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Bulletin

Why Require a Purchase Option In a Franchise Agreement

Fasken
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Overview

Franchising Bulletin

A purchase option in a franchise agreement consists of a contractual clause stipulating that, under certain circumstances described in the agreement, the franchisor has the right, but not the obligation, to acquire the business or assets of its franchisee at a price and under conditions stipulated in the clause.

Such a provision is found in many franchise agreements.

Recently, in the context of designing and drafting a new franchise agreement, the franchisor raised the following interesting question: “Given the fact that I wish to develop my network by way of franchises, and not by myself or by way of subsidiaries, why should I stipulate a purchase option clause in my franchise agreement?”

In certain sectors of activity (including, for example, pharmacy), this question becomes even more relevant since, by law, the franchisor may not have the right to own a franchised business in its network.

The answer to this question rests first on the role, indeed the duty, of the franchisor to protect its franchise network both from its competition and from any delinquent franchisee, a duty was clearly set out in the important judgment rendered by the Superior Court of Québec (and upheld by the Court of Appeal of Québec) in Dunkin' Brands Canada Ltd. v. Bertico Inc.

In order to fulfill this role, the franchisor must, among other things, (i) ensure a healthy continuity of the network, (ii) prevent a franchised business from falling into the hands of persons other than franchisees of the network (including a former franchisee or a competitor).

Of course, a well-drafted non-competition covenant already allows the franchisor to fulfill this role and these duties to a large extent, particularly with respect to a former franchisee.

However, it is not sufficient in all cases, particularly in the case where, immediately after the termination or end of the term of the franchise agreement, the franchisee (now ex-franchisee) decides to sell his business to a person who is not bound by a non-competition covenant in favour of the franchisor (including, obviously, a competitor).

Particularly in cases where (i) the location of the franchised businesses is important to the franchise network, (ii) the layout or equipment of the franchised businesses includes elements that are distinctive of the network, and (iii) the network operates in a highly competitive field where competitors are always ready to get their hands on a business in the network, a purchase option provision may be very useful, and even necessary, to preserve the continuity of the network.

For those situations where the franchisor does not wish to or does not have the right to own any of the businesses in its network, the purchase option provision may provide for the right of the franchisor to assign, upon exercise, its purchase option to any person of its choice (including, for example, a franchisee or a new franchisee).

Here are three practical tips for drafting a purchase option clause in a franchise agreement:

  1. Describe very clearly the cases in which the purchase option in favour of the franchisor may be exercised and the terms and conditions for exercising such option

    We have often underlined the importance of clarity in drafting a franchise agreement.

    In the case of a purchase option clause, this is essential with respect to (i) the circumstances giving rise to the option, (ii) the goods, both tangible and intangible, which are the subject of the option, (iii) the conditions, time and manner in which the option is to be exercised, (iv) the manner in which and the procedure by which the purchase price is to be fixed when the option is exercised, and (v) the conditions, time and manner in which the goods are to be sold following the exercise of the option.

    Depending on the circumstances giving rise to such purchase option, the price, as well as the terms of acquisition of the franchised business following the exercise of such option, must be reasonable, which does not mean, however, that such price must necessarily represent the full market value of the franchised business or of the property is the subject of such purchase option as, in almost all cases, this option is exercisable in situations arising from defaults or insolvency of the franchisee or where the franchise agreement comes to an end after the franchisee has elected not to renew it and has not proceeded to sell its franchised business before the expiry of the term of the franchise agreement.

  2. Have an expert lawyer draft your purchase option clause

    It is important to have an expert lawyer draft a purchase option clause in a franchise agreement to ensure that you will be able to exercise such option should the need arise.

    If the clause is not complete and very well drafted, the franchisor may not realize until too late, when a franchisee, a former franchisee or a potential purchaser has found a way to circumvent its purchase option or to make its exercise impossible or too costly, that its purchase option clause did not really provide him with the protection he was looking for the benefit of its network.

  3. Include provisions in the purchase option clause to ensure its eventual exercise

    Once a sale is made to a third party in contravention of a purchase option stipulated in favour of a franchisor, it will be extremely difficult, if not impossible in many cases, for the franchisor to request its cancellation.

    Therefore, if a sale is completed in breach of a purchase option in a franchise agreement, the franchisor's only recourse may well be to claim damages (which in such a case are often difficult to establish and prove).

    In order to prevent such a breach, it is therefore appropriate to add to the purchase option clause some additional provisions designed to ensure its compliance.

    Among these additional provisions, we often find :
  1. A penalty, or liquidated damages, clause for adequate (but not abusive) amounts.

    The amounts stipulated in this clause must be significant enough to truly dissuade the franchisee, or a potential buyer, from proceeding with a transaction in violation of the franchisor's purchase option.

    Unfortunately, we have witnessed several situations where, because the penalty, or liquidated damages, amount was too low, a franchisee and its purchaser have chosen to pay the penalty rather than honour the franchisor's purchase option, and

  2. A security agreement (in Québec, a hypothec) on the assets of the franchised business.

    An additional way to ensure compliance with a franchisor's purchase option is for the franchisor to own, or be the main lessee of, the premises in which the franchised business is operated.

Fasken has all the experience and resources necessary to help you draft complete and adequate agreements that protect your rights while avoiding potential pitfalls.

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