchise agreement before the location of the new franchise agreement is found appears to us to be a model that poses several significant issues, challenges and risks.
For the vast majority of franchisors, we generally prefer another method, including the signing of a pre-contract (territory reservation agreement, franchise offer, franchise application, etc.) that clearly describes the steps involved in the search for, and selection of, a location and what is to happen when that location is found and, conversely, if it is not found before an agreed-upon deadline. In this model, the franchise agreement is signed only when the location has been accepted by the franchisor and the franchisee and then replaces this pre-contract.
Fasken has all the expertise and resources to help you draft agreements that are complete, adequate and, even better, well adapted to your concept, needs and resources, that well protect your rights while avoiding potential pitfalls.