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Copyright © International Chamber of Commerce (ICC). All rights reserved. ( Source of the document: ICC Digital Library )
by Emily O’Connor
When a Franchisor and a Candidate decide that they want to commence negotiation of a Franchise Agreement for a Territory, other steps may need to be taken to protect their interests. Both parties may want to agree upon certain key business terms of the Franchise Agreement, such as the fees, Territory, training and support obligations and term of the Franchise Agreement. In addition to providing a disclosure document, which may be required in certain countries50, the parties usually may find that they need to disclose information that should be kept confidential. A Candidate may want the Franchisor to commit to grant it the rights to a certain Territory for the operation of its System. The Franchisor may want some assurance that a Candidate will not become a competitor and try to recruit its employees instead of becoming a Franchisee. Both parties may also be interested in agreeing upon the steps that will ultimately lead to the conclusion of a Franchise Agreement to make the selection process transparent. Therefore, the parties negotiating a Franchise Agreement should consider entering into certain preliminary agreements before negotiating the terms of the Franchise Agreement.
Preliminary agreements can facilitate negotiations. Confidentiality, non-competition and non-solicitation agreements can allow the parties to conduct free and open negotiations without risking disclosure of confidential information to potential competitors. A letter of intent allows the parties to reach agreement on key terms before spending a lot of time and money trying to negotiate the other terms of the Franchise Agreement, and then not be able to reach agreement on those terms. This section will discuss the benefits of preliminary agreements.
During the negotiation of a Franchise Agreement the parties primarily wish to protect their Know-how. They also want to keep the integrity of their staff and to prevent competition. In addition, they may wish to reserve a certain Territory and to establish further steps towards the conclusion of the actual agreement.
When a Franchisor approaches a Candidate for the purpose of establishing a franchise relationship, the Franchisor faces a dilemma which it has probably already encountered in the process of establishing direct franchises. A reputable Franchisor will always endeavor to supply a Candidate with any information necessary to help make an informed [Page81:]choice whether to enter into a Franchise Agreement. As already shown in § 4.2.1 in many countries, Franchisors are under a legal obligation to provide Franchisees with information prior to the conclusion of a Franchise Agreement. This legal obligation is sometimes based on special laws or just on general principles of law, which are applicable to franchising and master franchising. The information which the Franchisor has to disclose to a Candidate typically includes Know-how — including pre-contractual information — concerning the System. Know-how constitutes an economic value for the Franchisor and the members of its System because it is secret.
The Franchisor is well advised to conclude a separate non-disclosure agreement with the Franchisee before entering into the actual Franchise Agreement in order to ensure appropriate protection of Know-how.
To effectively protect information which is revealed during the negotiations, protection should not be restricted to Franchisor’s Know-how as it is not always easy to prove that provisions on the protection of Know-how have been violated. A breach of a non-competition clause, however, is much easier to substantiate. As a rule, it is advisable to exercise prudence in negotiations with Candidates. If someone is interested in becoming a Franchisee, it is, of course, interested in operating exactly the business in the unassigned Territory which is performed through the System. So if the negotiations fail, the Candidate might be tempted to pursue the activities of the System by itself.
The Franchisor’s staff members are a very valuable asset as they hold a lot of Know-how on the System. It may therefore prove advantageous to agree upon a clause which prevents each party from soliciting the employees of the other party.
In most cases, a Candidate intends to establish the System in the country where its company is registered. It is therefore eager to prevent the Franchisor from taking up parallel negotiations with other contenders for the same Territory and wants exclusive rights. The Candidate can protect its interests by reserving the Territory in which it wishes to establish the System. If the parties to the potential future Franchise Agreement intend to extend the Territory after a certain probationary period, the reservation should also include any territories which are added later.
The Franchisor, on the other hand, does not wish to tie up the Territory indefinitely. It will therefore be interested in limiting the reservation to a certain period of time.
In order to provide a certain degree of planning security, it may be advisable to establish individual steps and timeframes concerning the selection process of the parties. The kind of steps that are taken as well as their timeframes depend heavily on the characteristics of the individual System and possibly also on the contenders for the master franchise.
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In the stage prior to signing the MFA, time limits can be imposed with respect to the responsibilities of both the Franchisor and the Master Franchisee. These responsibilities can include a wide variety of aspects outlined elsewhere in this book (e.g. § 2.2.1). A key decision is who and how to test the System in the Target Market. This phase is called piloting of the System. The MFA typically defines with respect to piloting (1) the Master Franchisee’s duty (2) to establish and (3) operate in an ongoing way (4) at least one (5) “successfully” self-operated franchise, (6) as mandatory a prerequisite for selling franchises to third parties. Some Franchisors require more than one pilot franchise, but typically not more than three. The parties may define to some degree if and when the pilot operation is “successful,” e.g. by determining minimum business targets (by turnover, profit, margin etc.) to be reached in the pilot operation(s) before selling franchises. Other pre-sale requirements include the fulfilment of other typical Master Franchisee duties such as translating and/or adapting the documentation of the System.
For example, regarding languages, it can be provided that, within a certain period of time, one or both of the parties must fill certain positions with people who speak the language of the Master Franchisee. If the Franchisor has to provide products or raw materials, it can be provided that any resulting logistical problems must be solved by a given date. Where a new storage facility needs to be built to effectively supply a Master Franchisee in a certain target market or country, the party responsible for the construction and operation of these storage facilities has to be specified and given time limits as well.
The parties should also take into account the import and export restrictions discussed in § 4.4.7. In addition, the training of the Master Franchisee and its staff as well as the adaption of the concept to the local circumstances can be set out once a suitable Master Franchisee has been found. These two latter topics are described in the following sections.
a. Training
There is no uniform custom as to when training should take place. In some franchise Systems it is common practice that Master Franchisees should be trained only after they have finally committed themselves by signing the MFA and paying the Initial Fee. Other Systems rely on the Know-how protection provided by preliminary agreements. In this case, the training offers both parties the possibility to re-examine their willingness to commit themselves for many years by means of a MFA with the chosen partner. The types of trainings vary considerably in the different franchise Systems.
Systems that favor training on the job sometimes expect future Master Franchisees to take on a job in a franchise or System Unit before they are allowed to operate a Unit themselves. A Candidate will be allowed to sign the MFA only if it has successfully completed its job in the Unit. In other franchise Systems trainings take place in special training centers of the Franchisor. In these cases, the conclusion of the MFA can be made subject to the successful passing of examinations.
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In Systems that require training on the job or that the Master Franchisee operate a Unit, the parties may execute a labor agreement. The labor agreement may provide that the Candidate’s work or satisfaction of other conditions will lead to the conclusion of a MFA, or, in other cases, lead to some remuneration for the job.
Where a Candidate must contribute funds to cover the cost of training, it may be advisable to specify whether and under what circumstances this amount has to be paid back if the MFA is not concluded.
As a rule, the employees of the Master Franchisee are trained after the conclusion of the MFA. This issue will therefore be detailed in Chapter 11 on “Post-Closing”. If the parties wish to train the Candidate’s staff members before the conclusion of the MFA, the principles that have been outlined in this section will also apply to the Candidate’s employees.
b. Adaptation
The adaptation of the System’s concept varies considerably among different franchise Systems. This includes the extent of the adaptation to local circumstances, as well as the time required for adaptation and the related responsibilities.
Some hold the view that franchise Systems should not be adapted to local circumstances at all, although Systems taking this approach are usually not very successful and their international expansion is likely to fail. Today, a number of successful franchise Systems that, in the past, had a reputation of resisting adaptation have now adapted themselves to local circumstances, at least to a certain degree. In general, successful franchise Systems today cannot avoid a certain degree of adaptation to local circumstances, although the adaptation must not be taken so far as to change the key parts of the concept.
It is hardly surprising that Franchisors do not wish to lose control over adaptations as they are of utmost importance to the franchise System. However, the person who has already acquired experience in the market and therefore knows the market is often the most qualified person to conduct adaptation to local circumstances. As a result, adaptations, including translation and revision of the franchise manual, are carried out primarily by Master Franchisees, although design and implementation of proposed adaptation is typically subject to the Franchisor’s prior consent.
Nevertheless, this is not the only possible set-up. In some cases a Franchisor will establish a pilot operation in the target market at its own expense and risk and will revise the concept of the System, translate the franchise manual and carry out any required adaptions based upon the experience of running the pilot. Only after having implemented these measures will the Franchisor start to search for Master Franchisees to operate in the target market.
The issue of the adaptation of the concept and the franchise manual is interrelated with the question as to when these adaptations should be carried out. If the Franchisor establishes its own pilot operation and if, based on the experiences derived from this pilot operation, the System’s concept and the franchise manual are adapted by the Franchisor, the adaptation will usually be implemented before the MFA is concluded. If the System’s concept and the franchise manual are adapted by the[Page84:]Master Franchisee on the basis of its experiences from a pilot operation, the adaptation will usually be implemented after the conclusion of the MFA. The case in which the Master Franchisee first concludes a single DFA with regard only to the pilot operation, while the MFA is concluded only after the pilot stage has been successfully completed, is an exception to this practice. In such a case, the System’s concept and the franchise manual will be adapted before the conclusion of the MFA.
It is sometimes advisable to put one or more agreements in place to protect the interests of the parties prior to the conclusion of the Franchise Agreement. These may take the form of separate, individual, agreements or may be combined into a single preliminary document. Common documents used in the pre-contractual phase include:
In most cases, individual non-disclosure agreements protect only the Know-how of the Franchisor. However, if the Candidate also has to impart confidential information, the non-disclosure agreement can be drafted so as to protect both parties.
The non-disclosure agreement should define the specific elements of the Know-how to be protected as accurately as possible but without revealing the actual Know-how. To the extent permitted by the applicable law, any violation of the duty of confidentiality should trigger a penalty clause or liquidated damages compensation. It is important that the non-disclosure agreement prevent the recipient of confidential information not only from imparting this information to third parties but also from using it for its own purposes.
If the negotiations have progressed to the extent that a more significant agreement can be concluded, the parties often decide to sign a letter of intent. This kind of contract has been developed in Anglo-Saxon law and is now a widespread legal tool all over the world. However, its binding character varies, depending on the legal system. As a rule, a letter of intent expresses only the parties’ willingness to negotiate and nothing beyond. As a consequence, a letter of intent provides protection only if the willingness to negotiate is feigned and if the negotiations are terminated in breach of good faith. Its protective effect is further limited by the fact that compensation claims are usually limited to the expenses which have arisen from the negotiations. They do not include damages or any further expenses.
Due to its rather limited binding character, a letter of intent alone may not effectively protect Know-how or the reservation of the future Territory, but in any event, parties should consider including binding clauses concerning these two subjects.
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In most cases, the reservation agreement obligates the Franchisor not to conclude Franchise Agreements or similar contracts in the future Territory during the term of reservation agreement. In addition, the Franchisor is not allowed to enter into preliminary agreements or any other reservation agreement with third parties or to make any stipulations that could jeopardize the purpose of the reservation agreement. However, the reservation agreement typically does not prevent the Franchisor from conducting negotiations with other Candidates during the term of the reservation period unless the Candidate is in a particularly strong position.
If the parties already have a clear idea of the steps that will ultimately lead to the conclusion of a Franchise Agreement, they can also include a roadmap of Know-how.
Typically, a single, combined preliminary agreement contains provisions concerning the protection of Know-how, the duty to keep information confidential and the reservation of Territory. Such an agreement may also establish the duties of the parties concerning provision of information, training, participation and cooperation before the conclusion of the MFA.
In addition, it may prove advantageous to include a roadmap that establishes the steps towards the conclusion of the Franchise Agreement.
On the part of the Franchisor, these obligations can include the duty to provide information, to grant access to the franchise operations manual and to offer trainings.
As for the Candidate, the preliminary agreement usually determines the kind of information that the Candidate has to disclose during the term of the preliminary agreement and may also obligate the Candidate to attend the trainings offered by the Franchisor.
A roadmap would include all the steps to be taken before the Franchise Agreement is concluded. In this context, particular attention has to be paid to the binding character of preliminary agreements as described below. If the negotiations on the Franchise Agreement have been completed or if only minor changes are necessary, it may be advisable to annex a sample of the Franchise Agreement to the preliminary agreement that should provide that the Franchise Agreement has to be executed in its annexed form.
If the Franchisor reserves the Territory for the Candidate or offers trainings, the preliminary agreement may set forth some sort of remuneration. The Candidate will also have to be remunerated for its services, such as carrying out feasibility studies and the translation of the[Page86:]franchise operations manual, in case the Franchise Agreement is not concluded. The preliminary agreement should also clarify whether the Franchisor will be allowed to make use of these services if the parties do not conclude the Franchise Agreement later.
If the Franchisor is in a favorable negotiating position, it will also be able to include a non-competition clause. If the parties agree upon a non-competition clause in the event that the negotiations fail, the clause has to comply with the applicable laws concerning non-competition clauses. As a rule, the agreement will be governed by the chosen law. In addition, the agreement has to comply with the competition legislation that is in force in the Territory. It is advisable to establish a penalty clause or a liquidated damages compensation for the violation of both the protection of Know-how and the non-competition clause.
Finally, a non-solicitation clause that prevents each party from soliciting the employees of the other party can be included in the preliminary agreement. To the extent permitted by law, a penalty clause or liquidated damages compensation should be established.
When drafting a preliminary agreement, special care has to be taken to consider what kind of binding effects the preliminary agreement will have. During the term of the preliminary agreement, the parties primarily want to find out if it is advisable to conclude a Franchise Agreement. In such a case, the contents of the Franchise Agreement may often have already been set out and they are therefore no longer subject to negotiations. In these cases the preliminary agreement will be drafted in such a manner that enables the parties to decide if they want to conclude a Franchise Agreement. It does, however, not establish the possibility to renegotiate the contents of the Franchise Agreement.
Preliminary agreements may be binding if they provide that the Franchise Agreement, which has already been drafted, must be concluded if and when certain conditions set forth in the preliminary agreements are met.
The types of preliminary agreements, their legal characters and what they are called vary markedly across different legal systems. There are significant differences between common law and civil law systems. When drafting a preliminary agreement, special care should be taken to achieve the desired degree of binding effect and to ensure that the contractual partner who may be accustomed to a different legal system wishes to achieve the same binding effects. It is also important to make sure that the desired binding effects may be enforced according to the provisions of international private law and international civil procedure law.
When a preliminary agreement is drafted, it should be determined whether the Franchise Agreement has to comply with any special requirements concerning form. Depending on the desired degree of binding character of the preliminary agreement, special requirements concerning form may also be applicable to the preliminary agreement. Be aware that even a preliminary agreement, including a letter of intent,[Page87:]may trigger the duty to present pre-contractual information under many disclosure laws. Note also that payment of any consideration may trigger a disclosure obligation in some countries.
Typically, the parties will conclude one or more preliminary agreements, as discussed above, prior to signing the Franchise Agreement. However, the negotiating parties may sometimes wish to conclude the actual Franchise Agreement as early as possible. In these cases, the preliminary agreement usually contains resolutive conditions or the possibility to terminate the agreement if certain events occur. The preliminary agreement can, for example, provide that the Candidate has to attend training sessions and pass certain exams after the conclusion of the contract. If the Candidate does not pass the exams, the contract is terminated automatically or the Franchisor is entitled to terminate the contract through notice.
The conditions which can lead to the termination of the contract have to be defined as clearly and as unmistakably as possible. More often than not the success of a System depends on the personality of the Franchisee. As a consequence, the Franchisor must often watch out for personal traits which cannot be defined accurately in contracts or verified through exams. It is certainly not a solution to let a Candidate, whose personality does not satisfy, fail exams. This would not be fair towards the Candidate and, on the other hand, the Franchisor can be made liable if the Candidate is able prove that its failure was caused by a manipulated exam.
50 See § 4.2(a) for a discussion of disclosure laws and requirements.