When expanding a franchise system, franchisors may look to either an area development agreement (ADA) or master franchise agreement (MFA) to kickstart an expansion within a specific region or internationally. This article will provide an overview of both models to assist franchisees in making informed decisions that align with their goals and resources.
What is an ADA?
An ADA is an agreement which allows a franchisee to secure the rights to develop and operate a specified number of franchise units within a defined area over a certain period. Under an ADA, the developer does not have the right to sub-franchise, they will either operate the units themselves or find independent franchisees for the units. In all instances both the developer and the third-party franchisee will sign a franchise agreement directly with the franchisor. The developer acts like a “broker” by identifying and securing franchisees and/or franchise locations for the territory. The developer may be assigned certain operational and management responsibilities in addition to development obligations. An ADA may be terminated (i) once the agreed upon number of units are opened, (ii) if the developer fails to meet the development obligations or (iii) if the term of the ADA naturally expires. However, the ADA may persist if there are ongoing rights or obligations on either party that must survive.
What are the benefits of an ADA?
Exclusive territory: The developer may benefit from an exclusive territory, allowing the developer to build a strong presence in their region and protecting their investment from competition from other franchisees in the brand.
Increased potential for profit: Owning multiple units may permit the developer to realize operating efficiencies and improve revenue potential by benefiting from economies of scale, shared marketing costs, bulk purchasing, and other efficiencies that can improve margins.
Support and resources: As a multi-unit owner, the developer may receive greater support and incentives from the franchisor or hold more leverage in negotiations with the franchisor.
What are the risks associated with an ADA?
High initial investment: The developer must pay or at least commit to pay for the development of multiple locations, often all at once or at defined milestones. Opening and operating multiple units in a short period can strain finances, particularly if stores do not generate the revenue expected or as quickly as expected.
Complex operations: Establishing and managing multiple franchises in a region can be overwhelming, especially without sufficient resources or management experience.
Legal and financial exposure: The developer is contractually bound to a development schedule. Failure to meet the schedule can result in significant legal and financial liability, including forfeiting fees paid for unopened stores, losing the right to open future stores, as well as damages if the franchisor sues for breach of contract and other losses.
What is an MFA?
An MFA is an agreement where the franchisor grants a master franchisee the exclusive (or non-exclusive) right to directly establish and operate and/or to sub-franchise to authorized third parties the right to establish and operate franchises within a defined territory. The MFA will include fee and revenue-sharing provisions between the franchisor and master franchisee, as well as obligations for the master franchisee, like a development schedule for the territory. Unlike an ADA, the franchisor has no direct contractual relationship with sub-franchisees. Sub-franchisees will execute a sub-franchise agreement, the form of which must be approved by the franchisor, directly with the master franchisee.
What are the benefits of an MFA?
Established brand and model: A master franchisee assumes the benefits and support of an established brand, operating systems, training models, and supply relationships, instead of having to independently build a brand and franchise system. However, the master franchisee will often be responsible for customizing the franchisor’s system to ensure compliance with local laws and norms in the territory.
Territory exclusivity: A master franchisee may have the exclusive rights to a particular territory and the unrestricted right to develop and capitalize from the growth and revenues generated from its development of that territory, subject only to the terms of the MFA. A well-developed network of sub-franchisees in an exclusive territory can make the business attractive to potential buyers, providing a lucrative exit strategy for the master franchisee in the future.
Financial opportunity: Master franchisees have a higher earning potential as they earn income from both fees (e.g. initial franchise fees, royalties, renewal fees, transfer fees) and revenue generated by their own units as well as the fees payable by and the performance of sub-franchises. These multiple sources of income can lead to higher overall profitability and increase the value of the business.
What are the risks associated with an MFA?
Initial set-up costs: In addition to the master franchise fee paid to the franchisor, a master franchisee will incur set-up costs to establish the brand and its business in the new territory, including preparing compliant agreements, training programs, hiring staff, or opening corporate flagship stores to help sell franchises.
Complex operations: MFAs require time and resources to establish (and tailor, if necessary) the brand in the territory, recruit and train qualified sub-franchisees, market the brand, provide ongoing support and management of the local franchise network, and do the accounting and reporting to the franchisor, among other responsibilities.
Increased legal exposure: The master franchisee will be responsible for complying with local legal requirements and franchise law obligations for both its own business, any corporate locations, and all sub-franchises in the territory.
Ultimately, both models offer compelling opportunities for franchise growth and franchisees should choose carefully based on their skills, abilities, and risk tolerance. Be sure to consult a seasoned franchisor lawyer to navigate the unique complexities of both models.
Helen Fotinos
Partner, Lead of Franchising and Distribution for Canada
Dentons Canada LLP
helen.fotinos@dentons.com
Danika Kotylak
Senior Associate, Vancouver, BC
Dentons Canada LLP
danika.kotylak@dentons.com
Anthony Berlingieri
Associate, Toronto, ON
Dentons Canada LLP
anthony.berlingieri@dentons.com
Ann Chen
Associate, Toronto, ON
Dentons Canada LLP
ann.chen@dentons.com