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Special Issues for an Area Developer

Guest post by: Keith Kanouse

Article Overview: If you desire to own and operate more than one franchise outlet, you may want to consider becoming an area developer. An area developer is really a multi-outlet franchisee that commits at the beginning of the relationship with the franchisor to open a number of outlets within a given area (“Development Area”) over a specific period of time (“Development Schedule). This is different from the multi-outlet franchisee that may have first purchased one outlet and later purchases another outlet, etc., without ever being contractually bound to open further outlets. there are issues and terms unique to an area developer that must be addressed to make the relationship between the franchisor and the developer more equitable by having a fairer area development agreement.

Special Issues for an Area Developer



If you desire to own and operate more than one franchise outlet, you may want to consider becoming an area developer. An area developer is really a multi-outlet franchisee that commits at the beginning of the relationship with the franchisor to open a number of outlets within a given area ("Development Area") over a specific period of time ("Development Schedule). This is different from the multi-outlet franchisee that may have first purchased one outlet and later purchases another outlet, etc., without ever being contractually bound to open further outlets.

Usually, you and the franchisor will sign an area development agreement and also sign a franchise agreement for the first outlet at the same time. If a franchisor offers area development rights, the Franchise Disclosure Document Guidelines require specific disclosure regarding the area development rights. This disclosure is usually included in the franchisor's Franchise Disclosure Document ("FDD") for a single outlet franchise. Where required disclosure is the same for a franchise agreement and a development agreement (for example, ITEMS 2, 3 and 4) duplicate disclosure is not necessary. However there are certain items of the FDD (including ITEMS 5, 6, 7, 8, 9, 11, 12 and 17) where there is a discussion of certain terms of the area development agreement. A copy of the area development agreement will also be attached as an exhibit to the FDD.

There will usually be a number of terms contained in the area development agreement that are identical to, or substantially similar to, those terms contained in the franchise agreement. Hopefully, as part of your review and negotiation of the terms of the franchise agreement, you have already addressed these issues from a fairness perspective. A corresponding Addendum to Area Development Agreement will contain these provisions.

In addition, there are issues and terms unique to an area developer that must be addressed to make the relationship between the franchisor and the developer more equitable by having a fairer area development agreement. These unique contract issues for an area developer include (in alphabetical order):

A. CROSS-DEFAULT

The typical one-sided franchise agreement contains in the default section a term that provides that a default under any other agreement between the franchisee and the franchisor (this includes another franchise agreement) is also a default under this franchise agreement. While many events of defaults are automatic defaults under each franchise agreement (for example, insolvency) that trigger defaults under each franchise agreement, there may be a default that only applies to a particular outlet ("bad location") leaving the other outlets not in default. This term causes you to be in default under every franchise agreement. Therefore, you must make sure that the area development agreement and each franchise agreement stands on its own. Do not accept a provision in the default section that states that a default under the area development agreement or any franchise agreement constitutes a default under any or every other agreement. Otherwise, it would have a "domino effect" and jeopardize everything!

B. Development Area

A Development Area is the area in which the developer will locate its franchise units. You need to make sure that the franchisor gives you exclusive rights to the Development Area so that the franchisor cannot open its company-owned outlets or grant a franchise to another party within the Development Area. Some franchisors try to reserve for themselves the rights to certain key locations within the Development Area in which to operate its company-owned outlets or franchise to another (for example, outlets in regional malls, airports, highway facilities, schools, etc.). You need to negotiate a term provides that you have the right of first refusal to open in such a location, unless you are not qualified, by law or regulation, to operate at the location.

C. Development Fee

A development fee is the up-front fee paid by a developer to the franchisor for the development rights. This fee is usually negotiable. The franchisor desires to get as much up front as possible. The developer was to pay as little up front as possible, preferably by paying the entire initial franchise fee for each outlet as locations are found and a franchise agreement is signed. Although there is no set formula, the franchisor usually calculates the Development Fee by taking a percentage of the initial franchise fee (e.g., 50%) and multiplying it by the number of outlets to be opened by the developer under the area development agreement. The Development Fee should be credited against the total initial franchise fees so that as each single outlet franchise agreement is signed, you pay the standard initial franchise fee less the pro rata amount by the Development Fee previously paid. Some franchisors reduce the initial franchise fee for the second and additional outlets on the theory that the franchisor's costs, particularly training, will be less since the franchisee is already trained. Keep this in mind in negotiating the development fee and the initial franchise fee for 2 or more outlets. Be aware that the area development agreement will usually contain a term that provides that upon a default by the developer under the development agreement (including the failure to achieve the Development Schedule), the franchisor has the right to terminate the area development agreement and retain the entire Development Fee. This is another reason to negotiate a lower Development Fee.

D. Development Schedule

In my experience, the major issue to be negotiated in an area development agreement is the Development Schedule. The Development Schedule is the agreement between the developer and the franchisor as to how many franchise outlets are to be opened over a specified period of time. The franchisor wants the developer to open as many outlets as quickly as possible to saturate and pre-empt the market. The developer wants a very conservative schedule because of the uncertainties of the future, the developer's financial condition, the performance of the initial outlets and the developers' ability to manage the construction and operation of multiple units. The Development Schedule is totally negotiable since the circumstances vary greatly in each deal. The Development Schedule should be reasonable for both parties. The Development Schedule is usually a "minimum" development schedule. Consider negotiating the right (but not the obligation) to open more outlets within your Development Area, if it makes economic sense to you, without the payment of any additional up-front fees.

E. Failure to Achieve Development Schedule

The typical area development agreement has a provision that states that if you fail to achieve the Development Schedule the area development agreement can be terminated by the franchisor resulting in your loss of your development rights and the entire Development Fee. You need to make sure that the area development agreement term states that if you fail to achieve the Development Schedule, you have several possible options that do not include the loss of development rights such as the payment of an extension fee, the payment of minimum royalties or other terms that are fair to both of you. In addition, make sure the area development agreement provides that if the area development agreement is terminated due to your failure to achieve or maintain the Development Schedule, you can retain the outlets already open or under construction provided you are not otherwise in default under the franchise agreement.

F. Form of Franchise Agreement

The one-sided area development agreement normally provides that the developer will sign the franchisor's "then-current form of franchise agreement, which may be materially different than this Agreement." Since the area development agreement runs for several years, conceivably, there will likely be major material changes to the franchise agreement adverse to your interests and you will be obligated to sign it because you have already agreed to do so when you signed the area development agreement. Therefore, you need to negotiate a provision in the area development agreement that states that the franchise agreement you negotiate in conjunction with your negotiation of the area development agreement will be the form of the franchise agreement you sign for each outlet opened pursuant to the area development agreement.

G. Limit Other Fees

Each franchise agreement probably contains numerous other fees such as renewal fees, transfer fees, securities offering fees, etc. For example, if you decide to sell all your development rights and related franchise agreements, don't allow these fees to multiply just because you are a multi-outlet franchisee. Limit these fees to something reasonable in the aggregate.

H. Option to Renew

The typical term of an area development agreement ranges from 3 to 10 years. Once the area development agreement expires, the franchisor is free to open its company-owned outlets, grant franchises and/or appoint another developer within the development area so long as these outlets are not within the protected territories of your operating outlets. If there will room for further development in your development area after the area development agreement expires, you should consider negotiating an option to renew the area development agreement for an additional term subject to you and the franchisor negotiating in good faith a new development schedule based on demographic, economic and other conditions existing at that time. If the parties cannot agree, the issue will be submitted to binding arbitration. I. Reduced Royalty Fees

There may be economies realized by the franchisor in providing its services to all of your outlets. In addition there may be certain functions that you handle that reduce the services provided by the franchisor. If this is the case, you may consider negotiating that the royalty fees of all your outlets be aggregated and applied against a reduced sliding scale of royalties as gross revenues increase. Your argument is that this serves as a greater incentive to you to increase sales and also that the franchisor incremental services as gross revenues increase are not as great. While some franchisors already have a sliding scale of royalties, many do not.

K. OTHER ISSUES

There may be issues important to the developer other than the issues discussed in this paper. You and your attorney need to review the entire area development agreement very carefully to see what impact certain terms have upon your development rights. If there are terms that appear unreasonable and unfair, you need to attempt to negotiate these issues to protect your interests.

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Article Tags: MultiOutlet Franchisee Development Rights



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