Seven Tips for Negotiating an Area Development Agreement

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Authors: Ben Hanuka and Anthony Pugh, Law Works P.C.

An area development agreement allows a franchisor to expand its system and add new franchisees within a certain territory.  This arrangement could give the franchisor an ability to expand more quickly and confidently within a territory than the franchisor might otherwise be able to.  The area developer, who may be an experienced franchisee, typically has the trust of the franchisor and expertise within the territory.  

The area developer will normally be expected to locate prospective franchisees.  The area developer may also be involved in the set-up of each franchised unit and have an obligation to support each franchisee that he signs up.  The area developer may also have an equity interest in each franchisee business.

While an area development agreement presents potentially significant benefits to both sides, it could also create major risks to both.  The following are some of the many potential pitfalls that a franchisor and an area developer should consider before entering into an area development agreement.

The development schedule

The area developer will usually have an obligation to comply with a development schedule.  The area developer will be required to develop a certain number of outlets in the territory within a certain time.  

Both the area developer and the franchisor should consider whether the development schedule is realistic because there may be significant consequences if the area developer fails to meet the schedule.  An impractical development schedule may result in both the area developer and the franchisor losing out on a long-term profitable relationship based on unrealistic expectations.

The area developer’s support obligations

The area developer may have obligations to support the franchisees that it places.  This may extend so far as to amount to an obligation to even cure the franchisee’s defaults.  This obligation can be explicit in the area development agreement. It may also be implicit, based on the consequences in the agreement in circumstances where the area developer allows a franchisee’s defaults to remain uncured.

Consequences of franchisee defaults or termination

All parties should be aware of what happens if a franchisee who was placed by the area developer defaults on his or her unit franchise agreement with the franchisor.  In some situations, franchisee defaults may lead to termination of the area development agreement and may impact other unit franchise agreements that were entered under the area development agreement.

The area developer should also be aware of what happens if the franchisor terminates either the area development agreement or individual franchise agreements.  The area developer may find himself on the hook for a significant amount of money to the franchisor based on defaults of the franchisee, even if they were not directly within the area developer’s control.

Area developer’s default

If the area developer defaults, it could potentially have a catastrophic domino effect on unit franchise agreements associated with the area developer.  If the default is so significant as to deem the area developer unfit to operate a franchise, it may put in jeopardy all the unit franchise agreements with which the area developer is involved. 

Franchisor’s associate or franchisor’s liability

The area developer should consider whether it could be deemed to be a “franchisor’s associate” under the franchise disclosure legislation of British Columbia, Alberta, Manitoba, Ontario, New Brunswick and Prince Edward Island.  

A unit franchisee may argue that the area developer is controlled by the franchisor, even if indirectly, and that the area developer was involved in the grant of the franchise.  In addition, the area developer may have some control over franchisees, and the franchisees may owe the area developer ongoing payments. All these factors may lead to a finding that the area developer is a “franchisor’s associate” within provincial franchise legislation.

A franchisor’s associate is liable for damages under provincial franchise statutes for any of the following claims: rescission, misrepresentation, failure to comply with disclosure obligations, and interference with franchisee’s right to associate.  The risk exposure of the franchisor’s associate could potentially be joint and several with the franchisor. Rescission damages (or other damages) may be very significant. If damages are multiplied by several unit franchisees, they could have a devastating financial impact on the area developer. 

The franchisor should be aware that the area developer will most likely look to it for an indemnity against claims by unit franchisees for any liability that the area developer claims is the franchisor’s responsibility.

The area developer’s obligations to third parties

The area developer may have obligations to third parties such as landlords.  In some situations, the area developer may be required to be on the lease as tenant, or to indemnify the lease.  These obligations create significant risks if the location is financially unsuccessful.

It is also important to consider a right for the area developer to take over such leases if the unit franchisee is in default of his obligations under the lease or unit franchise agreement.

Dispute resolution

Both the franchisor and the area developer may benefit from arbitration agreements contained in unit franchise agreements, based of the confidentiality inherent in private arbitration.  However, if the area developer is not a party to the arbitration agreement between the franchisor and unit franchisee, the latter may be able to avoid arbitration by naming both franchisor and area developer as defendants.  This could put the parties within the court system, which is what the franchisor may have been attempting to avoid by using the arbitration agreement in the first place.

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These are just a handful of myriad complex legal issues that should be carefully evaluated and negotiated between a franchisor and an area developer.  These issues demonstrate the great impact that the many locations involved in the area developer’s mandate could have on him. A default, whether by an area developer or any of the unit franchisees that were placed by him – could potentially have a magnified effect on the area developer’s rights and obligations not only to the franchisor but also to defaulting franchisee and possibly other unit franchisees in the territory.