By Blair A. Rebane and Eric C. Little

As the COVID-19 pandemic drags on, creating continuing uncertainty in many business sectors, some franchisors have experienced challenges in attracting or identifying suitable candidates for new unit franchisees.  In these circumstances, some franchisors are focusing their franchise development strategies on area development arrangements as a means of expanding their franchise systems and generating growth through a smaller number of franchisees operating a larger number of units.  This article discusses some of the key elements that franchisors should consider, from both a legal and practical perspective, to ensure that their prospective area development deals are set up for success.

What is an area development arrangement?

An area development arrangement is an arrangement whereby a franchisor grants to a franchisee (the area developer) the right to establish and operate a number of unit franchises within a specific geographic territory.  It is the area developer that will develop and operate the individual unit franchises within the development area, either itself or through subsidiaries.  This is what distinguishes an area development arrangement from a master franchise arrangement, where the master franchisee is granted the right to sell sub-franchises to prospective unit franchisees within a specified territory.

Area development arrangements are attractive to franchisors because they often allow franchisors to establish new locations and expand their system faster and more efficiently than if they had been working with a number of different unit franchisees.  They allow the franchisor to maintain a direct relationship with the party that will be operating each of the new unit franchises (which differs from a master franchise arrangement, where the master franchisee sits between the franchisor and the individual unit franchisees), and they also reduce the number of individual franchisees that the franchisor needs to recruit, vet, train and manage.  In most cases, area developers are also more sophisticated and better capitalized than a typical unit franchisee.  For these reasons, area development arrangements can streamline support, reporting, supply and payment arrangements between the franchisor and its designated suppliers and the various franchised locations to be developed within the development area.

Territory

One of the most important items that a franchisor must consider in setting up an area development arrangement is the geographic territory that will be offered to the area developer, and what sort of exclusivity they will be granted in relation to that territory.  The franchisor must consider carefully the development prospects of the territory being offered, and should ensure that the number of locations contemplated by the development schedule makes sense and will make optimal use of the territory.

The franchisor must ensure that the development area is clearly defined in the area development agreement.  A development area will typically comprise an entire province, territory or municipality, but in some cases may refer to another geographic region which may not have an official or generally recognized boundary.  In these circumstances, it is particularly important to ensure that the development area is clearly described in the area development agreement, so there is no question or ambiguity with respect to its boundaries.

With respect to exclusivity, the franchisor must consider specifically which rights it is granting to the area developer in relation to the development area, and what exceptions the franchisor wants to carve out from those rights.  For example, will the franchisor reserve the right, for itself and its affiliates, to establish and operate businesses of the same type within the development area?  Are there certain types of locations that are excluded from the development rights being granted to the area developer (e.g. the right to establish franchised locations at airports, train stations, stadiums, arenas, hospitals or educational institutions), or other channels of distribution that the franchisor wants to reserve for itself and its affiliates (e.g. the right to operate food trucks within the development area)?  The area development agreement should be very specific with respect to the rights being granted to the area developer and any exceptions to or reservations from those rights, as any lack of clarity regarding these terms can be the cause of a potential dispute between the parties once the development arrangement is underway.

The area development agreement should also make very clear that the development rights and any exclusivity granted to the area developer will come to an end upon the expiration or termination of the area development agreement.

Development schedule

Most area development agreements will contain a development schedule, which requires the area developer to establish and maintain in operation a certain number of new unit franchises within the development area by certain specified dates.  The development schedule is one of the most important components of an area development arrangement, as it sets the course for the scope and pace of the area developer’s activities within the development area.  Accordingly, in determining the development schedule, it is important for the franchisor to consider whether the number of locations to be developed and the pace at which they are to be established makes sense, given the size of the territory, its demographics and its regional or local market profiles.  In addition, the franchisor should consider whether there is a certain regional balance or distribution of new franchised locations that it would like to achieve within the development area.  If there is, the development schedule can be set up to facilitate this.

Typically, there are significant consequences if an area developer fails to meet its obligations under the development schedule.  Some area development agreements may provide that the area developer can lose its exclusivity rights with respect to the development area, or that the franchisor can reduce or modify the boundaries of the development area, if the area developer fails to adhere to the development schedule.  While an ambitious development schedule can seem appealing at first blush, it is important to ensure that the development schedule is realistic, taking into consideration the nature of the territory, local market factors and other practical considerations.  An overly aggressive development schedule can set the area developer up for failure from the start, and can result in the loss of what might otherwise have been a successful business venture for both parties.  From the franchisor’s perspective, even if it does have the ability to take away the area developer’s exclusivity rights, or to reduce or otherwise modify the boundaries of the development area, it might not be easy to offer new franchise opportunities to others in an area that already has a number of locations being operated by the area developer.  Accordingly, taking a measured and practical approach to the development schedule is usually in the best interest of both parties.

Separate, Individual Unit Franchise Agreements

With respect to the contractual relationship between the franchisor and the area developer, it is best to use a master form of area development agreement, which sets out the terms and conditions for the area development arrangement and governs the relationship between the franchisor and the area developer, and to enter into separate, individual franchise agreements for each unit franchise to be established by the area developer (or a subsidiary) within the development area.  It is generally not advisable to try and deal with all of these arrangements in a single form of agreement, even if it will be the area developer itself (and not a subsidiary) that will be establishing and operating each of the individual unit franchises.  The franchisor has different relationships with the area developer as developer, and the area developer as unit franchisee, and issues can arise in relation to particular unit franchises that may not be common to all unit franchises within the development area.  Using separate, individual franchise agreements for each unit franchise established by the area developer gives the franchisor greater flexibility to deal with issues as they arise in one relationship or the other, or from one unit franchise to the next.  The franchisor can better isolate potential problems and address them without necessarily disturbing the operations of all unit franchises within the development area.

If the franchisor intends to use its standard form of unit franchise agreement in connection with an area development arrangement, the area development agreement should specify that the form of unit franchise agreement to be used is the franchisor’s “then current form” as of the time that each unit franchise agreement is being entered into.  Since most area development agreements provide for a term that will last a number of years (and potentially renewal rights for the area developer), the franchisor must have the ability to update its form of unit franchise agreement to address changes in the franchise system, changes in applicable laws or regulations, and other such developments, and to require the area developer to use its most current form of unit franchise agreement, as updated by the franchisor from time to time.

The franchisor will also need to take care to ensure that the terms of the area development agreement and the form of unit franchise agreement are complementary and do not conflict with each other.  Among other things, the franchisor will need to consider how it intends to handle different types of defaults by the area developer under each form of agreement, and ensure that the franchisor’s rights and remedies are structured such that it can manage defaults effectively and without creating other problems within the broader business arrangement between the parties.

What are you looking for in a development partner?

Franchisors should consider carefully the characteristics, skills and resources that they are seeking in a potential area development partner.  These attributes will often differ in comparison to what the franchisor typically looks for in a prospective unit franchisee, as it requires different skills and resources to successfully establish and operate multiple franchised businesses than it does to establish and operate a single one.  Accordingly, even if a prospective area developer is already an existing franchisee of the system, the franchisor will still need to carefully evaluate its prospects as a potential area developer and operator of a number of franchised locations.  Among other things, the franchisor will need to consider the prospective area developer’s business experience, access to capital and financing, and operational capacity, as well as its connection to, and familiarity with, the development area.

One thing that franchisors should keep in mind when evaluating a prospective area developer is that although area development arrangements offer many advantages (as discussed at the beginning of this article), they also carry certain risks.  Among other things, granting to one party the right to develop and operate a number of locations within a specific development area, and granting them exclusive rights with respect to the development area, increases the risk that the franchisor will face should the area developer run into operational or financial difficulties in the course of the development arrangement.  It can also limit or stall the development prospects of the system within the development area if the relationship between the franchisor and the area developer takes a bad turn.  Accordingly, it is important for a franchisor to evaluate its prospective area developers very carefully, taking into account the nature and scope of the business relationship they are proposing to enter into together.

Key Takeaways

Area development arrangements can be an attractive way for a franchisor to expand its franchise system to new areas and promote growth within its network.  They offer many benefits in comparison to simply selling individual unit franchises, and they can provide a path for advancement for existing unit franchisees who are seeking opportunities to grow their own business and take on a greater role within the system.  However, like any large-scale business relationship, area development arrangements also involve certain risks.  Managing those risks requires careful planning and consideration of the matters discussed above (among others).  Experienced franchise counsel can assist franchisors in working through these considerations and ensuring that their prospective area development arrangements are set up for success.

About the Authors

Blair A. Rebane is a partner at Borden Ladner Gervais LLP (“BLG”) and the National Leader of the firm’s Franchise and Distribution Group.  Eric C. Little is a partner in the Corporate and Capital Markets Group at BLG, who practices corporate commercial law with an emphasis on franchising, licensing and distribution.