Looking Closer At The Franchise Territory Clause: Item 12 Of The FDD

Franchise disclosure documents (FDD) are the gateway into a franchising operation for a prospective franchisee, and understanding them is critical to a new owner’s success. FDD Item 12 …

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Franchise disclosure documents (FDD) are the gateway into a franchising operation for a prospective franchisee, and understanding them is critical to a new owner’s success. FDD Item 12 discusses issues of territory and outlines whether and where the franchisor can place other franchises. It is not uncommon for an FDD to stipulate that there are no restrictions on where a new franchise may spring up. If a franchisee is not careful, this means he or she may end up competing against another franchise in the same town, or even on the same street. For more on this continue reading the following article from Blue MauMau.

This is the fourth in a series of articles for prospective franchisees that discuss the components of a franchise disclosure document. Unlike almost all other articles about what you will learn in a franchise disclosure document, however, this series will focus on what you may not learn. This focus is intended to help you both refine and expand your due diligence efforts.

Item 12 – Territory

The go-to catchphrase for anyone championing franchise ownership is that you will be "in business for yourself, not by yourself." This old slogan, first widely promoted by McDonald’s founder Ray Kroc, takes on a new, maybe less reassuring meaning when thinking about the territory disclosures in Item 12 of the franchise disclosure document (FDD). That’s because "not by yourself" could mean that your implicit benefactor might become your unwelcome competitor. For example, your franchisor may be permitted to set up a competing outlet right next door to your franchise unit. In that case, you may be protected by a "four walls" territory (the franchisor cannot set up a competing unit within your store!), but, short of that, you may have no territorial protection at all. Take Jimmy John’s FDD Item 12 disclosure, for example, which reads in part:

You will not receive an exclusive territory. You also do not have any type of non-exclusive territory … We … retain the right at all times to engage in any and all activities that we … deem appropriate, wherever and whenever we … desire, and whether or not these activities compete with your Restaurant. Our permitted activities include the right to (1) establish and operate, and allow others to establish and operate, JIMMY JOHN’S ® restaurants at any locations and in any areas, other than at your Restaurant’s specific location … (emphases supplied)

The companion form of franchise agreement, perhaps in a flourish of attorney overkill, leaves no room for doubt: "you have no territorial protection whatsoever." So, that’s it. Once you step outside your Jimmy John’s storefront, you’re potentially in enemy territory. And that’s not so farfetched. Starbucks, for example, which does not franchise its outlets, currently has six outlets within a 10-block radius in Washington, D.C. Better to cannibalize than be cannibalized. If the Jimmy John’s franchise ever achieves the same degree of success as Starbucks, it’s not a stretch to imagine the same sort of "encroachment." I’m not trying to pick on Jimmy John’s here (many franchisors have similar Item 12 disclosures); I’m just trying to make the point that to understand whether you have any territorial rights and, if so, what those rights are, you must carefully read and fully comprehend Item 12 of the FDD.

What you will learn.

The most important things you will learn are the main terms of your bargain regarding territories. And here’s what you get:

  • Any minimum territory granted to the franchisee;
  • The conditions under which the franchisor will approve the relocation of the franchised business or the franchisee’s opening of additional franchised outlets;
  • Franchisee options, rights of first refusal or similar rights to acquire additional franchises;
  • Whether the franchisor grants an exclusive territory and,
  • if not,
  • a prescribed warning that you indeed will not get an exclusive territory and that you may face additional competition
  • if so,
  • any requirements for the continuation of territorial exclusivity (e.g., achieving a certain sales volume, market penetration, etc.) and the franchisor’s rights if the franchisee doesn’t meet any of those requirements, and
  • any other circumstances that permit the franchisor to reduce the franchisee’s territorial rights and the effect of that reduction on the franchisee’s rights;
  • For all territories, whether they are exclusive or not:
  • Any restrictions on the franchisor against soliciting or accepting orders from consumers inside the franchisee’s territory (including Internet, catalog and direct marketing sales under any franchisor trademarks);
  • Any compensation that the franchisor must pay for soliciting or accepting orders inside the franchisee’s territory (don’t count on any);
  • Any restrictions on the franchisee against soliciting or accepting orders from consumers outside of his or her territory (count on them);
  • Any current or planned operation or franchise of a business by the franchisor that’s under a different trademark but sells or will sell goods or services similar to those the franchisee will offer; and
  • Whether the franchise is for a specific location or a location to be approved by the franchisor.

What you will not learn.

FDD Item 12 does not compel a good or bad bargain. It does not mandate any specific terms of your bargain, whether it’s the grant of a protected territory or the prohibition of franchisor encroachment. It only requires that certain material terms of that bargain are disclosed. So even if the deal offered by a franchisor is completely one-sided, so long as its principal terms are spelled out in accordance with the FDD’s regulatory regime of full and truthful pre-sale disclosure on territories, that’s what you’ll get. Nothing more, nothing less.

If the FDD (or the related franchise agreement) does not offer up an exclusive territory, the most important thing you will not learn is whether you can sleep at night. You will not know whether your franchisor, directly or through a competing franchisee, can take away your hard-won customers. So long as your territory remains unprotected, your customer base remains so. You also will not learn about any of the franchisor’s past expansion or planned trademark-specific expansion (although, as described above, you may learn about the franchisor’s expansion plans under a different trademark).

Your relatively meager fallback in the face of unprotected territory would be to negotiate a right of first refusal (generally, if a franchisor wants to open a nearby outlet, you must be given an opportunity to accept or reject an offer before it’s made to anyone else). If you have the means, risk tolerance and energy you can nip any same-brand competition in the bud. But, of course, that assumes that you have that right in the first place. And Jimmy John’s, for one, probably won’t grant you that right: "You have no options, rights of first refusal, or similar rights to acquire additional franchises."

Despite all of these cautions, Item 12 is obviously only one component of FDD disclosure, although an important one. So, while its Item 12 disclosure is well short of compelling, Jimmy John’s has a lot of other things going for it: among the most favorable failure and charge-off rates for franchisees who financed their investment through an SBA loan, robust Item 19 disclosure and designation as one of the Forbes magazine’s 2012 "best franchises for the money" and as the number 22 franchise in Entrepreneur magazine’s 2012 Franchise 500 Rankings. So, if you got derailed by Jimmy John’s Item 12 disclosure alone, you may have overlooked a great opportunity (I do not have nor do I anticipate having any referral or compensatory arrangement of any kind with Jimmy John’s).

Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.

This article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own franchise attorney concerning your own situation and any specific legal questions you may have.

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