Terminating a franchise agreement can have significant consequences.
Economic conditions in Australia remain challenging, placing pressure on both franchisees and franchisors.
According to IBIS1, while the COVID pandemic hampered the performance of franchised businesses over 2020 and 2021, post-pandemic conditions have continued to be difficult. In particular, interest rate rises have caused spending on franchised goods and services to decrease.
While franchise agreements will generally contain post termination provisions designed to protect the franchisor's brand, data suggests that replacing a franchisee may not be a simple process.
Recent figures cited in the Independent Review of the Franchising Code of Conduct indicate that from 2014 to 2023 the number of franchisees in Australia declined by approximately 5.2%.
Additionally, post termination provisions contained in a franchise agreement may negatively impact the franchisee if the franchisee wishes to operate an independent business.
What Happens When a Franchise Agreement is Terminated?
What are the Consequences for a Franchisee when a Franchise Agreement is Terminated?
What are the Consequences for a Franchisor when a Franchise Agreement is Terminated?
Simply, when a franchise agreement is terminated, the franchisee loses the right to operate a business using the franchisor's name and system.
The franchisor can re-franchise the business, provided that the franchisor can sell the franchise to an incoming franchisee.
The franchisee will generally lose the goodwill in the business (subject to some exceptions).
Goodwill has been defined as "the legal right or privilege to conduct a business in substantially the same manner and by substantially the same means that have attracted custom to it". 2
Data from the Franchise Disclosure Register indicates that over 80% of franchise agreements explicitly provide that a franchisee does not have any goodwill in the franchised business.
For a franchisee, the consequences of terminating a franchise agreement may include:
A franchisee may lose the initial investment made to start the franchise business.
When a franchise agreement is terminated, the franchisee will not generally be paid any compensation for the goodwill in the business (except in specific circumstances).
Additionally, the initial fees paid to enter into the franchise agreement (eg the initial franchise fee, the initial training fee and the initial promotion fee) will not be repaid, even if the franchisee does not operate the franchise business for the full term of the franchise agreement [What is the term of a franchise agreement?].
Some franchise agreements contain provisions that enable the franchisor to buy the assets of the franchise business on termination of the franchise agreement. However, the value received for the assets is likely to be far lower than the price paid for the assets on entry into the franchise agreement.
In it's 2009 report Opportunity not Opportunism, the Parliamentary Joint Committee on Corporations and Financial Services stated:
At the end of an agreement, a franchisee has already committed considerably to the franchise system, financially and through their hard work, and is financially tied to the business. Franchisees stand to lose the prospect of returns on their capital investment, which in many cases is substantial. 3
A franchisee will be prohibited from using the franchisor's brand name, trademarks, and intellectual property.
When the franchise agreement is terminated, the franchisee must immediately stop using the franchisor's intellectual property [What is intellectual property?].
This may involve removing signage, returning or destroying stationery, removing or altering the fit out, changing the colours of the premises, ceasing to use any of the franchisor's systems, ceasing sponsorship with community sports clubs and closing social media accounts.
If the franchisor holds the head lease, the franchisee will be required to vacate the premises.
If the franchised business is operated from a premises, either the franchisor will hold the head lease and sub-lease the premises to the franchisee, or the franchisee will hold the head lease.
If the franchisor holds the head lease, the sub-lease granted to the franchisee will normally be terminated at the same time as the franchise agreement is terminated and the franchisee will be required to vacate the premises. This may be the case even if the franchisee has paid for the fit-out of the premises.
If the franchisee holds the head lease:
The franchisee may be restricted from operating a similar business in the same geographic area for a certain period of time.
Nearly all franchise agreements contain non-compete provisions which operate after the franchise agreement is terminated.
Not all non-compete provisions are enforceable. That is, while a franchise agreement may contain a restraint preventing a franchisee from operating a competing business, a Court may find that the restraint is unreasonable and not able to be enforced. (For further information about the enforceability of restraint of trade clauses see our resource article Restraint of Trade Clauses in Franchise Agreements).
However, the practical implication of a franchise agreement containing a non-compete clause is that a franchisee is required to dispute the enforceability of the clause if the franchisor tries to stop the franchisee from competing. The expense of doing this may be prohibitive to the franchisee. This is evidenced by a submission made to the recent Review of the Franchising Code of Conduct which stated:
I understand that this [restraint of trade] is not really enforceable, however quite a few of my friends who have been put out of business did not have the funds to challenge this in court, which meant not only had they lost their savings and livelihood they also [lost] [sic] their ability to operate in a field they know. 4
For the franchisor, the consequences of terminating a franchise agreement may include:
The franchisor may lose the ongoing royalty fees and other financial benefits provided by the franchisee.
If a franchise agreement is terminated the franchisor will no longer receive the royalty and other payments made by the franchisee under the terms of the franchise agreement. These payments may be substantial, particularly if the franchisor supplies product to the franchisee.
In addition, the loss of the franchisee's advertising contribution may impact the advertising and marketing available to the franchise network.
If the franchisor is able to replace the exiting franchisee with an incoming franchisee, then the loss of revenue arising from the termination may be minimal. However, granting a new franchise may take time.
The termination of a franchise agreement can potentially impact the franchisor's brand reputation, especially if the termination is due to negative circumstances.
The closure of any site may have a significant impact on the overall brand reputation of a franchisor, especially if the particular site has established a loyal customer base for the franchisor's products or services. This can lead to a loss of trust and credibility in the eyes of consumers who have come to rely on that specific location for their needs.
Whether a franchisor chooses to retain a site (either to re-franchise the site or to operate the site as a corporate store) will depend on the particular circumstances, including whether the lease is held by the franchisor and the proximity of other franchise branded stores.
Terminating a franchise agreement may lead to legal disputes and litigation, which can be time-consuming and costly.
Any legal dispute with a franchisee will take resources away from the core business of the franchisor [Legal Disputes in Franchising].
Legal disputes that can arise from terminating a franchise agreement early include:
Understanding the implications of terminating a franchise agreement can help both franchisors and franchisees protect their interests and move forward effectively.
However, both parties should carefully consider the potential consequences before deciding to terminate a franchise agreement.
1 - Franchising in Australia - Market Size, Industry Analysis, Trends and Forecasts (2024-2029) IBIS World
2 - Federal Commissioner of Taxation v Murry (1998) 193 CLR 605 [23]
3 - Opportunity not opportunism: improving conduct in Australian franchising - Commonwealth Government Response to the report of the Parliamentary Joint Committee on Corporations and Financial Services at page 80
4 - Anonymous franchisee (private and confidential submission), Review of the Franchising Code of Conduct noted at Foot note 187.
Disclaimer
The information in this article is general in nature and is not intended to address the circumstances of any person or other entity. Although we do our best to provide timely and accurate information, we do not guarantee that the information in this article is accurate or that it will continue to be accurate in the future.