What Is a Franchise Agreement and How Does It Affect Business Formation?

Expansion through franchising is one of the most structured ways to grow a business. But before signing, entrepreneurs often ask themselves: what is a franchise agreement and how will it affect their role as entrepreneurs?

A franchise agreement is a legally binding contract that defines the relationship between franchisors and franchisees. It outlines the rights, obligations, and expectations of both parties, covering every aspect. For those considering expansion models, this document is as critical as asking what insurance do I need to start a business, or, for those looking to balance employment and entrepreneurship, can I start an LLC while employed? Understanding this contract is critical, because it not only regulates daily operations, but also affects long-term business formation, financing and compliance. 

For entrepreneurs who work with a trusted consultant for setting up businesses, the franchising contract is one of the first documents to analyze before committing capital.

Defining a Franchise Agreement

A franchise agreement is a legal document that governs the franchise relationship between the franchisor (i.e., the owner of the trademark, intellectual property rights, and know-how) and the franchisee (the entrepreneur or company that manages the business in the local market).

Its use is justified by its importance in governing the relationship between the parties and preventing any conflicts and ambiguities; for this reason, entrepreneurs often ask what is included in a franchise agreement before signing.

What Information Is Included in a Franchise Agreement?

Not all franchise agreements include the same information, but some elements are generally common, and entrepreneurs often ask what information is included in a franchise agreement before reviewing the contract in detail. Among the seven main aspects are:

• Franchise fees and royalties: This section specifies both the initial investment and the ongoing payments. It provides for periodic royalties to be paid to the franchisor, usually calculated as a percentage of turnover. In addition, it provides for any additional contributions related to marketing and advertising.
• Intellectual property rights: This section specifies and regulates the use of trademarks and patents. In fact, the franchisee may use them within certain limits but does not acquire ownership from the franchisor.
• Territorial rights: This item defines whether the franchisee will have territorial exclusivity or whether they will have to compete with other outlets in the territory. This point is essential to avoid internal competition.
• Training and support obligations: Another key point of the agreement. Here, the franchisor defines the operational, logistical, marketing, and even after-sales services it will provide to the franchisee. It establishes the initial training and ongoing support provided to the firm so that all franchisees operate in accordance with a minimum standard. 
• Operating standards: Related to the previous point, minimum standards of product and/or service quality and common practices among the various franchisees are established. In this way, the franchisor ensures that the customer will always have a consistent experience.
• Duration and renewal terms: Here, the parties specify the duration of the agreement (e.g., 5 or 10 years) and establish renewal conditions with all associated costs.
• Termination clauses: Finally, the parties choose the clauses for termination or the conditions under which termination may be requested. Among the most common are violations of established standards, non-payment of royalties, corporate bankruptcy, etc. These clauses are essential to protect the franchisor and maintain the integrity of the system.

Each of these sections affects how the franchise business is structured, financed, and managed. Taken together, they form the framework for the franchisee’s entire operation.

How a Franchise Agreement Impacts Business Formation

Choosing franchising instead of starting an independent business radically changes the path to setting up a company. In an independent company, the entrepreneur has the freedom to choose what they want in terms of brand, market positioning, marketing, and operational structure.

In a franchise, on the other hand, you become part of an already structured system with predefined rules. 

This choice has advantages and disadvantages. Among the benefits are the use of an already well-known brand (instead of creating one from scratch), operational support from the franchisor resulting in fewer mistakes, proven and functioning systems to implement,  and greater access to financing.

As for the disadvantages, the company will have to cope with less decision-making and operational autonomy, undergo periodic checks (audits and reviews), and comply with the procedures and standards required by the franchisor.

In conclusion, the franchising model can be advantageous thanks to greater security, but it legally and financially commits the company to the franchisor (through the payment of royalties and an initial fee).

Advantages of Franchise Agreements for Entrepreneurs

Specifically, when analyzing the advantages of a franchise compared to an independent business, there are four main ones:

• Access to a recognized brand and customer trust, resulting in a faster start-up. Starting your own business, on the other hand, means initially focusing on brand development itself;
• Reduced risk compared to starting from scratch, where processes must initially be tested, branding strategies created, and strategies developed;
• Support in training, marketing, and supply chain provided by the franchisor with periodic courses and centralized marketing campaigns as a brand;
• Greater access to financing thanks to a structured system and greater appeal of the franchisor.

Potential Challenges of Franchise Agreements

Among the most significant challenges, instead, we can focus on:

• Limited flexibility in decision-making with less discretion than in an independent company. Companies cannot intervene in pricing and positioning strategies, for example;
• Ongoing costs (royalties and advertising contributions) in addition to the initial investment. Franchisees must pay periodic royalties and sometimes contributions to marketing funds managed by the franchisor. These costs reduce the operating margins, even when profits are not yet high;
• Dependence on the franchisor’s reputation and performance, with consequent unmanageable and unforeseen events (such as reputational damage);
• Legal complexity in the international context, with a consequent need for specialized consultants and professional support.

Global Considerations in Franchise Agreements

In conclusion, franchise laws change greatly from one jurisdiction to another. Some countries, for example, have very detailed regulations that require a franchise disclosure document and mandatory registrations. Others provide a more flexible approach, sticking only to the agreement between the parties. 

In any case, each contract must comply with the labor, health, safety, advertising, and consumer protection regulations of the relevant jurisdiction, especially when services are provided across borders. It is the responsibility of the company and its specialized consultants to ensure that it always complies, reducing the risk of penalties and reputational damage.

FAQs

What is a franchise agreement?

It is a legally binding contract between the franchisor (owner of the brand and system) and the franchisee (local operator) that defines the rights, duties, and obligations of both parties.

What information is included in a franchise agreement?

Various sections. The most important ones concern fees and royalty payments, intellectual property rights, territorial rights, operating standards to be followed, support and training provided, and clauses for termination, renewal, or resolution.

What is included in a franchise agreement regarding fees?

All financial details are specified: the initial contribution, the percentage of royalties on turnover or revenue, and marketing/advertising contributions.

How does a franchise agreement affect business formation?

It shapes ownership privileges, operational structures, and long-term obligations, distinguishing franchising from independent company formation.

Are franchise agreements the same worldwide?

No. Each country has different rules, with some jurisdictions requiring a franchise disclosure document and official registrations, while others regulate franchising only through general contract law.

Can a franchisee negotiate a franchise agreement?

In theory, yes, but the reality is that most franchises use standard contracts with little room for negotiation.

References

Manning Fulton. (2023). Breaking Down Franchise Agreements: 10 Things to Know.

https://www.manningfulton.com/blog/breaking-down-franchise-agreements-10-things-to-know/

Franchise Law Solutions. (2023). The Difference Between the FDD and a Franchise Agreement.

https://www.franchiselawsolutions.com/learn/franchise-your-business/the-difference-between-the-fdd-and-a-franchise-agreement

Wayback Burgers. (2023). Franchise Agreements: What Every New Franchisee Should Know. https://waybackburgers.com/franchising/blog/franchise-agreements-what-every-new-franchisee-should-know/