Pre-contractual phase

Preliminary Agreement (Letter of Intent)

A franchisor may conclude a preliminary agreement with a prospective franchisee before actually concluding a franchise agreement. This preliminary agreement is also called the letter of intent. By concluding a preliminary agreement, the parties indicate their intention to cooperate with each other. The preliminary agreement forms the basis for the parties to (exclusively) negotiate with each other in good faith.

In the preliminary agreement the following matters may be addressed:

  • the exchange of information;
  • the duration of the preliminary agreement;
  • confidentiality;
  • exclusivity (the exclusive territory);
  • the provision of financial data;
  • the making of financial arrangements (such as the entry fee and the franchise fee);
  • the manual;
  • agreements on the location survey.

The main reason for a franchisor to conclude a preliminary agreement with the prospective franchisee is the non-disclosure agreement that forms part of the preliminary agreement. After all, protecting the know-how is of great importance to every franchise organisation. To that end, the franchisor agrees on a duty of confidentiality with a prospective franchisee regarding company-sensitive information which is disclosed during negotiations. This is one of the ways to prevent this sensitive information from ending up with possible competitors or from being used by the prospective franchisee itself when starting a competing business. The franchisor may choose to enter into a so-called ‘non disclosure agreement’ with the prospective franchisee, but may also choose to include a confidentiality clause in the letter of intent. For a confidentiality clause in a letter of intent or a confidentiality agreement to have any effect, it will have to be accompanied by a penalty clause.

 

The franchisor's duty of disclosure

An important purpose of the Franchise Act is to strengthen the franchisee’s access to information, both before and during the term of the franchise agreement. Therefore, the Franchise Act includes extensive duties of disclosure for the franchisor. The franchisor must, prior to the conclusion of the franchise agreement, provide all information to the prospective franchisee of which the franchisor knows or can reasonably suspect that it is important for the franchisee's decision whether or not to enter into the franchise agreement.

The franchisor should in any case share the following information with the prospective franchisee:

  • the draft franchise agreement, including annexes;
  • historical (financial) location data, to the extent reasonably available;
  • an overview with an explanation of the investments to be made by the franchisee or the fees, surcharges or other financial contributions to be paid by the franchisee;
  • information on the manner in which consultations between the franchisor and franchisees are conducted and how often these consultations will have to take place;
  • an overview with the contact details of the franchisees’ representative body;
  • information on the extent to which and the manner in which the franchisor may compete with the franchisee, whether or not through a derived formula;
  • information on the financial position of the franchisor; and
  • financial information on the intended location where the new franchisee will operate or, in the absence thereof, information on comparable franchise locations. According to the explanatory memorandum to the Franchise Act, this obligation does not include providing a forecast.

The draft franchise agreement including annexes does not include the manual. If, however, the manual contains obligations for the franchisee that are relevant to its decision to join the relevant franchise organisation as a franchisee, these obligations do form part of the duty of disclosure.

Another important element of the franchisor’s duty of disclosure concerns the consultation structure between the franchisor and its franchisees. More about this subject may be read here. It should furthermore be noted that the legislator encourages the prospective franchisee to in advance contact existing franchisees, or their representative bodies in any case. This may contribute to the franchisee obtaining a realistic view of the franchise organisation and everything it entails.

If the franchisor should in any way restrict the franchisee in that party’s right to at all times inspect its own (sales) figures, this should be addressed in advance. Examples are accounting packages or cash register systems that can only be accessed by way of the franchisor.

 

The provision of financial data and forecast by the franchisor

The franchisor may provide the prospective franchisee with an operating forecast in order to enable the franchisee to prepare a business plan and/or obtain the necessary financing from the bank. Such a forecast indicates what the prospective franchisee may in due course expect to achieve in terms of turnover and profit.

However, the franchisor is not obliged to provide an operating budget to the prospective franchisee, such as a report on the expected turnover and profit. If the franchisor does, however, decide to provide such a report (/ forecast) to the prospective franchisee, the franchisor may, under certain circumstances, be liable for any errors in the forecast. This applies, inter alia, in the event that the errors in the forecast are caused by carelessness of the franchisor, regardless as to whether the franchisor is aware of the fact that the report contains errors. In the event that the franchisor has contracted out the study of the figures and the drafting of the report based thereon to a third party, the franchisor may, as a rule, rely on the accuracy of the report prepared by the third party. In that case, the franchisor will, in principle, be deemed to have acted negligently, if it knows that the report concerned contains serious errors and fails to draw the prospective franchisee’s attention to these errors.

According to the Franchise Act, the franchisor must also provide the prospective franchisee with information on its financial position. After all, if the franchisor cannot meet its financial obligations or even goes bankrupt, this may have serious consequences for the franchisee. Normally, it will be sufficient for the franchisor to provide its annual financial statements for filing purposes. This is different if those documents do not give a true and fair view of the actual situation. The franchisor will therefore have to assess, on the basis of its own documents, whether additional information is required.

 

Reflection time

One of the aims of the pre-contractual duty of disclosure is to ensure that the franchisee does not agree to a franchise agreement of which it can insufficiently assess the contents and the effects of the obligations contained therein, as well as the related risks. For this reason, the Franchise Act provides that there has to be a period of four weeks between the moment of receiving all the information and the moment of concluding the franchise agreement. During this period (the so-called stand-still period), the draft franchise agreement may not be amended to the detriment of the prospective franchisee.

During this period, no investments nor any other payments with a view to the upcoming franchise relationship may be requested from the prospective franchisee either. No changes, or contractual changes, may be made to the detriment of the prospective franchisee. It is furthermore forbidden for the franchisor to encourage a prospective franchisee to conclude agreements related to the franchise agreement. One explicit exception is the non-disclosure agreement. The franchisor is free to agree such a document with the prospective franchisee, including prior to or during the stand-still period. After all, the conclusion of such an agreement will have no impact on the prospective franchisee’s decision to enter into a franchise agreement with a franchisor.

During this period, the prospective franchisee is expected to conduct research. The prospective franchisee has a responsibility of its own to prevent it from entering into an agreement on the basis of incorrect and/or too rosy assumptions.

 

The franchisee's duty of disclosure and obligation to investigate

The franchisee in its turn is also under a duty of disclosure towards the franchisor. The franchisee must be open about its financial situation, thus enabling the franchisor to assess whether the franchisee is capable of making the necessary investments.

In addition, the franchisee must independently investigate the feasibility of the business undertaking. In view of the business risk, an attitude of that nature may also be required from a prospective franchisee. The prospective franchisee may inter alia do so by performing a location survey.