FRANCHISOR 101:  INITIAL FRANCHISE FEES AND ROYALTY FEES

• How strong are the legal fences protecting your brand and trademarks from competition? To be sure, a franchisor without a brand and trademarks is a cowboy without a horse. But it can take as much work to protect these assets as it does to create them in the first place, and the more successful you get, the more likely it becomes that competitors will try to get in on the action. Ray Kroc may have been among the first to see opportunity in fast food, but McDonald's isn't the only place serving up hamburgers.


• What about your business systems? Like your brand and trademarks, your business systems constitute valuable intellectual property. You must protect the unique processes you develop to manage your supply chain, your inventory, and your production or delivery processes. This means shielding these systems from outside view, for starters. It also means understanding that outsiders will figure things out sooner or later and keeping watch to make sure that, once they do, they don't copy what you do to your disadvantage.

FRANCHISEE 101:  PAY US NOW OR PAY US NOW

Fledgling franchisees, like people launching any business, tend to be optimists, and when they talk about the future, they generally see opportunity, not the threat of failure.
 
But failure happens in franchising, too, and when it does, it may bring into play a complex, sometimes-overlooked clause in the typical franchise agreement that can prove devastating - the liquidated damages clause.
 
In essence, a liquidated damages clause in a franchise agreement may mean that losing your franchise won't put an end to your misery. In fact, it could mean that if your franchise agreement is terminated before its scheduled expiration date for any reason at all -that is, no matter if or why you close your doors - you may still owe your franchisor a pile of royalties despite your straitened financial circumstances.
 
How much? A typical franchise agreement might require the franchisee to pay liquidated damages equal to two years' worth of royalties - a heavy burden to bear on top of failure itself. Worse, the agreement may give the franchisee only 30 days to hand over the money.
 
Why so much? And why so soon? Because, as a typical franchise agreement might put it:
 
"It would be impossible and impracticable to determine the precise amount of damages franchisor will incur upon the termination of this agreement due to the complications inherent in determining the amount of revenue lost by franchisor because of the uncertainty regarding the number of months that will expire while franchisor searches for a replacement franchisee...or for a replacement location in the trade area of the franchised business. Franchisor and franchisee...acknowledge and agree that this calculation of franchisor's potential damages is a reasonable, good faith estimate of such damages."
 
In plain English, this means that by signing on as a franchisee you acknowledge from the get-go that your franchisor can't know how long it might take, or how much money it might cost, to recruit and train somebody to take up the slack in the event your franchise is terminated, and that when it all shakes out, something like two years' worth of royalties will compensate your franchisor for the trouble.
 
Does this mean that franchisors hold most of the cards when recruiting franchisees? You bet. However, the good news is that in many states, including California, certain liquidated damages clauses are unenforceable. Nevertheless, the bottom line is clear: Before you sign that franchise agreement, look carefully at its liquidated damages clause. You probably can't get out from under it, but prudence dictates that you prepare by factoring its possible costs into your budget, just in case you walk away from your franchise agreement before it expires.
 
That way, if you have to close up shop, you can put an end to your misery. If you succeed, you can put the money to other uses - say, growing your business.