Key Points in Franchise Agreements that Business Owners Should Know

When we think of franchises, major convenience stores and restaurants often come to mind. However, the franchise system itself can be utilized in any industry. For the franchisor, it allows for a quicker and more cost-effective nationwide expansion than if they were to do it on their own. Therefore, it is believed that there are opportunities to consider using franchises regardless of the industry.

In this article, we will explain what a franchise agreement is and the key points to check in a franchise agreement.

What is a Franchise Agreement?

Legal Nature of Franchise Agreements

A franchise agreement is a contract in which the franchisor grants the franchisee the right to use its trademarks, brand, and business know-how. In return, the franchisee pays a monthly fee, known as a royalty, to the franchisor.

Franchise agreements can be considered as innominate contracts, as they do not fit into the typical contracts defined by the Japanese Civil Code. The legal nature of a franchise agreement includes elements of a lease contract, as the franchisor grants the franchisee the right to use its trademarks and business know-how.

In addition, franchise agreements also have elements of a quasi-mandate contract, as the franchisee is obligated to sell products or services designated by the franchisor, and the franchisor is obligated to provide necessary guidance and assistance to the franchisee in managing the business.

Advantages and Disadvantages of Franchising

While major convenience stores and fast food restaurants actively utilize the franchise system, theoretically, any type of business can use franchising. Indeed, franchises are used in various industries, including tutoring schools, massage parlors, and private dental practices.

Franchising differs from direct store development by the franchisor, as it is carried out by the franchisee, a separate business entity, with its own capital and responsibility. For the franchisor, the advantage of franchising is the ability to rapidly expand the number of stores using other people’s capital. On the other hand, for the franchisee, franchising allows them to utilize the brand value built by the franchisor, enabling them to start a business with lower risk than starting from scratch.

However, franchising also has disadvantages. For the franchisor, there is a risk that the brand value of the franchise chain may be damaged if the franchisee engages in competitive or hostile activities against the franchisor. To mitigate this risk, it is necessary to include non-competition clauses and other provisions in the franchise agreement to prevent the franchisee from engaging in activities that could negatively affect the entire franchise chain.

For the franchisee, there is a possibility that the sales forecasts provided by the franchisor before the contract may differ significantly from the actual performance. Also, when joining an unknown franchise, there is a risk that the franchise itself may be a fraudulent scheme aimed at defrauding the franchise fee. Therefore, it is necessary for the franchisee to carefully consider whether to join the franchise during the contract review stage.

Statutory Disclosure Documents for Franchise Agreements

Under the Japanese Act on Promotion of Small and Medium-sized Retail Commerce, the franchisor is obligated to provide and explain statutory disclosure documents to the franchisee before concluding the contract, once the franchisee has expressed an intention to join. However, this obligation to provide and explain statutory disclosure documents only applies to retail and food service franchises.

Nevertheless, according to the guidelines on the Japanese Antimonopoly Act, it is desirable to disclose the contract overview through statutory disclosure documents even in service industry franchises other than retail and food service. Therefore, in practice, many franchisors, regardless of industry, provide and explain statutory disclosure documents to franchisees.

Key Points to Check in Franchise Agreements

Next, we will explain typical clause examples in franchise agreements. In these clause examples, ‘Party A’ refers to the franchisee, ‘Party B’ refers to the franchise headquarters, and ‘Party C’ refers to the representative in the case where the franchisee is a corporation.

Clause on the Licensing of Trademarks and Know-how

From the effective date, Party B grants Party A the right to use the following items related to the business (hereinafter referred to as “the Business”) that Party B has been conducting under the name “●●●●”.
(1) Trade name or trademark (including service marks)
(2) Trade secrets or know-how

The licensing of trademarks and know-how forms the core of a franchise agreement. Therefore, it is important to clearly define what is subject to the license.

As a franchisee, it is necessary to thoroughly investigate whether the trademark, including the service mark, is registered with the Japanese Patent Office, based on the registration number and other information. This is because if the trademark is not registered, there is a risk that other businesses may use the trademark without permission. For more details on trademark infringement, please refer to the article below.

https://monolith.law/corporate/penalty-for-trademark-infringement[ja]

Also, it is important to align understanding before the contract, as the scope of trade secrets and know-how provided by the franchise headquarters tends to be vague. If the scope of the provided know-how is unclear, there is a possibility that complaints may arise from franchisees claiming that the franchise headquarters has not fulfilled its obligations commensurate with the royalty payments.

Clause on Guidance to Franchisees

The Party B shall instruct the Party A on the know-how related to the business in question in accordance with the appendix, and ensure that the Party A acquires such know-how. Furthermore, even after the execution date, the Party B shall provide appropriate guidance across all aspects of the business and cooperate in the prosperity of the Party A.

In a franchise agreement, it is common for the headquarters to provide ongoing guidance to its franchisees. This is a very important item to ensure the effectiveness of the use of know-how licensed by the franchise headquarters, as explained above.

The content of the guidance may include regular monthly visits to the franchisees by employees (supervisors) of the franchise headquarters. As the specific content of the guidance can easily lead to disputes with franchisees, it is recommended to clearly define it in appendices to the contract or similar documents.

Clause on Non-Competition Obligation

The Party B shall not, directly or indirectly through any third party other than the Party A, engage in the subject business or any business similar to the subject business (meaning a business that competes with the subject business in the market) after the execution date, as long as this contract remains effective and without the written consent of the Party A.

There are two types of non-competition obligations: those during the franchise contract period and those after the contract ends. The clause example pertains to the obligation during the contract period.

The purpose of establishing a non-competition obligation is not only to maintain the sales territory, but also to protect the trade secrets such as know-how provided by the franchise headquarters. It is said that even if a franchisee uses trade secrets improperly, it is difficult to prove in court to claim damages.

Therefore, by prohibiting competitive actions that often utilize trade secrets, it is also possible to indirectly protect trade secrets. For more details on non-disclosure agreements, please refer to the article below.

https://monolith.law/corporate/checkpoints-nondisclosure-agreement[ja]

While non-competition obligations during the contract period often do not have geographical limitations as in the clause example, when establishing non-competition obligations after the contract period, care must be taken as there is a possibility that it may be deemed invalid if there are no geographical or time limitations, as it excessively restricts the freedom of business of the franchisee.

Royalty Clause

Party A shall pay to Party B, as a royalty, an amount equal to 20% of Party A’s monthly sales revenue resulting from the execution of ●●●● (hereinafter referred to as “Royalty Subject ●●”), by the end of the following month. This includes:
(1) The fee for Royalty Subject ●●
(2) The money paid for the purpose of ●● of Royalty Subject ●●
(3) The purchase cost necessary for Royalty Subject ●●

Royalties are typically the consideration for the use of trademarks, know-how, etc., licensed by the franchise headquarters, and are usually paid monthly by the franchisee to the headquarters.

The calculation method for royalties is divided into two cases: a fixed percentage of sales, as in the clause example, and a fixed amount every month regardless of sales. What’s important about royalties is to clearly define the calculation method to avoid any ambiguity.

Provisions on Damages

1. Party A or Party B may claim damages if the other party breaches its obligations under this contract.
2. Damages incurred by Party A due to a breach of obligations by Party B or Party C under this contract are presumed to be no less than the royalties for the period from one month prior to the breach until the breach is remedied. In addition, Party C shall jointly and severally guarantee such liability for damages payment within the maximum amount of ●● yen.

If one party suffers damages due to a breach of the franchise agreement, a claim for damages can be made. In franchise agreements, it is often difficult to prove the amount of damages, so it is common to stipulate a predetermined amount of damages (penalty) as in the first clause example.

If the amount of damages is predetermined, there is an advantage that when a breach of contract occurs and a claim for damages is made, it is only necessary to prove the occurrence of damages, and the often difficult task of proving the amount of damages is not required. However, there have been cases where the predetermined amount of damages has been reduced by the court on the grounds that it is excessive compared to the normally expected amount of damages, so care must be taken in determining the amount.

The second clause example is a provision regarding joint and several guarantees. The amount of money that the guarantor should bear at the time of contract conclusion is not unambiguously determined for liabilities for damages based on contract violations like in the clause example. This type of joint and several guarantees for unspecified liabilities that may arise from ongoing transactions in the future is called a root guarantee contract.

With the amendment to the Civil Code (Japanese Civil Code) enacted in April 2020 (Gregorian calendar year), there were revisions regarding root guarantee contracts, and it was stipulated that the maximum amount (liability limit) must be clearly defined at the time of contract conclusion. Joint and several guarantees without a defined maximum amount will be invalid in the future. Therefore, it is important to note that the maximum amount should be stated in the franchise agreement as in the above clause example.

Summary

A franchise agreement is a convenient system for expanding a business. However, since it is not a typical contract stipulated in laws such as the Japanese Civil Code, it is important to clearly define the rights and obligations of both the headquarters and the franchisee in the franchise agreement. In order to properly create a franchise agreement, it is necessary to have a deep understanding of the franchise business itself. Therefore, we recommend consulting with experts such as lawyers who are familiar with the business you are dealing with.

Introduction to Contract Creation and Review Services by Our Firm

At Monolith Law Office, as a law firm with strengths in IT, Internet, and business, we offer services such as the creation and review of various contracts, not limited to franchise agreements, to our advisory and client companies.

If you are interested, please take a look at the details below.