Hilary Muza 
This is a continuation from last week’s installment.
Know-how transfer
A distributor could be a very successful reseller without receiving any know-how from the manufacturer. However, the transfer of know-how is an important part of the franchise relationship, even if it is only know-how, which enables each franchisee to present itself as offering the same quality of product or service as other franchisees. There may not be anything very technical about the know-how transfer.
Control
Usually, the supplier will not regulate in any detail the way in which the distributor operates its business other than, perhaps, to oblige the distributor to reach minimum turnover levels, advertise, maintain a minimum stock of goods and spare parts and meet servicing criteria. On the other hand, there are distributorships where the supplier exercises a great deal of control over the retail process and after-sales service, so that the customer may not even be aware that it is dealing with a legal entity separate from the manufacturer. Nevertheless, franchise relationships usually involve a much higher degree of control over quality and brand image than do most appointments of distributors.
Royalties
No royalties are payable by the distributor. The manufacturer or supplier makes its profit solely on the mark up on the goods it sells to the distributor. However, the franchisor will expect a royalty in return for the know-how and goodwill that it has shared with the franchisee, in addition to any profits it may make from sales to the franchisee of distinctive branded items or raw materials.
These similarities and differences remind us that, while a clear distinction can be drawn between franchising and distribution, it should not be forgotten that franchising arrangements did develop from distribution agreements, and that a variety of different components may be found in a single relationship. However, it can at least be said that a franchise relationship will always involve extensive licensing of branding rights and know-how in return for royalties, plus a high degree of quality control.
Licensing agreements
Intellectual property rights and know-how may be licensed to enable another manufacturer to produce and/or sell goods. While most franchise agreements contain a licence to use the franchisor’s trademarks and know-how, franchise agreements are unlikely to relate to the manufacture of products. A licensor simply imposes quality control restrictions in relation to the goods to be produced pursuant to the licence. By contrast, a franchisor will try to regulate the way in which the franchisee operates its business in much more detail.
Legal considerations when setting up a franchise
Franchise structures have their basis principally in contract and intellectual property law. A business sets up a franchise operation in, essentially, two circumstances: First, it may have a successful existing business which it wishes to expand and will choose business format franchising to do this.
Second, either a newly-formed business or an existing business with little or no experience of a proposed area of business activity may decide to enter this business area. As with all new businesses, the first step for a prospective franchisor is to prepare a business plan. The form of the business plan for a franchised business will be similar to other businesses, but should contain sections on: Reasons for franchising, confirmation that the proposed products or services are susceptible to franchising, a breakdown of the proposed management structure and an explanation as to its appropriateness to franchising.
Implementation – How to set up a franchise operation
It is usually considered essential for a franchisor to develop and refine its franchise business using a pilot operation. This is where a franchisor tests out its model to assess if the market will react favourably to it. One option is to establish franchisor-owned outlets, which are operated as if they were franchised outlets.
This creates a blueprint for franchisors to follow in future franchise deals as they accumulate knowledge on how the franchise should operate ideally. In some cases, a franchisor may recruit a “pilot franchisee” on preferential terms for the franchisee, having made it clear that the franchise would be a “litmus test”. Ideally, such operations should be open for about two years in order to fully assess the state of the business. Normally, it makes good business sense to have multiple pilot operations going on concurrently in order to get a fair picture of the franchise’s profitability from more than one perspective. The pilot operation will establish the following:
– Whether the business will be successful.
– How the business can be improved.
– Problem areas.
– Marketing methods.
– Applicable laws and regulations.
– The positioning of outlets.
– Staff selection/training/wages.
– The most desirable combination of layout, equipment, and staff.
Techniques for:
Management, training, accounting, stock control and quality.
Franchising new ideas
There is a growing trend to start franchising without such pilot operations, particularly when the proposed franchise business relates to a “new activity”, which the franchisor does not wish third parties to copy. This trend should not be encouraged, because the essence of a franchise is that a franchisor is providing a proven successful business to franchisees.
Without successful pilot operations, franchisors will simply be using the experience of franchisees to develop their business and cannot be said to be providing a proven and successful format without pilot testing.
What is the franchisor’s legal exposure?
A franchisor who misrepresents the viability of a franchise to a franchisee will be legally exposed. A franchise agreement at the end of the day is a contractual agreement. The principles applicable to any other contract, like principles of interpretation of contracts and the law of misrepresentation also apply.
This two-part series has been a brief introduction to franchising and the issues companies must pay attention to in order to establish successful franchise operations. The legal issues I address in this article are not designed to constitute legal advice. They are comments to improve the general public’s appreciation of the law. If you have any questions or need any clarity, please contact me directly.
Muza is a duly admitted lawyer with expertise in business law, labour law and commercial litigation. He writes in his personal capacity. For feedback, email him at hilarykmuza@gmail.com or call on +263719042628.
