One of the primary sources of angst in ending a franchise business is the liquidated damages provision. Why is this so? Because the Franchise Agreement (the Agreement) says so. The primary issue is that most franchisees (1) are unaware a liquidated damages provision exists and (2) are in financial distress (so how can they pay additional monies?!).
The Agreement is the contract governing the franchise business. It is the contract between the only two parties to the Agreement, the franchisor and the franchisee. The Agreement is big for a reason; it contains a lot of information. The Agreement supplies the terms for all aspects of the relationships between the two parties. The Agreement governs and supplies the terms for marketing, technology…and also for a franchisee withdrawing from the franchise system.
If a franchise business owner exits the franchise system a transfer of interest must occur. This is because the franchise (business) is a property interest, in this sense, the same as a house (a franchise can contain multiple property interests, most significant of which are the intangibles, including the grant of right to use the franchisor’s intellectual property, branding, operations manual, and systems). The franchise has rights, obligations, liabilities, and a contract (the Agreement). So, something must be done with the franchise. It does not simply disappear; something must be done with the property (the collective rights and responsibilities associated with the franchise). If the franchise is sold to a third-party buyer, then the property is transferred to the subsequent owner. If the franchise is closed then the franchise is transferred back to the franchisor; the franchisee no longer has rights in the franchise system and the franchisor being free to resell, reopen or otherwise do as is wished.
For a franchisee to resign as such a couple of things must occur. First, there is the business, the actual entity that likely exists and technically owns the franchise. This would be the business formed with the Secretary of State (e.g. a LLC). The business entity must properly wind up (its affairs) and dissolve (a whole separate article in itself, a mere dissolution with the Secretary of State being inadequate). Second, and most applicably herein, the Agreement must be contemplated.
The Agreement is the contract supplying the terms for the franchise, including the exit. The terms for exiting include selling the franchise (again, a different topic entirely) and the terms for ending the business. If a franchisee exits the franchise before the expiration of the term in the Agreement, then the franchisee is effectively terminating the Agreement. This is because the Agreement mandates the franchisee operate the business for the specified, and mutually agreed upon term (mutually agreed upon as evidenced by both parties signing the Agreement).
The liquidated damages provision is often inconspicuous and ignored during acquisition. Generally, the liquidated damages provision works like this: the remaining term (after termination) x a royalties calculation (e.g. the average of preceding 12 months of royalties) + incidental expenses and franchisor’s legal fees = total amount owed to terminate the franchise.
The problem -for franchise business owners- with the liquid damages provision is the financial hardship already incurred. Proverbially kicking a man when he’s down or pouring salt on an open wound pretty accurately sums this up – a terminating franchisee usually has distressed finances, since, rarely, is a profitable franchise simply terminated (the prerequisite for termination is generally no money!). So, a franchisee with a failing business has to pay more money to close despite already exhausted finances.
WHY ARE LIQUIDATED DAMAGES INCLUDED AND WHY ARE THEY AGREED TO?
To the courts, franchisees are deemed as sophisticated as their franchisor counterpart. The court is generally not going to go out if its way to protect the franchisee.
Franchisees agree to the terms of the Agreement, evidenced upon signing. The Agreement usually contains conspicuous language advising the use of legal counsel. Therefore, the Agreement includes the terms and the franchisee agrees to them. Basically, we can agree to anything in contract that is not illegal or otherwise impermissible.
Franchisees agree to liquidated damages for a number of different reasons, including ignorance and oversight. For my acquisition clients, part of my counsel is to educate my clients on the terms contained in the Agreement and to articulate the significance of such terms. For those franchisees that buy a franchise without the assistance of an attorney, caveat emptor!
A frequent observation in new and/or prospective business owners is the sense of urgency. Urgency does not beget patience and diligence when buying a business; quite literally urgency is contradictory to patience. So, franchise clients urgently racing to the buy the franchise are at a disadvantage, namely the lack of time to properly conduct due diligence. Many clients simply do not give much thought to the issues faced when closing, since their paramount concern is opening. Latent as it may be, the termination and default sections of the Agreement are of considerable importance.