How franchisors and franchisees can work together to combat the impact of Covid-19

For franchisors, one of the principal advantages of the franchise model has always been the ability to open up new markets (and revenue streams) at very little risk to themselves. The franchisor licenses its brand and knowhow to the franchisee and receives an upfront fee and a regular royalty (often subject to a guaranteed minimum amount) in return. The franchisee enjoys the “springboard” effect of a recognised brand with established goodwill, but otherwise operates the franchise business at its own risk.

However, what the current crisis has shown, with almost the entire world in lockdown and economies in freefall, is that when things go very badly wrong on a global scale, in ways which no-one could really have anticipated, the franchisor and franchisee can find themselves very much in the same boat, unable to trade by carrying on their respective businesses “as usual”. Whatever the franchise agreement might provide for as regards the apportionment of risk, far-sighted franchisors will appreciate the importance of working together with their franchisees to ensure, as far as possible, that both franchisor and franchisee have viable businesses when circumstances allow for a return to business as usual.

So, what are the key contractual issues for franchise businesses to address in the current climate?

Force majeure and frustration

Force majeure and frustration are hot topics at the moment, as businesses scramble to find ways to avoid liability for non-performance and/or to avoid being held to the terms of their contracts. You’ll find a more detailed discussion of force majeure and frustration in our coronavirus hub, but in short:

• Force majeure provisions in a contract generally excuse a party’s non-performance where caused by circumstances outside that party’s reasonable control. Where a franchise agreement includes force majeure provisions, the parties will need to assess whether or not such provisions are engaged by the current crisis at all, which will depend on the precise wording of the clause. It should be borne in mind however that even where a franchisee is excused for failing to operate its franchisee business in the contractually-mandated manner it may yet remain liable to continue paying royalties, costs and expenses to the franchisor while continuing to incur all of its own usual business costs and expenses but without earning much – or perhaps even any – revenue

• The common law doctrine of frustration applies where the performance of a contract has been rendered impossible by events and circumstances. It has the effect of terminating the contract. It can be very difficult to demonstrate that a contract has been “frustrated” as the doctrine is construed very narrowly by the courts.

For some, these contractual and common law levers may offer temporary respite or even a way out of a contract altogether. They can also be a useful bargaining tool for franchisees – a possible “nuclear option” that can force a franchisor to come to the negotiating table. Frustration in particular is a blunt instrument, however, as termination of the franchise agreement is rarely going to be a desirable outcome for a franchisee, especially in cases where the franchise business has been developed over a period of years and where the franchisee has budgeted to recover its capital costs of establishing the business over the lifetime of the franchise. Moreover, both franchisor and franchisee may prefer to avoid the uncertainty of a legal argument and instead look for a pragmatic solution that allows the relationship to continue whilst limiting the damage to both parties.

Royalties

The franchise agreement may require the franchisee to pay a minimum royalty, regardless of the revenue actually earned by the franchisee from carrying on the franchise business. This contractual “stick” encourages the franchisee to perform, whilst reducing risk for the franchisor, who is entitled to the payment of set minimum amounts regardless of how successful (or unsuccessful) the franchisee proves to be. However, for the majority of franchise businesses in the current circumstances, if the franchisor were to enforce the minimum royalty, it could cause an already struggling franchisee to fail. Multiply the effect across that franchisor’s franchise network and the franchisor stands to lose the majority - and possibly all - of that network. Now is the time for the franchisor to suspend the application of any minimum royalty provisions and to reduce the royalties generally for a reasonable period. The royalty provisions may also need to be reassessed by reference to what the media is now referring to as “the new normal”, for when economies emerge from lockdown while continuing to be subject to social distancing requirements. The owners of retail, hospitality and leisure businesses may struggle to justify reopening for business at all if they are only permitted to cater to 25-33 percent of their usual customer numbers, even without an ongoing obligation to pay some of the reduced revenue to their franchisors.

Unit opening deadlines

Where the franchise business is a retail store or restaurant, or other business that provides goods or services from physical premises, a new franchisee needs time to fit out (or even build) the premises. However, the franchisor will be keen to ensure the franchisee begins trading as soon as possible, so that it can start receiving royalty payments and the contract will therefore usually set a deadline for opening which, if missed, would entitle the franchisor to terminate the contract. However, with most construction works currently mothballed, and supply chains subject to severe disruption and restrictions (as to which see further below), it is unlikely that opening deadlines will be met any time soon. At the same time, many franchise agreements have detailed provisions relating to the training of key franchisee staff, with that training generally to be provided by the franchisor. In the current circumstances, it may be very difficult for the franchisee to recruit the staff it needs and just as difficult for the franchisor to provide the agreed training. It is therefore vital for the franchisor and franchisee to discuss extensions and revise timetables as soon as possible, taking into account other scheduled openings across the network. The parties should then also discuss extending the minimum initial term by an equivalent period.

Development obligations    

The franchisee may have development obligations, requiring it to open a certain number of franchise outlets in a particular territory over an agreed period of time. Again, these targets are unlikely to be met in the present circumstances and the parties may wish to consider suspending these obligations and/or setting a revised timetable. Where the franchisee has rights in multiple territories, it may be a case of switching focus to territories which have been less affected by the current crisis or which are closer to emerging from lockdown.

Lease issues

In some cases, the franchisor will lease premises to the franchisee directly. In these cases, the parties may wish to agree a rent holiday or temporary reduction in rent to ease the financial pressures on the franchisee. This may or may not be feasible for the franchisor, depending on its financial strength, but it will need to consider the alternative – some landlords are currently threatening tenants with winding-up petitions if they fail to pay their rent on time, but this may not be in the best interests of the franchisor if the result of this action would be to put its franchisee out of business.

The franchise agreement and the lease itself will also include numerous other obligations in relation to the premises, ranging from prescribed opening hours to maintenance obligations and other issues. The parties should consider where these obligations can be relaxed, taking into account applicable law, government advice and rules around social distancing and business operations.  

Exclusivity and trading restrictions

With most physical stores and restaurants now closed to the public, and with social distancing measures in place, many businesses will not be able to operate at all. However, some franchise businesses are still trading, including those offering goods and services deemed essential, such as convenience store chains, some takeaway restaurants as well as essential service providers like plumbers. In some cases, these franchisees may need to adapt the way they operate in order to comply with the prevailing government advice and it will be important to look at the franchise agreement to see what changes may or may not be permitted. For example, a restaurant may be restricted from offering takeaway services outside a designated area – or at all. It may be possible to relax these restrictions, but the franchisor will need to be careful to avoid breaching any exclusivity arrangements agreed with other franchisees within its network. Where it has no such constraints, a franchisor could consider agreeing a temporary extension of the territory.

Supply chain issues

Some franchise businesses will depend heavily on imported products and may be required to use franchisor-designated suppliers (which may include the franchisor itself). Equally, restaurants may be required to carry certain menu items at all times, while retail businesses may be required to stock and display a full range of mandated merchandise at all times. Most businesses around the world are experiencing substantial disruption to their supply chain issues, and those issues may prevent franchisees from being able to meet such requirements. In such cases the parties will need to consider where certain obligations and restrictions can be relaxed to allow those franchisees that can legitimately carry on trading to do so without the risk of being accused of breach of contract.

What happens if the franchisor’s business is at risk?

Whilst many of the above scenarios anticipate the franchisor making concessions to the franchisee, it may be the case that the franchisor is itself in serious financial difficulty through its own inability to carry on trading, and more reliant than usual on the revenue stream from its franchise network. It may be tempting therefore for franchisors to insist on strict compliance with the royalty/payment provisions of their franchise agreements. That runs the risk of resulting in mutually assured destruction however, and an open dialogue with its franchisees may enable a franchisor in that situation to negotiate a solution which works for all. Most franchisees will be concerned about the prospect of failure of their franchisors, given that their own businesses depend on the franchisor’s goodwill, reputation/brand value and knowhow.

Franchisors in that position may therefore consider offering a franchisee that is an established and well-financed operator permanent variations to the terms of the franchise agreement (such as an extension to the term, an expansion to its territory or a reduction to the royalty rate) in return for a one-off payment and/or an advance on future royalties.

Conclusion

Ultimately, successful well-run franchisors and franchisees have a mutual interest in ensuring each other’s survival and protecting their respective businesses. However, there’s no one-size-fits-all approach. It is important to remember that franchise businesses have a lifecycle of their own: a franchisor may have a number of franchisees operating franchises around the world at any one time, but it may also have a pipeline of new franchisees coming through, some with contracts signed and businesses under development, and others still at the contract negotiation stage. The Covid-19 pandemic, and measures imposed by authorities in response to it, is of course having an enormous impact on current, in-development and prospective franchisees and the right approach for dealing with them will depend on the nature of the franchise business, where the network is in its lifecycle and the financial strength – and willing – of each party.