Territories are important both in the context of a franchisor setting up a franchise network, but also when a prospective franchisee is selecting a particular franchise.
Emily Shingler, a solicitor in Darwin Gray’s Franchising team, outlines key considerations for both franchisors and franchisees when it comes to negotiating territories.
Defining the area
Most franchise territories are based on a specified geographical area. This is usually done by reference to a map or alternatively post codes. A territory can also be measured as a radius originating from the location of the franchise or limited to one place, such as a shopping centre.
Whatever the method, the franchise agreement should clearly define the territory. The franchisee should be satisfied that they understand the boundaries of the territory in which they are permitted to operate. If not properly defined, it is possible for disputes to arise between franchisors and franchisees as to the precise extent of the territory.
Although it may seem attractive to a franchisor to keep each territory roughly the same size, careful consideration needs to be given to the demographics and local geography of a particular area to determine its sales potential.
It is common for franchisors to grant exclusive territories to franchisees. Exclusivity protects the franchisee from competition from the franchisor or another franchisee within a defined area of operation. From a franchisor’s perspective, it avoids franchisees from the same network competing and potentially undercutting each other, which could devalue the franchise brand.
Where an exclusive territory is granted, the franchise agreement will usually contain a provision preventing franchisees from actively seeking customers outside of their exclusive territory.
Whilst on the face of it an exclusive territory may seem attractive to prospective franchisees, franchisors should consider carefully whether geographical exclusivity actually enhances their franchise model. Not all franchise businesses will benefit from boundary restrictions. Relationship-driven, referral-based businesses, such as professional services, may be negatively impacted by boundaries. Such businesses often depend on the referrals that existing customers provide and therefore a geographical restriction could hinder the success of the individual franchisees.
Ultimately, whether exclusivity is granted or not will depend on the type of product/service offering, the success of the franchised brand and whether it is particularly vulnerable to local competition.
Even if a non-exclusive territory is granted, it is in the interests of the franchisor to not introduce a second franchisee into a territory where there is no demand for it; otherwise, it risks jeopardising the profitability of the first franchisee.
If you are a prospective franchisee and are being offered a non-exclusive territory, you should check whether there are any existing franchisees operating in the proposed or surrounding area. It is also essential to speak with as many existing franchisees as possible, to gain an insight into how the franchise is likely to work out in practice and what the franchisor is like to deal with on a day-to-day basis. Such conversations might also help you determine whether your proposed territory is likely to be profitable.
When it comes to exclusivity, one risk for franchisors is that they give large exclusive territories to franchisees who fail to fully develop them, therefore leaving a wealth of potential customers untapped. To limit this risk, franchise agreements will often contain the right for the franchisor to withdraw exclusivity or alter the boundaries of the territory if the franchisee either fails to achieve minimum performance targets or breaches the terms of the franchise agreement.
Prospective franchisees should consider whether the right to operate exclusively is going to be instrumental to the success of the franchise business. If it is likely to be an important factor, then they should check that the franchise agreement does not allow the franchisor to easily withdraw or change the territory. Ideally, changes to territory should be a last resort when all other options under the franchise agreement have been exhausted.
Advertising and cross-border enquiries
Where a franchise network is built on exclusive territories, the franchisor should ensure that its standard form franchise agreement contains provisions restricting franchisees from actively seeking customers outside their respective territories.
However, franchisees cannot be prevented from carrying out passive advertising – where the marketing is not specifically targeted at customers in a particular area but still happens to reach a prospective customer outside the exclusive territory. Passive advertising over the internet is ever more prevalent due to social media. Therefore, even where exclusivity is offered, it still may be diluted by passive advertising.
Issues can arise when a franchisee receives an enquiry from a prospective customer outside of their exclusive territory. How to deal with such an issue will depend on the nature of the business. For example, networks that rely on customers travelling to the business (such as a fast-food outlet) would find it practically impossible to restrict which customers use which franchisee’s outlet.
Where it is easy to establish the customer base of a particular territory, franchisors should ensure that it has a procedure in place across its network for dealing with cross-border enquiries. This will hopefully avoid disputes arising between franchisees. For instance, the procedure may specify that the franchisee can continue to deal with the customer even though they are outside their territory or alternatively that the enquiry is passed to a local franchisee in the customer’s area.