STRUCTURING THE MASTER FRANCHISE AGREEMENT
By Andrew J. Sherman, Esq.

There are a wide variety of forms that an international franchising program can take, each with their respective advantages and disadvantages. Although an extensive discussion of these issues is beyond the scope of this article, small and emerging business owners should consult with experienced counsel as to whether joint ventures, subfranchising, regional development, area franchising, direct franchising or direct product or service distribution strategies or even more creative strategies or structures should be pursued.

Most international franchising transactions are structured as either: (a) an award "multiple-unit franchises" to aggressive entrepreneurs who will be responsible for the development of an entire geographic region, either through their own resources or by sub franchising to third parties; or (b) through some joint venture structure as discussed below.

(a) Multi-Unit Franchising. The two primary types of multiple-unit franchise development strategies are: (a) subfranchisors, who act as independent marketing agents that are responsible for the recruitment and ongoing support of franchisees within their given region; and (b) area developers, who have no resale rights but rather are themselves responsible for meeting a mandatory development schedule for their given region. There are a wide variety of variations on these two principal types of multiple-unit franchises. For example, some franchise relationships which are at the inception single-units, wind up as multiple-unit owners through the use of option agreements or rights of first refusal. Other franchisors have experimented with co-development rights among adjacent franchisees of a nearby territory, franchises coupled with management agreements (under those circumstances where the franchisee desires to be more passive), equity participation by franchisors in franchisees (and vice-versa), employee ownership of franchisor-operated units and co-development rights between the franchisor and franchisee.

As a general rule, the inclusion of multiple-unit franchises in a franchisor's development strategy allows for even more rapid market penetration and less administrative burdens. Often times the franchisee demands the right to develop and operate multiple units. However, there are a wide range of legal and strategic issues which must be addressed when multiple-unit franchises are included in the overall franchising program.

(b) Structuring Area Development Agreements. The key issues in structuring an area development agreement usually revolve around the size of the territory, fees, the mandatory timetable for development, and ownership of the units. The franchisor will usually want to reserve certain rights and remedies in the event that the franchisee defaults on its development obligations. The area developer must usually pay an umbrella development fee for the region, over and above the individual initial fee that is to be due and payable as each unit becomes operational within the territory. The amount of the fee will vary, depending on factors such as the strength of the franchisor's trademarks and market share, the size of the territory and the term (and renewal) of the agreement. This development fee is essentially a payment to the franchisor that prevents the franchisor from offering any other franchises within that region (unless there is a default).

(c) Structuring Subfranchising Agreements. Subfranchise agreements present a myriad of issues that are not raised in the sale of a single-unit franchise or an area development agreement. This is primarily because the rewards and responsibilities of the subfranchisor is much different than the area developer or single-unit operator. In most subfranchising relationships, the franchisor will share a portion of the initial franchise fee and ongoing royalty with the subfranchisor, in exchange for the subfranchisor assuming responsibilities within the given region. The proportions in which fees are shared usually has a direct relationship to the exact responsibilities of the subfranchisor. In addition, the subfranchisor will receive a comprehensive regional operations manual which covers sales and promotions, training and field support over and above the information contained in the operations manuals provided to individual franchisees. Some of the key issues which must be addressed in the subfranchise relationship include:

• How will the initial and ongoing franchise fees be divided among franchisor and subfranchisor? Who will be responsible for the collection and processing of franchise fees?
• Will the subfranchisor be a party of the individual franchise agreements? Or will direct privity be limited to franchisor and individual franchisee?
• What is the exact nature of the subfranchisor's recruitment, site selection, franchising, training and ongoing support to the individual franchisees within its region?
• Who will be responsible for the preparation and filing of franchise offering documents in the those states where the subfranchisor must file separately?
• What mandatory development schedules and related performance quotas will be imposed on the subfranchisor?
• Will the subfranchisor be granted the rights to operate individual units within the territory? If yes, how will these units be priced?
• What will the subfranchisor be obligated to pay the franchisor initially for the exclusive rights to develop the territory?
• What rights of approval will the franchisor retain with respect to the sale of individual franchises (e.g., background of the candidate, any negotiated changes in the agreement, decision to terminate, etc.)?
• What rights does the franchisor reserve to modify the size of the territory or repurchase it from the subfranchisor?

A subfranchisor enters into what is typically referred to as a Regional Development Agreement with the Franchisor, pursuant to which the subfranchisor is granted certain rights to develop a particular region. The Regional Development Agreement is not in itself a franchise agreement to operate any individual franchise units, rather it grants the subfranchisor the right to sell franchises to individuals using the Franchisor's system and proprietary marks solely for the purpose of recruitment, management, supervision and support of individual franchisees. To the extent that the subfranchisor itself develops units, then an individual franchise agreement for each such unit must be executed.

The relationship between franchisor and subfranchisor is unique and somewhat complicated. If the appropriate individual is chosen for this role, the relationship can be mutually beneficial. The advantages of such a relationship to the franchisor include rapid market penetration, the delegation of obligations it would otherwise be required to fulfill to each franchisee in its network and the ability to collect a percentage of the initial franchise fee and royalty fees from each franchisee, generally without the same level of effort that would be required in a single-unit relationship.