By Peter Snell
This column will explore different aspects of the franchise agreement, to give you a better understanding of its basic elements. We will look at the requirements in franchise agreements for the franchisee to provide a personal guarantee.
Please note it is extremely important for you to take the time to fully analyze and review a franchise agreement before you sign it. While the following information serves as a general overview, as always, you should also seek your own legal advice when reviewing any franchise agreement. Only then can you obtain specific information and advice relevant to your particular circumstances.
Why does the franchisor want a guarantee?
Once an individual has been awarded the rights to operate a franchise, that individual typically incorporates a new company to operate the business. Incorporating is frequently done (a) for tax reasons, (b) to limit liability or (c) for both of those reasons.
Ultimately, however, the franchisor is awarding the franchise to an individual who meets its qualifying standards, in terms of both financial and personal traits. Therefore, the franchisor will need, in most cases, to assess the individual’s personal financial statements, rather than those of the incorporated entity.
The franchisor will have legitimate concerns about the strength of the financial commitment being made by a corporate franchisee. And those concerns will be even greater when a new company is being formed by the individual to act as the franchisee, since this company will usually be thinly capitalized and will not have a financial performance track record to review.
As mentioned, beside possible tax considerations, one of the common reasons franchisees choose to incorporate and use a company to act in their place is to limit the potential personal liability they may encounter. In most cases, individuals who are going to set up and operate a franchise through a new company will specifically and deliberately not invest all—or even a substantial amount—of their assets into the corporation, since that would defeat the intention of limiting personal exposure and liability.
In such a situation, the franchisor may have assessed the financial wherewithal of the prospective franchisee who will be acting as the operator of the franchise, but legally, the newly formed company will carry all of the financial and operating performance obligations under the franchise agreement. So, it is typical for the franchisor to ask the individual principal(s) of the newly formed company to provide their personal guarantees of those obligations.
It is important to note these obligations are not merely financial, but also performance-based. This represents a critically important second element of the guarantee.
Enforcing a non-compete clause
There will be a variety of performance-related clauses in the franchise agreement the franchisor will consider very important. One of the most common, for example, is the covenant not to compete with the franchise business or system during the term of the franchise agreement and, for that matter, for a limited period in a limited area after the reassignment, termination or expiry of the agreement.
Even if the franchise agreement specifically states “neither the franchisee company nor its directors, officers or shareholders will compete,” for example, that wording cannot completely satisfy the franchisor if the principals of the franchise do indeed go out and compete with the business, as only their company will be faulted, not the individuals themselves. This means the franchisor might not be able to enforce its non-compete clause against these individuals, unless they were also parties to the franchise agreement as guarantors.
Indeed, it is all too common, at the end of a relationship between franchisor and franchisee, for the individuals who set up the franchisee company to want to continue in a similar line of business. The franchisor will understandably not be in favour of this outcome, as it can negatively affect the franchise system and, specifically, the individual location that was previously operated by the franchisee.
The issue becomes even more important to the franchisor if the franchisee company becomes insolvent and cannot realistically pay any damage awards that may be found against it by a court of law for a breach by its principals of the non-compete covenant in the franchise agreement. In such a situation, the franchisor would be left competing with the principals of the franchisee company, unable to enforce any judgment obtained against it. This is certainly not a scenario a franchisor ever wants to face.
So, by requiring a guarantee of the performance of the franchise agreement from the individuals who are going to be key operators of and shareholders in the franchisee company, the franchisor can achieve direct contractual obligations with these individuals, allowing it to seek enforcement of non-compete provisions against them, rather than just against the company.
When the franchisor can obtain personal guarantees, in addition to being able to sue for damages if a non-compete provision is breached, another benefit is the franchisor can seek an injunction to stop the corporate or individual franchisee(s) from establishing or continuing to operate a business that could be in competition with the franchised business. Without personal performance guarantees, the franchisor would not be able to seek this form of legal relief.