Franchises – what are they and how do they work?

Business information | Print Article

[Spring 2013]

So you’re contemplating getting into business and wondering whether to go for a franchise. This article discusses the basic terminology and features of a franchise.

‘Franchisor’

Owner of a unique business system.

‘Franchisee’

Person who is licensed to use the franchisor’s system and name in their own separate business for a specified term. Commonly the term is five years with one or two rights of renewal.

Franchise agreement

This regulates the operation of the franchisee’s business. The agreement is usually weighted in favour of the franchisor, and franchisees will not be able to negotiate changes to it. This is necessary to protect the integrity of the franchise system, but it must still be fair.

Fees, levies or royalty payments

A franchisee will usually have to pay an initial franchise fee which is a lump sum to compensate the franchisor for development costs and as a licence fee.

Ongoing service or royalty payments are for the ongoing use of the system and trade name by a franchisee and for the ongoing support and assistance of the franchisor. It is common for these payments to be in the range of 5-8% of gross sales.

The advertising or marketing levy is normally in the range of 2-4% of gross sales. All franchisees pay the same advertising levy to the franchisor, to be held in a separate trust account and only used for marketing. The franchisor will usually consult with a committee of the franchisees to reach a consensus on how the marketing funds should be spent. But at the end of the day the final decision will rest with the franchisor.

Purchase prices for franchise businesses tend to be higher than for independent businesses carrying out the same trading activity. The theory is that a franchisee pays a higher up-front fee, and ongoing costs, in exchange for lower economic risk.

Franchise Association of New Zealand

The best franchisors belong to the Franchise Association, and therefore follow its Code of Practice. This reassures potential franchisees that the franchisor is serious and has undertaken to practise in a fair and reasonable manner.

Among other things, the Franchise Association requires its members to:

  1. Publish a disclosure document to maximise the information available to prospective franchisees, so that they can make a sound business decision whether or not to proceed.
  2. Insist that each franchisee has independent legal and accounting advice.
  3. Use agreements that contain a minimum of a 7-day cooling-off period.

Other features to look out for

A franchisor will have rights to terminate a franchise agreement. These usually relate to matters such as the insolvency of the franchisee, persistent failure to follow the terms of the franchise agreement, bringing the brand into disrepute etc.

The territorial restriction needs to be clear. A marked-up map should be attached to the agreement.

A restraint of trade normally applies both during the term of the franchise agreement and afterwards, to prevent the franchisee from competing with the franchisor. The restraint must be reasonable. The term should not exceed 2 years after the franchise ends, and it would not normally cover more than 10 or 20 kilometres from the premises where the franchise business was operated. However, this depends on the type of business and there have been cases covering the whole of New Zealand. Restraints must be reasonable because it is undesirable to prevent people from working in a field in which they have skill and expertise, or away from their home environment. In a dispute the courts consider whether the restraint is reasonably necessary to protect the franchisor’s goodwill from future competition and is not too harsh on the franchisee.