Q. What do I need to know about master franchise agreements?

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In a master franchise arrangement, a franchisor grants a franchisee (the “master franchisee”) the right to operate the franchise system in a specific geographic area. The master franchisee essentially acts as a “mini” franchisor for its territory, and will enter into sub-franchise agreements with franchisees (or “sub-franchisees”) in its territory. While master franchises can be an exciting opportunity to bring a concept to a new market, investors should be aware of the potential pitfalls:

  1. Business risk. Master franchise arrangements often entail significantly more risk, and require a very large amount of start-up capital as compared to unit franchises. Since master franchise agreements are used for markets where the franchisor is not present and is unable to dedicate the resources to develop the territory itself, master franchisees ultimately bear the risk and responsibility for evaluating how the given concept will translate in the new market. Even porting brands from one side of a country to the other can result in significantly different unit economics based on local market conditions and consumer preferences. Master franchisees may also need to invest heavily in marketing if the brand is unknown in their territory. Although the initial franchise fee for master franchise agreements is often quite high, it may not be justifiable where the franchisor does not have a long track record of successful master franchise arrangements in other markets or strong brand power in your territory. Accordingly, you should consider whether the amount of the initial franchise fee is reasonable in the circumstances, whether the fee can be refunded in certain situations, and what your exit options are if the concept fails in the territory. You should also determine whether the term of the master franchise agreement is long enough for you to be able to recoup your initial investment and earn a return on your investment.
  2. Adequate management skills. In reviewing the master franchise agreement, it should clearly outline your responsibilities and obligations versus what the franchisor is providing to you. As a master franchisee, you may be responsible for recruiting and training franchisees, marketing the system in your territory, as well as supervising and supporting your franchisees’ operations. Whether you or the franchisor is responsible for training your sub-franchisees or preparing the operations manual to be used by your sub-franchisees can greatly affect your initial and ongoing costs. You should also be comfortable that you will receive adequate training from the franchisor and have sufficient prior business experience to manage multiple business functions. The level of ongoing support that the franchisor provides should also be considered when assessing the amount of any continuing royalty payments to the franchisor.
  3. Logistics. If unique ingredients or proprietary technology are key to the franchisor’s competitive advantage, it is critical that you and/or your sub-franchisees are able to purchase/import and use those items in your territory, and that you understand the cost to do so. You may also need to coordinate distribution of certain products to your sub-franchisees and develop the infrastructure to do so. In this vein, you should review how much flexibility you are given in the master franchise agreement to adapt or substitute specified products and services to your local market as needed. If the franchise model involves physical storefronts, consider who is responsible for building your sub-franchisees’ locations. If you are responsible for the build out, you will need to secure designers, a construction team, and equipment suppliers to build the outlets. The interplay between the master franchise agreement and sub-franchise agreements should also not be overlooked. Is the term of the master franchise agreement appropriate given the term to be granted under the sub-franchise agreement? What happens to sub-franchisees if the master franchise agreement is terminated? Are they assigned to the franchisor? These questions should be answered before a master franchise agreement is signed.
  4. Legal considerations. You should ensure that you, or the franchisor, have registered the relevant trademarks in your territory, since much of the value in investing in a system is the associated goodwill. Of equal importance is compliance with applicable franchise laws. If you will operate in any of Canada’s provinces with franchise statutes, you will likely be required to prepare franchise disclosure documents for your prospective sub-franchisees. The initial costs to draft these documents are significant, and a failure to do so properly can result in substantial legal liability.

If you are considering becoming a master franchisee, ensure you consult your business and legal advisors to discuss some of the issues noted above.

Faye Lucas
Associate, Corporate and Commercial Department
Sotos LLP