Business and Operations
Primer on franchising
A franchise lawyer provides insight into the franchisor-franchisee relationship and tackles frequently asked questions
By Colleen Cross
Are you thinking of buying a pizzeria franchise? Not sure what to expect? To learn more about the relationship between franchisor and franchisee and what to expect as a new franchisee, we talked with franchise lawyer David Kornhauser of Macdonald Sager Manis LLP in Toronto, who has worked with franchisors, franchisees and franchisee associations across a variety of industries, including the food industry.
Canadian Pizza: What is the first consideration in deciding to become a franchisee?
David Kornhauser: First and foremost, franchisees have to ask themselves, ‘What is the franchisor doing for me that I can’t do for myself?’ There are a myriad of decisions that have to be made by someone who is going to operate a business. The idea of buying a franchise is that you’re already buying an established method of operating a business that has been successful and has been replicated. The idea is that if you follow the system, and because the franchisor has the breadth and depth of experience in choosing the right locations, negotiating leases and all of the other decisions that go into operating a business, you’re going to have a better chance of being successful than you would have on your own.
CP: Why does somebody decide to franchise their business?
DK: A franchisor is somebody who has developed a business method and a system of operating their business. He or she wants to expand their business, achieve some market penetration. There are various ways you can do that. You can do it through the Starbucks model of opening corporate locations, which involves hiring your own employees and taking on the leases as well as the other costs and risks of owning and operating your own business. Or you can do it through the Second Cup model of having independent third parties operate their own businesses under the franchisor’s banner and following its systems. That’s really what the relationship is all about – it’s all about the rights between the franchisor and the franchisee: these rights are governed by the agreements that the parties execute. The franchisor grants the franchisee a right to operate a business and use its trademarks and requires it to follow its system and methodology.
CP: How would you describe the franchisee-franchisor relationship?
DK: The relationship is about having third parties operate their own businesses under the franchisor’s banner and following its systems. These rights are governed by the agreements the parties execute. The franchisor grants the franchisee a right to operate a business and use its trademarks and requires it to follow its system.
The unique thing about a franchise relationship is that in some ways it’s independent, but in others it’s interdependent. The parties are like any other independent parties to a business relationship. Yet, you have the franchisee, who is out in the marketplace representing the franchisor’s brand. A franchisee may be thought of as an extension of, or an ambassador for, the brand.
CP: How long does a typical franchisor-franchisee relationship last?
DK: Generally speaking, the initial terms range from five to 10 years and there are often renewal terms that can last from five to 10 years. What I see most often, especially in the food business, are 10-year terms with either one or two five-year rights to renew.
CP: What are the key differences between becoming a franchisee and operating an independent restaurant?
DK: First of all, in a franchise system the way you’re going to operate your business is already decided, whereas when you’re operating your own business you have to make all of the decisions yourself. For example, if you’re going to open a doughnut store, you have to decide many things: Where am I going to locate it? Am I going to have a drive-through? Am I going sell just doughnuts or am I going to sell soups, salads and sandwiches? Am I going to make everything on site and have my own baker or am I going to buy my doughnuts from a bakery? What are my hours of operation going to be? How big is my seating area going to be? There are numerous decisions that have to be made, and in a franchise system, all, or most of, those decisions are made for you.
Secondly, in a franchise, you have to follow the system. That means, if they say you have to change the coffee every 20 minutes – that’s their system, and you have to change the coffee every 20 minutes. In your own store, you get to decide how often you change the coffee – if at all. You can make your own decisions regarding what, when, how, why and where, but you also then incur the risk of those decisions. With a franchise system, although you also incur the risk of those decisions, the idea is that you have a better chance of being successful.
CP: What is the most common misperception you see among entrepreneurs setting out to become franchisees?
DK: Some people think buying a franchise is a guarantee of success. In fact, it gives you a better chance of being successful but it’s not a guarantee.
CP: What kind of temperament is ideal for a franchisee?
DK: The best franchisees are those that have an entrepreneurial spirit but are willing to follow a system. From the franchisor’s perspective, they’ve developed this franchise and believe that the business can be replicated and that the franchisee will make money provided they follow the system. Sometimes a prospective or existing franchisee thinks they know better than everyone else. I always advise my franchisor clients that if they think the prospective franchisee is that type, then the franchisor should not grant the person a franchise. These types are better suited to operating their own businesses. A franchisor wants someone who, while being entrepreneurial, is willing to follow their system.
CP: Can you give us a brief overview of franchise legislation in Canada?
DK: The law in franchising is essentially comprised of two parts: a) contract law; and franchise-specific legislation in various provinces across Canada – B.C., Alberta, Manitoba, Ontario, New Brunswick, P.E.I. (Franchise Legislation). Franchise contract law is essentially equivalent in all the provinces of Canada except Quebec. My comments do not apply to franchising in Quebec. Although the forms of agreements are very much the same, there is some language you have to add to comply with the Civil Code of Quebec and language laws. There are six provinces that have franchise legislation. In provinces with Franchise Legislation, a franchisor has to provide a prospective franchisee with a disclosure document at least 14 days before any agreement relating to the franchise is signed or any monies are paid to the franchisor. There are certain exceptions which permit confidentiality agreements or refundable deposit agreements to be signed prior to the franchisor providing a disclosure document. In those provinces without franchise legislation there is no requirement to provide a disclosure document but sometimes franchisors will do it for information purposes only.
Generally speaking, franchise legislation affords a franchisee the following rights and remedies relating to disclosure. a) A right to rescind (cancel): There are two instances in which a franchisee can exercise a right to rescind. In the first instance, a franchisee may rescind the franchise agreement no later than 60 days after receiving the disclosure document if the franchisor fails to provide the disclosure document or statement of material change within the time requirements of franchise legislation or if the contents do not meet the requirements of franchise legislation. Generally, the courts have held that the 60-day rescission window applies in circumstances where a prospective franchisee paid consideration (money) before receiving the disclosure document or were there was a minor technical breach. In the second instance, a franchisee is entitled to rescind the franchise agreement no later than two years after signing the franchise agreement, if the franchisor never provided a disclosure document.
In addition to circumstances where a franchisor never provided a disclosure document at all, the courts have held that the two-year rescission window applies in circumstances where the disclosure document was so deficient that it was as if the franchisor did not provide it at all such that the franchisee was not able to make a fully informed decision; and b) a right to sue for misrepresentation or failing to comply with a franchisor’s obligations pursuant to franchise legislation.
CP: As a franchisee, when I pay into a franchise’s marketing fund, what can I expect to receive?
DK: A marketing fund is generally used by the franchisor to grow the brand and it doesn’t necessarily mean you’re going to get a direct benefit. Tim Hortons is probably a great example, forgetting recent events. The brand became valuable as a result of years of sponsorship, branding and marketing. That included sponsoring hockey tournaments, running its Roll Up the Rim campaign, through the use of various advertising media including creating television commercials. A franchisee could not necessarily point to a television commercial that was aired on March 1, 1974, or March 1, 1984, and prove that it was of benefit to him or her. But certainly the cumulative impact of all of the money spent on that branding was of benefit. Generally speaking, I don’t think anybody can dispute that the money Tim Hortons has spent over the years has created enormous brand recognition and that it was money well spent. It doesn’t mean that every single dollar benefited a particular franchisee but it does benefit the overall system.
Generally, franchisors are required to provide financial statements at the end of each year that provide details to the franchisee as to how much money it collected and what it spent that money on. That’s something a franchisee can negotiate for in a franchise agreement and any responsible franchisor should be willing to provide that kind and quality of information.
CP: Do I receive all the savings from bulk purchases made by the franchisor?
DK: A franchisor is able to decide if it wants to keep the benefit of rebates or volume discounts or share those benefits or rebates with franchisees – some franchisors do, some franchisors don’t. I think franchisors are entitled to keep the rebate, but what I would say is – and this relates to fair dealing and commercial reasonableness – a franchisee should not have to pay more than what it could buy the product or supply for in the open marketplace in order for the franchisor to get the benefit of the rebate or volume discount. Let’s talk about cheese. If a franchisee could buy cheese in the marketplace – for example, a five-pound bag of grated mozzarella cheese for $30 – then if the franchisor is charging $30, and making a dollar a bag, good for the franchisor; if the franchisor is charging $29 and still making a dollar a bag, even better: the franchisee benefits from being in the system because it’s a dollar cheaper. But if the franchisor is charging the franchisee $31, in my view, what they’re doing is making money off supplies. It’s a business issue and not a legal issue, but I think that franchise systems where a franchisor is making money off the success of the franchisees’ sales rather than off supplies is a better business model, subject to that qualification.
CP: Can I transfer my franchise to another party?
DK: Yes. As a generalization, every franchise agreement has transfer provisions that allow the franchisee to sell the business as a going concern and get as much money as they can for it, subject to the franchisor’s right to approve the transferee, and in some cases, the price being reasonable. The relationship between the franchisor and the franchisee is a personal one. . . . If you want to sell that franchise to someone else, the franchisor has a right to say, ‘I want to make sure that the person you sell your franchised business to, and that will be representing my brand, is someone who can properly operate my business and appears to be of good character, etc.’
CP: I am looking to take on a franchise. What final advice would you give me?
DK: Two pieces of advice. First, do your homework. Make sure you really understand what you’re buying. Speak to other franchisees, professional advisors, accountants and bankers. Make sure you have a good idea of what you can expect from the operation of the business.
Secondly, you need to speak to a franchise lawyer because the franchise relationship is unique. It requires someone to understand the nature of the relationship and to have an understanding of what franchise law is all about. It’s not just what is written in the statute. It has been shaped by the case law that has evolved over the last 17 years, which has provided guidance on a franchisor’s and a franchisee’s respective rights and obligations. Not every lawyer understands what those rights and obligations are, but someone who practices in the franchise area should understand. That’s why not only do you need to see a lawyer but you need to see a franchise lawyer.
If you’re spending a quarter of a million dollars buying and establishing a restaurant that you’re going to work at 60 hours a week and that’s going to be your source of income, you should spend one or two per cent having the disclosure document and agreement properly reviewed and making sure you understand what your rights and obligations are. To me it’s just common sense.
David N. Kornhauser represents franchisors, franchise associations and franchisees in the areas of franchising, licensing and distribution. David is recognized as a leading lawyer in Canada in the area of franchise law by the Lexpert Directory and is co-author of “Franchisee Associations in Canada” (Carswell, 2011). He has been a speaker at numerous franchising conferences and authored or co-authored numerous papers. David is the recipient of the 2015 Marcus Cohen Award, an award granted by the Ontario Bar Association’s Franchise Law Section for scholarly contributions to the area of franchise law. He may be contacted at 416-862-6280 or firstname.lastname@example.org, or through his website, franchisingforum.ca.