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Copyright © International Chamber of Commerce (ICC). All rights reserved. ( Source of the document: ICC Digital Library )
by Guillermo C. Jimenez
Licensing and franchising allow successful businesses to expand rapidly and internationally even if they lack the capital or experience to expand on their own. The licensor or franchisor contributes a proven brand or other valuable intellectual property, and the licensee or franchisee contributes capital and energy for expansion, and further agrees to pay the licensor or franchisor a royalty on sales (or other guaranteed payment).
Licensing and franchising structures are similar in that both involve the transfer of the right to use intellectual property (such as trademarks, patents or trade secrets). However, in practice there are important differences. Notably, the widespread use of franchises as an investment vehicle has led to stringent government regulations that apply to franchises.
In cooperative contractual arrangements such as licensing and franchising, as with commercial agencies and distributorships, there is an inherent tension as regards the duration of the relationship. Both parties will invest substantial efforts and/or capital in the relationship, yet is possible or even likely that the arrangement will be a temporary one. Consequently, it is important to be precise in the wording of contract clauses that define the limits of the relationship — e.g., term, termination, breach and renewal.
Licensing and franchising are engines of worldwide economic growth. Global retail sales of licensed merchandise reached US$ 272 billion in 2016. The Walt Disney Company was the world’s largest single licensor with over US$ 4 billion in sales of licensed merchandise. In 2017 it was estimated that there were 744,000 franchise outlets worldwide employing some 7.9 million people with total output on the order of US$ 710 billion USD.
From a legal perspective, franchising and licensing contracts are similar. However, in practice there are differences in the types of business to which they apply. Trademark licences are commonly used in the production and sale of branded consumer goods, while patent and knowhow licences are vital in the technology sector. While franchises are found in a broad range of sectors, the service sectors of restaurants, hotels and retail stores are the most important.
In practice, licensing contracts tend to be unique contracts carefully tailored to a specific context, while franchising typically involves a franchisor who offers similar terms and conditions to a number of potential franchisees.
So-called “unit” franchises (franchises for individual stores in a network, e.g., a single McDonald’s restaurant site) are offered to the general public as investment vehicles. Consequently, most countries now closely regulate the franchise format as they do other investment vehicles, such as stocks, bonds or limited partnerships. The licence, which is viewed as an arms-length negotiation between equally sophisticated parties, is not similarly regulated. For this reason, parties may seek to characterize an agreement as a licence rather than as a franchise — but it is important to respect local law in making that decision.[Page106:]
Licensing and franchising are alike in that both involve the transfer of a right to exploit intellectual property (I.P.). However, most licensing and franchising contracts also contain provisions for additional services and/or goods. For example, in a trademark licence for luxury goods, the licensor (the brand) will grant the licensee the right to use the brand’s trademarks in manufacturing and selling certain items — a temporary transfer of the right to use the licensor’s I.P. In exchange for this grant, the licensor will receive a royalty on sales. In addition, however, the licensor may agree to provide certain design, marketing and/or consulting services, and for this the licensor is often paid a fee in addition to royalty payments. In this sense, the content of these contracts could be summarized as “I.P. plus X”: in addition to the I.P. provisions the licensor/ franchisor agrees to provide additional services and/or goods.
Licence and franchise agreements are sometimes referred to as “living instruments” in that they must govern how people and companies work together over significant periods of time as true business partners, united in the mutual goal of exploiting a valuable intellectual property right. For this reason, and because both parties will invest heavily in the mutual business for a number of years, it is extremely important to be precise and complete in negotiating and drafting the relevant contracts.
A licence is an agreement pursuant to which the owner of valuable intellectual property (I.P.) grants to another party the right to exploit that I.P., subject to the licensor’s guidance, oversight and other specific constraints. Ideally, the licensing relationship will prove mutually advantageous. Licensing allows the I.P.-owner to engage in controlled expansion without having to invest in costly infrastructure.
Licensing facilitates expansion into new product categories, increases market penetration, expands distribution channels, and enhances brand awareness. For example, an apparel line can seek brand extensions into fragrances, cosmetics, jewelry, shoes, handbags, home collections, etc. A sporting goods retailer could expand into branded sporting equipment, footwear, eyewear, etc. These complementary extensions can enhance brand awareness, supported by new points of sale in prime locations and different categories of stores.
Licensees also benefit from licences because they allow a domestic party with infrastructure and expertise to market internationally-recognized brands. For example, a factory owner may have capacity to produce additional products, yet be unable to market them profitably without the power of a well-known brand. Marketing a famous brand can enhance the licensee’s access to retailers for other brands (although most licences prohibit a licensee from marketing which are directly competitive to the licensor).
Licences are thus beneficial for licensors looking to penetrate new international markets as well as for licensees looking to import foreign brands. Licensors benefit from access to foreign distributors and retailers who have established local commercial relationships and expertise. Likewise, local licensees benefit from introducing foreign brands and products to their home markets.
In the context of licensing, agents may help licensors:
> Develop a strategic licensing plan, including identifying promising retail channels, and identifying target licensees capable of assisting in the execution of the licensing objectives;
> Identify and pursue opportunities with potential partners who have the proper expertise and market positioning;
> Provide guidelines on realistic financial goals[Page107:]
Agents may help identify “out of the box opportunities” for developed or well-known brands. For example, a Swiss watch brand might be advised to target luxury automotive companies for prestige product placement through the licensing of branded interior clocks.
Conversely, a prestige brand might be interested in exploiting down-market opportunities in the mass channel, an option fraught with risk (since brand integrity is at stake). A wrong move with a poor partner can compromise a brand’s prestige in a particular country. A good licensing agent will have the know-how to match the licensor with the best possible licensee and assist with the negotiation of a successful licence agreement.
The best licensors succeed through strategic agreements that increase brand exposure while minimizing business risks and costs.
As with agency and distributorship, parties should take the time to get to know their partners — otherwise, after the contract is signed, the parties may find themselves locked into an under-performing relationship for years.
> Practice Tips
> Ascertain whether the licensing partner has the infrastructure to support the licence.
> Investigate the other party’s financial situation.
> Research the other party’s reputation and track record.
Since licensing requires a multi-year commitment, any antagonism in early negotiations is a warning sign. If the negotiations are difficult from the start, it may be prudent to re-evaluate the choice. Patience is helpful — a licensing negotiation can take months and may be the fruit of extended contacts over a period of years. Both sides should remain flexible, but licensors usually insist at a minimum on the right to maintain tight control over creative and distribution channels so as to protect the integrity of the brand.
Licensing agreements represent large investments by both sides. A poorly drafted licensing agreement or a bad match can be detrimental to a company’s brand image, sales, and customer relations.
> Pre-Negotiation Checklist
> Draft a “term sheet” with key goals and responsibilities (with the caveat that it clearly states that it does not represent the full or final agreement).
> Work with counsel to memorialize business terms, communicate and understand the meaning of the key terms, and help reach a final agreement for execution.
> Contract checklist:
> When executing a Term Sheet, Letter of Intent or Deal Memo (various forms of summarizing contract terms for convenience in negotiation), limit the binding nature of the document to avoid undue pre-contractual liability.
> Allow for changed circumstances in the agreement. If a licence is very long in duration, allow for options to accommodate to a potentially changing marketplace. Licensors should seek prior approval over new retail channels in agreements.
> If a retail price criterion defines a product or its market positioning, possible future price inflation should be anticipated.
> If the parties intend for there to be a fiduciary (special relationship of complete transparency with a very high level of duty toward the other party) or other specific relationship between them, they must expressly provide for it in the agreement.[Page108:]
> Parties should draft liquidated damages provisions which pre-determine the measure of damages if a party breaches the agreement. These provisions are likely to be upheld by the court so long as they are not grossly out of scale with foreseeable losses.
> Licensees should consider negotiating for exclusive licences with regard to certain marks or certain geographic regions.
> Typically, licence agreements include provisions stating that acceptance by the licensor of royalty (and other) payments does not constitute an acknowledgement that payments are adequate or that there are no outstanding breaches.
> A provision prohibiting assignment forbids the licensee (typically) from transferring its licensed rights to someone else. Usually, a licensor wants to control who has the right to exploit its property.
> Due diligence requires research of the financial health of the other party. Contractual safeguards should also provide that if the licensee becomes insolvent or if there is an imminent potential for bankruptcy, the contract may be immediately terminated.
The following are typical key terms in a licensing agreement:
The Definitions section sets forth the specific meaning of key terms used in the agreement, such as “Products” or “Net Sales”.
The Grant of Licence/Rights Retained by Licensor section sets forth exactly what intellectual property is being licensed. It should clearly define the rights granted, such as trademark, patent, copyright, trade secret, manufacturing, and technical know-how. Note for example that in the case of copyright licences a copyright owner maintains a “bundle” of exclusive rights, so the licence should clearly define which rights are granted (these rights are separable).
The grant section should also clearly state which rights are retained by the licensor and are not granted to licensee. Rights granted under a licence may be exclusive or nonexclusive. Under an exclusive licence, the licensee is the only entity authorized to exploit (as defined by the contract) the licensed intellectual property in the designated “territory.” Licensors should be careful not to grant an overly broad territory, which might limit the licensor’s ability to profitably license to other parties. Licence agreements commonly prohibit licensees from manufacturing and selling competitive products under a competitive trademark. Thus, many well-known brands prohibit their licensees from acting as licensees for other competing brands. .
Patent and trademark licence contracts should feature an attached schedule listing the licensed patents or marks and their registration numbers. In the event that new patents or trademarks are added by the licensor (for use with the licence), the licence should specify responsibility for clearance and filing of additional registrations (for example, local registrations in the country of the licensee) and should confirm that ownership is retained by the licensor. The agreement should also include a provision requiring the licensee to cooperate in the process of obtaining and maintain the registrations. The agreement should also specify who will enforce the licensor’s I.P. and who will bear the expense of enforcement if there is third-party infringement.
In some countries, trademark licences must be “recorded” and the trademark must first be registered in order to permit recordation. In such countries, licensing agreements which are not recorded may not be enforceable. It is therefore imperative to update the recordation each time a new mark becomes subject to the licence.[Page109:]
All agreements should specify the “term” (i.e. duration of the licence) and what happens upon termination or expiration. Licensors commonly seek a short initial term to give the licensee an introductory period of performance. Conversely, a licensee may want a very long term if it is making a substantial investment in infrastructure or personnel. The term may be renewed upon written notice or may be automatic. Ideally, renewal should require affirmative measures and should not be self-effecting. Occasionally, the parties may negotiate “roll-over” provisions that automatically extend the length of the agreement, but this is not advisable for a first agreement as the parties may wish to renegotiate terms at the conclusion of the initial term.
The licensor should always retain the ability to terminate upon a “material breach” of the agreement, e.g., failure to pay royalties, failure to satisfy quality obligations, failure to meet sales minimums, or unauthorized sale of products.
The licensee usually pays the licensor a royalty, which may come in the form of a flat fee, a percentage of net sales, or some combination thereof. Licence royalty rates commonly range from two to fifteen percent of a revenue stream which may be defined as “wholesale sales”, “gross sales” or, more typically, “net sales.” Generally, royalties on wholesale sales generate the greatest income to the licensor. Net sales are calculated as gross sales less specified discounts and returns, and are preferred by licensees because they are based on the income that the licensee actually receives. Higher royalties may be commanded by more well-known brands and by agreements which may also contemplate separate advertising contributions (often, licensees agree to spend a certain percentage of sales on advertising the licensed product — e.g., from 2 to 5% of sales). The agreement should also state the exclusions or deductions that are not allowed. For example, foreign withholding taxes on royalty income in certain countries can be as high as thirty percent and can be excluded from the net sales calculation.
Some agreements set “guaranteed minimum royalty” payments per given time period based upon earned royalties only. Well-drafted licences for mature brands generally include both guaranteed minimum annual royalty payments (generally paid in advance and pro-rated on a quarterly basis) and minimum annual net sales obligations. The use of guaranteed minimum obligations avoids the “warehousing” of brands and compels actual business development commensurate with royalties. However, guaranteed royalty payments alone cannot assure the licensor of reaching objectives as regards expansion of the brand, its good will and reputation. The inclusion of minimum sales requirements also enables the licensor to terminate the agreement if such objectives are not being met. The licensor is thus able to seek out another licensee if sales fall below expectations.
The Audit section of the agreement sets forth the manner of payment to the licensor and further specifies the licensor’s rights to inspect the licensee’s accounting books and records. Licences commonly require the licensee to pay for the audit if the licensee is found to owe a specified amount (usually a percentage) in excess of the royalties actually reported and paid.
Design sections in licence agreements explicitly provide for how the licensed products will be designed, the approval process, the creation of prototypes, and schedules relating to production, delivery, promotion and market delivery of the goods. This section should state whether third party contractors are permitted, and the extent to which such parties are governed by the terms of the agreement, proper indemnities, and ethical compliance guidelines.[Page110:]
Quality control of licensed products is important because sale of poor-quality products will harm a brand and its reputation. The licensor should retain the right to control the design of the licensed product, including materials used, overall quality, and manufacturing processes. These quality controls should include the right to inspect manufacturing plants and review and comment on samples and prototypes throughout the manufacturing process.
The licensor should specify the appropriate channels of distribution for sale of the products. For example, if the licence grants rights to designer names or marks associated with luxury goods, the licensor should prohibit inappropriate distribution, as by stating: “Licensee may not distribute Articles bearing the Licensed Marks to discount outlets, mass market discounters, and warehouse stores.”
Licensors should maintain control over manufacturing by requiring the licensee to identify its manufacturers by name and address, and by reserving the right to inspect the manufacturers’ premises for human rights compliance and quality control. The licence should permit the licensor to conduct sample inspections and spot visits to the licensee’s facilities.
The parties should agree upon sales guidelines, e.g., the size and nature of the sales staff which licensee must employ (for example, the agreement may require the licensee to assign a full-time executive to be a brand manager).
Delivery of designs, prototypes, and/or product samples may be specified on a production schedule. Delivery of product samples may also be required on a continuing basis to ensure quality control. Structured deadlines will help keep production on schedule and avoid delays. A complete agreement will also include a structure or calendar for product development, including product launch dates.
Both parties commonly provide assurances in the form of representations and warranties. These include, for example, assurances that the licensor actually owns the marks or has the right to exploit and grant rights to use the mark; that licensor is not involved in any disputes challenging such rights; that the licensor has the authority to enter into the licensing agreement; and that the licensor will maintain the validity of the marks. Likewise, licensors should seek assurances that the licensee has the requisite financial status and staffing to produce and market the licensed products; that the licensee will use its best efforts to promote and sell the licensed products; and that licensee does not and will not sell directly competing products.
An “indemnification” clause sets forth the parties’ respective responsibility for legal claims or lawsuits brought in connection with the agreement. The licence agreement should include indemnification from the licensee in favour of the licensor — and its affiliates, parents, subsidiaries, officers, directors, employees, and customers — for licensed products that are manufactured by the licensee.
Insurance requirements support the indemnification obligation and ensure that the party charged with indemnifying the other will have insurance to support the representation. The licensee, as manufacturer of the product, is in the best position to be aware of the risks, safety issues, and potential pitfalls in manufacturing. Thus, the licensing agreement should require the licensee to name the licensor as an “additional insured”, thereby obligating the licensee’s insurer to provide coverage directly to the licensor.[Page111:]
The agreement should indicate whether the licensee may grant sub-licences. Granting sub-licences may be necessary for manufacturing certain products or to allow affiliates of the licensee to use the marks or sell the licensed products. As a general rule, licensors should restrict the right to sub-licence and require prior written approval.
A licensor may wish to limit the types of customers to whom a licensee may sell licensed products. One motivation for such a limitation is the desire to minimize “parallel importing” or “gray markets”. Parallel importing arises when goods bearing valid trademarks are manufactured abroad but are then imported into the licensor’s home country without authorization.
Disputes concerning a licence agreement may be resolved via the court system, mediation, or arbitration. In an international commercial context arbitration is often preferable, and in such cases the arbitration clause should specify a local site for the arbitration. The agreement may also provide for recovery of damages, attorneys’ fees, and equitable relief.
Franchising is a form of shared investment in the expansion and replication of successful business systems. International franchising allows franchisors to grow rapidly in foreign markets without making major capital investments. Franchising contracts can be complex and, in many jurisdictions, are subject to local laws for the protection of franchisees.
“Business format” franchising, our focus in this chapter, offers investors (the franchisees) the opportunity to participate in a successful and proven business system (usually comprising trademarks, knowhow and support services). Franchising is based on replicating proven success, which explains its rapid worldwide growth. Franchising has become one of the primary distribution channels for products and services in developed economies, where image and service reputation can determine market share. Franchising is found in industries as diverse as fast food, computer sales, real estate services, automobile rental and service stations, to name but a few.
Well-known examples of the franchise concept are: McDonald’s (USA), Yves Rocher (France), InterContinental Hotels (UK), H&R Block (Canada), Kumon (Japan), and DIA (Spain).
In order to grow rapidly, business networks need capital. In franchising, this capital is provided by the franchisee, and in exchange the franchisor grants to each franchisee the right to exploit the franchisor’s business system, including trademarks, logo and distinctive signs, intellectual property, technical know-how and processes. In return, the franchisee usually makes a “front money” payment in order to enter the franchise network, invests a minimum amount in setting up and operating the business, pays the franchisor fees and royalties and adheres to the franchisor’s standards for quality of services (sometimes known as “QC” or quality control standards). The combination of the franchisor’s reputation and expertise with the franchisee’s capital, local knowledge and motivation, can result in attractive rates of growth.
In many countries franchising (like agency) has been the subject of governmental scrutiny. Governments have been concerned that local franchisees, like agents, have little bargaining power against large franchisors and therefore require mandatory legal protection. Thus, in many countries there are strict regulations dealing with such things as the amount of disclosure that must be made by franchisors when recruiting franchisees (such information is commonly contained in a document known as a[Page112:]“franchising prospectus”). Such regulation is intended to protect franchisees, many of whom in the past claimed to have been “lured” into franchises by franchisors’ inflated or misleading statements as to likely returns on investment.
International franchising is conducted through the following structures:
> Master franchises,
> Direct or unit franchises,
> Franchisor’s branch or subsidiary,
> Area or territory development agreement,
> Joint venture.
“Unit franchises” confer the right to exploit a single operation, while “master franchises” and “area development” agreements confer the right to sub-develop and/or grant sub-franchises in a particular territory. Master franchises are particularly suitable internationally because they permit local supervision of networks. However, in cases involving countries that are relatively proximate (e.g., France and Belgium, or U.S. and Canada), unit franchising is not uncommon.
In the case of unit franchising, the franchisor enters into an agreement directly with each franchisee. Under a territorial / area development franchise, a geographical area is developed by a master franchisee or area developer responsible for a number of outlets.
Unit franchising is more common in domestic markets than internationally — it facilitates a maximum of control by the franchisor over the individual outlets. In an international context, however, a unit franchise approach makes it harder to minimize costs via decentralization. The costs of supervising an international network from a single headquarters can prove onerous. In the international context, therefore, it is generally only advisable to franchise directly when the target country is geographically, culturally, linguistically and/or legally proximate to the franchisor’s country.
Territorial franchises cover multiple outlets in a specified area and may be granted through either a “franchise development” agreement or a “master franchise” agreement. Under a typical development agreement, the developer/franchisee is required to open and operate a certain number of units in the assigned geographical area (usually a particular country) within an agreed time frame. The franchisor benefits from dealing with a manageable number of franchisees. Area developers usually have sufficient financial and human resources to manage the set-up and day-to-day operation of the business with a relatively high degree of independence from the franchisor. Training costs can also be reduced, because the franchisor only trains the developer; the developer, in turn, trains the unit franchisees.
“Area developer” agreements are also subject to corresponding risks. If the developer fails, all of the outlets in the territory will be affected. On the other hand, if the franchisee does extremely well, he may become uncomfortably indispensable to the franchisor, because the developer may represent so many outlets. Another possible problem is that area developers may employ salaried managers to run the individual shops (as opposed to highly motivated unit franchisees).
Under “master franchise” agreements, the franchisor grants the master franchisee (or sub-franchisor) the right to develop and operate franchise outlets on his own account, as well as — in most cases — the right to sub-franchise outlets to sub-franchisees. Some sub-franchisees may even be allowed to run several units, which may add to the complexity of the system. Decreased control over sub-franchisees is to be expected as a corollary to the increased level of decentralization. Although master franchise agreements commonly include strict provisions regarding the supervision of the system, their enforcement may be difficult.
Yet another option is to establish an overseas subsidiary in each target territory to act as franchisor. Under this system, the franchisor retains direct control over the foreign[Page113:]franchisees, but still benefits to some extent from local know-how. Alternatively, a joint venture may be set up by the franchisor and a local enterprise with experience in franchising. Guidance from an experienced franchise lawyer is essential.
Product (or trademark) franchising involves granting the right to manufacture and/or market a product under a specific trademark to the franchisee. This structure is extremely similar, and in many cases indistinguishable, from a trademark licence.
Business format franchising covers a complete system of doing business, including service concepts and operations, in addition to trademark and logo rights. In production (or manufacturing) franchises, the franchisee manufactures according to the franchisor’s specifications and sells the goods under the franchisor’s trademark. In a service franchise, the franchisee provides a service developed by the franchisor under the franchisor’s service mark.
Under a distribution franchise arrangement, the franchisor manufactures the product and sells it to the franchisee for resale to the final consumer.
There are thus a wide variety of legal forms that can be chosen for international franchise agreements, and those discussed here are only the more common forms.
The philosophy of the ICC Model Contracts is to provide a balanced, fair template for the parties to work with. The contracts can be used “as is” or can be adapted for the parties’ particular preferences.
This ICC Model Contract applies to international distribution franchise agreements.
Note the following key elements:
> Know-how
Know-how includes valuable and proprietary information, experience and operating techniques of the franchisor that would enable the franchisee to operate the franchised business. This also includes the franchisor’s assistance in the operation of the business and training of the franchisee. In return, the franchisee must respect the franchisor’s proprietary rights and take all reasonable steps to protect the confidentiality of the franchisor’s training materials and operation manuals.
> Franchisor’s Trade Name, Trademarks and Patents
The franchisee must acknowledge that the franchisor is the owner of all proprietary rights, titles and interest in the systems to ensure a proper protection of the franchisor’s rights. Customer recognition and confidence in the products or services are usually linked to the trade mark, which is one of the key elements of a successful franchise system.
> Products and Territory
A clear definition of the products and the territory is essential to achieve the quality requirements, and also to allow the franchisee to maintain a stock of products to meet the needs of customers and to attain the sales requirements or targets. It is acknowledged that the granting of an exclusive territory (as defined in the contract, and which may be quite narrow) enables the franchisee to maintain a profitable business. During the term of the contract, the franchisor is not allowed to operate or permit any person other than the franchisee to operate the business within the territory.
> Payment of Fees and Royalties
The parties are required to clearly decide how and when payment shall occur, taking into consideration the fact there are many ways to calculate royalties. Failure to pay royalties may be considered a breach of the contract and result in a right to terminate the contract.[Page114:]
> Term and Renewal of Contract
The parties may contract for a definite period or an indefinite period. In the former case, they should bear in mind that the number of years cited in the contract should be tied to the capital investment of the franchisee, which should be reasonably able to recover its investments. Moreover, the relationship may evolve and new products or services may be introduced on the market. The parties should therefore carefully consider the conditions upon which the contract will be renewed, prolonged or terminated (i.e., the grounds for early termination and its effects).
Test your Knowledge: Licensing and Franchising
True/False
Answers: 1. F 2. T 3. T 4. T 5. T