TERRITORY - WHAT ARE YOU GETTING?

Knowing what is and isn't your territory helps new franchisees avoid problems, say Stewart Germann and Clive Neifeld

If you're buying a franchise, it pays to know before you make the decision exactly what your obligations will be under the franchise agreement, and exactly what the obligations of the franchisor are too. That way, you'll understand what you must and must not do, what you do and don't have the right to expect, and what should and should not happen. If you understand those points clearly, the chances of a dispute arising within the franchise further down the track are lessened considerably.

Accordingly, when you have selected a franchise which you want to pursue, you must carry out what is called due diligence. This will involve obtaining a copy of the disclosure document and franchise agreement from the franchisor and going through it both yourself and with your legal and financial advisors. They will help ensure that you go into your new business with the best possible chance of success.

One of the key elements which you must examine during this process is that of territory - the specific area within which you as the franchisee will be able to conduct the franchised business. Will it be just the St Lukes Shopping Centre? Will it be a territory covering an area defined in yellow on a map to be attached to the franchise agreement? Will there be a non-exclusive territory or no territory at all? If there is no territory, how does the franchisor prevent a 'free for all' situation with numerous franchisees conducting their own separate business with no demarcation line?

The issue of territory is therefore a very important one for careful consideration. As franchising lawyers, we find territorial issues are one of the main areas in which disputes arise. These stem mainly from franchisors trying to allow new franchisees to operate franchises either within what the existing franchisee thought (rightly or wrongly) was his own particular territory, or offering the right to open a second franchise to a new franchisee within the same territory because the existing franchisee is under-utilising the territory.

This article considers various permutations of territory and highlights the key areas to consider when a prospective franchisee is considering the franchise agreement and its ramifications.

Concise Territory
Although there are cases where territories are not appropriate (see below), in the majority of cases a franchisor will divide up New Zealand into concise and separate territories which will be allocated to each new franchisee. These territories will be carefully defined on separate maps and a typical clause in the franchise agreement will be as follows:

"The franchisor grants to the franchisee a franchise to establish and carry on a business within the territory as set out in the Schedule and delineated in red on the map attached and to carry on the business within the territory using the methods and techniques developed by the franchisor …"

This type of clause gives certainty to a franchisee by way of a map being attached to the franchise agreement with the boundaries of the territory clearly defined. There can be no doubt as to the boundaries of the territory which a franchisee is contracting by way of execution of the franchise agreement and payment of the initial franchise fee.

In our opinion, some franchisors make the mistake in the early days of giving franchisees too big a territory. This may appear attractive to the buyer and therefore make a franchise easier to sell, but it can lead to problems in the future. If a franchisee does not or cannot service the full area and therefore exploit it to its maximum potential, there will be a gap in the market in the area which will encourage the growth of competition. At the same time, the franchise will be restricted in its growth.

While a franchisor might recognise the problem of having granted too large a territory, if a map is attached to the franchise agreement which clearly delineates the territory's boundaries then the franchisor cannot alter that contractual arrangement without agreement by the franchisee. As you can imagine, in most cases that is by no means an easy thing to do.

It is therefore the case that some franchisors cover their position by reserving in the franchise agreement the right to 'take back' part of the territory by redefining the boundaries during the term. This may apply if in the future (perhaps when the system has become established) the territory is not, or has become incapable of, being serviced to 'maximum potential'. Such a provision may be framed in the franchise agreement as an absolute right or in the franchisor's discretion (reasonable or otherwise). While this is not necessarily unreasonable, a franchisee should beware of a blanket sole discretionary right which may be drafted as follows:

"The franchisor shall have the right at any time during the term to reduce the territory if in the franchisor's opinion the franchisee is not maximising or is unlikely to be able to maximise business exploitation of the territory."

A possible way out of the above is for the franchisee's lawyer to suggest inclusion of an amendment along the following lines:

" provided that the franchisor shall not be entitled to reduce the territory to an area within a [insert number of kilometres] radius from the premises."

Exclusivity of Franchise
What a franchisee always requires in entering into a franchise arrangement is certainty. There must be certainty as to the upfront franchise fee payable, certainty as to the ongoing service fees or royalties payable together with advertising levies and, most importantly, certainty in relation to the territory. A clause which we have come across in one or two franchise agreements which gives certainty and which is clear and unequivocal is along the following lines:

"If the franchisor or the franchisee identify the opportunity to establish a further franchise in the territory ("the proposed franchise") then the franchisee shall be considered prior to any third party as to the proposed operator of the proposed franchise. The existing franchisee, subject to meeting all new franchisee criteria, shall be offered a 21 day first right of refusal".

What can be seen with this type of clause is a clear indication that the franchisee has not been given an exclusive territory but will be considered first and foremost should the franchisor wish to open another outlet in the territory. However, an important caveat for the franchisor is whether the existing franchisee has been operating the business in such a way that gives confidence to the franchisor that the existing franchisee will be able to manage more than one outlet in the territory. Because of this important fact, the above clause usually runs on and says the following:

"If the franchisor considers the franchisee is capable of operating the proposed franchise it shall notify the franchisee in writing and the franchisee shall indicate its willingness to accept the proposed franchise. The final decision as to the suitability or otherwise of the franchisee to operate the proposed franchise shall rest solely with the franchisor. If the franchisee declines within 14 days to accept the proposed franchise, then the franchisor shall be free to either itself open a new store within the territory or allow a new franchisee to open a new store within the territory."

As can be seen above, the clause is explicit, clear and unambiguous but it is essential in all cases for the proposed franchisee to have independent legal advice from a lawyer experienced in franchising.

Good Faith
It is important that both parties act in good faith towards each other. The subject matter of the territory, regardless of how a clause may be drafted, is always a crucial consideration and it is absolutely essential for a prospective franchisee not to enter the franchise with the wrong idea about the territory and its boundaries. One franchisor for whom we act retains the right to put a second franchisee in the first franchisee's territory should there be reasonable grounds for doing so. However, in such a case the franchisor agrees to share the initial franchise fee payable by the second franchisee on a 50/50 basis with the original franchisee. The relevant clause has been drafted to read as follows:

"The franchisor shall have the right to appoint an additional franchisee in the territory if the franchisor reasonably determines that existing demographic data or actual comparative evidence or other reasonably based financial assertions indicate that there is an opportunity for an additional franchise in the territory without detracting substantially from the business conducted by the franchisee, in which case 50% of any franchise premium gained by the franchisor from the sale of such new franchise shall be paid to the franchisee."

We assert that the main principle which should flow through the right of a franchisor to appoint an additional franchisee within the original franchisee's territory should be one of reasonableness and fairness. It is quite wrong to punish an existing franchisee who is working extremely hard merely by saying that there is room for another franchisee.

The franchisee may also be a 'forward thinker' and anticipate the possibility of owning more than one franchise. In this event, and depending on circumstances, it may be convenient to have adjacent or neighbouring territories. If that is the case, the franchisor may be amenable to the inclusion in the franchise agreement of an option in favour of the franchisee to take an additional territory (bounding on the original territory) upon notice being given to the franchisee by the franchisor of its requirement for a new outlet to be opened in the adjacent territory. Failing exercise of that option within a specific period, the franchisor itself would then be able to open the outlet in that territory or offer the territory to a new franchisee.

No-Territory Franchises
As we mentioned earlier, some franchise systems prescribe no territories whatsoever. In some cases, retail franchises are defined by location (such as a specific shopping mall). The creation of a new mall or roading network locally may change the dynamics of an area. Vehicle-based franchises may have defined areas for marketing purposes, but the realities of, say, having a customer with locations in another territory may mean working in another's marketing area. Some businesses, such as mortgage broking, may be so heavily dependent on referrals for lead generation that even to have defined marketing territories would be unfairly restrictive.

Where no territory - or no exclusive territory, at least - is granted, franchisees may be understandably concerned about the potential for 'saturation' of the area of a new franchisee's proposed operation - ie. how far is the new franchisee going to travel to get business? This is especially relevant in the case of a new system where there are no actual (as opposed to hypothetical or anticipated) figures to justify a viable business.

The logical reaction for a franchisee is to request a limit on the number of franchisees to operate in a wider area. Although this can also be counterproductive because it may stultify the establishment of and/or the growing of brand awareness to the public, it can work.

For example, the Auckland area is often divided into, and granted by reference to, five territories - North, East, South, West and Central Auckland. If the alternative 'no-territory' option is utilised then a franchisor may say, effectively: 'Go for it all over Auckland!' Invariably, what happens in this latter case is that franchisees want to work areas reasonably near to where they live. However, this would not preclude a franchisee who lives on the North Shore from servicing a customer who lives at West Auckland if the job is worth battling the traffic for. Also, relatives and friends of a particular franchisee may want to be looked after by that particular person, regardless of where he or she might live.

Know The Rules
In summary, territories or the lack of them is an interesting area of franchising which, in our opinion, will rear its head more and more often as franchising matures in this country. The territorial provisions in longer-standing franchise agreements are often a basis for dispute, and in a traditional franchise agreement there are often good grounds for franchisees to jump up and down. Too often a franchisor in the early years has granted franchises which have attached too large an area or territory to the franchise and the franchisor is now suffering as a result.

A franchisor must be fair to each particular franchisee but must also abide by the provisions of the franchise agreement. For new franchisors, note that it is easier to give a person a limited area and to agree to widen it if the business is succeeding than to give a person a large area and to take it away or subdivide it if the territory is not being utilised to its maximum potential.

The lessons for potential franchisees are:

1. Take professional advice from experienced franchising lawyers.
2. Analyse the area you are being granted for strengths and weaknesses.
3. Seek confirmation in writing where verbal assurances are given (eg. 'We are only going to appoint 20 franchisees throughout Auckland').
4. Know what you are getting into in relation to all aspects of the franchise agreement but particularly in relation to the territory.