By Blair A. Rebane and Eric C. Little

It is very common for franchisors to mandate the use of specific software or technology systems within their franchise network.  Whether that is a point-of-sale, customer relationship management, ordering or booking system (or some combination of those systems), an automated customer service platform, or something more advanced, requiring franchisees to use the same software and technology systems plays an important role in ensuring consistency of customer experience, service delivery, reporting and certain aspects of operational performance across the franchise network.  In cases where a franchisor has developed its own proprietary software or has a special purchasing arrangement or preferred pricing terms with a designated supplier, an effective technology offering can form a significant part of a franchisor’s value proposition to its franchisees, as well as a way of differentiating itself from its competitors.  That said, requiring franchisees to use specific software or technology systems also raises certain business and legal considerations that franchisors should evaluate carefully prior to introducing a new system.  This article discusses some of the key factors that franchisors should consider.

What Does the Franchise Agreement Say?

As with any system change, one of the first questions a franchisor must address when considering requiring franchisees to use a new software application is whether the franchise agreement grants the franchisor the express authority to impose the change.  Most franchise agreements will contain a general provision requiring the franchisee to obtain, implement and use the computer hardware, software and technology systems that the franchisor prescribes, at the franchisee’s cost.  These provisions are often broadly-drafted and generic, with the details of the required technologies being set out in the franchisor’s operations manual or operating standards and specifications.  However, as the technologies used in some franchise systems become more advanced, it is now common to find detailed technology provisions in franchise agreements, which set out with specificity the kinds of technologies that franchisors can require franchisees to obtain, implement and use.  In either case, the key question for a franchisor is whether the language of the franchise agreement clearly permits the franchisor to introduce its proposed software and require franchisees to use it.  In some cases, newer, more advanced systems may not necessarily be covered by older, more generic contractual language.  Since the franchise agreement is the source of the franchisor’s authority to introduce the change, the franchisor should be confident that the proposed change falls within the language of the franchise agreement.  If this is at all unclear, it could become a source of conflict with franchisees, particularly if the required expenditure from franchisees will be significant.

It is also important to ensure that the franchise agreement gives the franchisor the ability to require franchisees to change, update, upgrade and supplement the required software after it has been implemented.  As noted above, ensuring the uniformity of the software and technology used across the franchise system is a key part of promoting consistency in service delivery and operations.  Given the rapid pace of technological advancement, the right to require the use of a particular software application or technology system is of limited value if it does not also come with the corresponding right to require implementation of the latest updates or upgrades to such software or system.

Confirming contractual authority to introduce a new software requirement is only the first step, though.  Franchisors must also be mindful of the limitations imposed by the statutory and common law duties of good faith and fair dealing on their ability to exercise their rights under the franchise agreement.  The duty of good faith and fair dealing requires, among other things, that a franchisor have “appropriate regard” for franchisees’ interests in exercising its rights under the franchise agreement and that it not “seek to undermine [franchisees’] interests in bad faith.”  It also requires that a franchisor act reasonably in exercising its discretion under the franchise agreement.  In the franchise context, “reasonableness” will be assessed in light of the nature of the franchise agreement, being a long-term commercial agreement where both parties have made significant investments in the relationship.  When it comes to introducing a system change, such as requiring the use of a new software application or technology system, the duty of good faith and fair dealing requires that a franchisor take franchisees’ legitimate interests into account and be able to show adequate consideration for those interests in deciding to proceed with the change.  It also requires that a franchisor exercise its discretion with proper motive and consistently with the purpose for which it was granted under the franchise agreement.  The nature and extent of the steps that must be taken will vary depending on the significance of the change being proposed.  To be clear, the duty of good faith and fair dealing does not create new rights or obligations beyond what is contemplated in the franchise agreement, but it does inform how a party’s rights can be exercised or enforced.  What this means in practice is discussed further below under “practical considerations”.

Whose Software Is It?

Various considerations arise depending on who owns the software in question.  In some cases, a franchisor may decide to develop its own proprietary software.  This most often occurs where the function the software is intended to perform, or the need it is intended to serve, is fairly specific to the franchise system or the underlying business.  If this is done properly and the software works well, it can provide significant relationship and competitive advantages for a franchisor, as it adds value to the franchisee’s business and offers them something they cannot get elsewhere.  At the same time, developing its own software means that a franchisor bears the burden of the development cost, which is often significant.  A franchisor may be able to recover some of that cost from franchisees under the terms of the franchise agreement, but in some cases the cost may exceed what the franchisor can reasonably pass on.  Developing its own software also means that a franchisor bears all of the risk if the software does not work as intended.  If franchisees are required to implement and use a franchisor’s software, and the software does not work, franchisees will quickly become disgruntled and will look to their franchisor to fix the problem (including potentially demanding that the franchisor address any costs or losses they incurred in connection with implementing or troubleshooting the software or as a result of its failures).

Rather than developing its own software, a franchisor may license the required software from a third party provider and sublicense it for use by its franchisees.  If a franchisor proposes to do this, it must first ensure that the terms of its license agreement with the software provider permit sublicensing of the software to its franchisees.  Doing this without express authorization under the license agreement would put the franchisor offside of the terms of its own license from the software provider.  This could create exposure for the franchisor on multiple fronts and is a scenario that must be avoided.  In addition, if the franchisor will be required to collect sublicense fees from its franchisees (either because that is a requirement under its own license agreement with the software provider or because the franchisor wants to cost recover its own license fees by passing them on to franchisees), it must ensure that the franchise agreement clearly allows for that.  If the franchisor will be sublicensing software, it should also ensure that its own license agreement with the software provider contains appropriate mechanisms and protections to address any potential operational or service failures or other incidents involving the software.  Among other things, the franchisor will want to ensure that the license agreement contains appropriate covenants from the software provider to adhere to any required service levels, provide technical support and fixes when required, and maintain the confidentiality of all confidential, proprietary or personal information (to the extent that the provider may gain access to any of these things in connection with providing the software), appropriate cybersecurity protections, and indemnification obligations for any loss or damage resulting from a failure or other significant problem involving the software.  The franchisor will also want to ensure that it has appropriate termination rights under the license agreement in case there is a significant problem with the software, any associated services, or the software provider that is not addressed to the franchisor’s satisfaction.

A third possibility is that a franchisor might simply require that its franchisees obtain the required software directly from the software provider as a designated or approved supplier, enter into their own license agreement with the provider, and pay all fees and other required amounts to the provider directly.  The obvious advantage to this approach is that it removes the franchisor from the arrangement entirely and allocates all of the financial burden and the risk of non-compliance to the franchisees.  On the other hand, franchisees may not enjoy the same pricing or other benefits where they enter into their own agreements with the software provider directly, so this approach may not offer the same value proposition for franchisees that a sublicensing arrangement might.

Practical Considerations for Implementation

Regardless of who owns the software or how it is provided to franchisees, there are certain practical considerations that franchisors should consider carefully prior to introducing it to the franchise system or mandating its use by franchisees.

Among other things, if a franchisor proposes to require franchisees to implement and use a particular software application, it should first ensure that the software is reasonable in that it appropriately reflects the needs of the business and the expenditure required from franchisees makes sense in the specific context of the business.  If the system is overly complex, significantly more expensive than is reasonably necessary for a business of the kind in question, or if it otherwise could potentially raise issues for franchisees as to whether it really adds value for the business, then a franchisor could potentially receive pushback from its franchisees if it attempts to require its implementation and use in the franchise system.  Being able to clearly establish the reasonableness of the proposed new software requirement in the context of the franchise system and from the perspective of the underlying business will also be a critical factor in establishing that a franchisor acted in accordance with its duty of good faith and fair dealing, should that ever be called into question.

Before moving to implementation, a franchisor should ensure that it has a significant amount of direct experience with the software itself.  Among other things, a franchisor will want to ensure that it has a comprehensive understanding of the software, how it works, and how to use it properly.  Franchisors will also want to confirm that the software actually works for the intended purpose and is well-suited to meet the business needs of their specific franchise system.  If there are any issues with how the proposed software works in practice or how it addresses the needs of the underlying business, comprehensive initial testing can help the franchisor to identify those issues and determine whether they can be fixed to the franchisor’s satisfaction.

In addition to the franchisor’s own initial testing, it may decide to further assess the software’s functionality and appropriateness for the franchise system by implementing the software in the franchisor’s corporate or affiliate-owned businesses or conducting a pilot project with specific franchisees.  Testing the software over a longer term in actual operating businesses within the franchise system can provide valuable insight and feedback that may differ from what the franchisor was able to obtain through its own initial testing.  Testing the software with interested franchisee participants can also be an effective way of gaining early adopters and promoters of the software within the franchise system, which can assist the franchisor in making the ultimate business case to franchisees for the software’s adoption and use in the franchise system.  Franchisees may find a fellow franchisee’s positive experience with the software to be more persuasive than any assurances they might receive from the franchisor regarding the software and the benefits it offers.

As with any system change, prior communication and consultation with franchisees can be vital steps for minimizing potential issues that may arise with respect to implementation, particularly if the change will be significant or will require a significant investment from franchisees.  These steps can help to ensure that franchisees understand the business rationale for introducing the new software requirement, assist in identifying potential concerns from franchisees’ perspectives, and give the franchisor the opportunity to address any concerns and ensure that the new software is as responsive to the needs of the system as possible.  Communications regarding the proposed new software should be clear, concise and transparent, and should make it very clear why the new software is being proposed and how it will add value for franchisees and the system.  Consultations should legitimately give franchisees a meaningful opportunity to provide their input or feedback regarding the proposal, and the franchisor should take care to consider such feedback in developing its implementation plan.

These steps can also be effective ways of demonstrating that a franchisor has complied with its duty of good faith and fair dealing in introducing the new software requirement.  If a franchisor can show that it communicated the proposed change to franchisees well in advance and consulted with them in a meaningful way prior to its implementation, a franchisor will be better placed to establish that it gave adequate consideration to its franchisees’ interests and did not simply disregard them.

Finally, prior to implementing a particular software application or technology system, a franchisor should have a clear plan as to how it will handle any potential problems regarding the software or its use within the franchise system.  Regardless of who owns and provides the software, the reality is that if a franchisor has mandated its use within the franchise system and there is a problem with the software, the franchisor is likely to hear about that from its franchisees.  If a franchisor owns the software and provides it to franchisees directly, it will need to have a comprehensive plan for dealing with any issues and an effective technical support system so that problems can be addressed in a responsive and timely way.  If a franchisor is sublicensing software from a third party provider to its franchisees, it will be caught in the middle if there is ever a significant problem involving the software or its performance.  Accordingly, the franchisor must ensure that it fully understands its rights and remedies under its license agreement with the software provider and knows what steps it can take in the event of a problem.  Trying to figure all of this out after a problem has arisen will put the franchisor on its heels and will significantly hinder its ability to respond quickly and manage the problem effectively.  If franchisees obtain the software directly from the provider themselves, their recourse will be set out in their own agreement with the provider; however, the franchisor may have its own agreement or commercial relationship with the provider that it could potentially leverage in the event of a significant problem that impacts its franchisees.  Prior consideration of these issues and a proactive issues management plan will greatly assist franchisors in managing any potential problems that may arise with the software they have prescribed for use in their franchise system.

Key Takeaways

There can be significant benefits to prescribing the use of specific software within a franchise system.  However, like any system change, the introduction of a new software requirement must be considered carefully and implemented in a thoughtful way, taking into account the terms of the franchise agreement, the business needs of the franchise system and the underlying business, the interests of franchisees and the franchisor’s duty of good faith and fair dealing.  Every franchise system is different and each franchisor who is considering introducing a new software requirement will need to consider what the right approach for their particular system is.  Experienced franchise counsel can assist franchisors in navigating these considerations and developing the right approach.

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.