In a world in which business strategies and management techniques are continually improving, superior customer relations and outstanding supplier relationships are critical. In many ways the franchise relationship is the definitive expression of this principle. A franchisor and its franchisees jointly contribute to a supply system for products or services focused on the customer. They obligate themselves to each other under an agreement and endeavor to establish a durable, long-term relationship that will impact virtually every aspect of their respective businesses and protect that supply system. Few other business arrangements are so all-encompassing. Unless a franchisor and its franchisee deliver to each other what they have promised, the supply system to the customer will be compromised. World class franchise systems are easily recognized by the mutual commitment of the franchisor and franchisee to their network and the resulting consistently high level of customer approval of their products or services. The more important elements of successful franchise relationships and networks are discussed below.

A Franchise Relationship Must Have An Effective Structure
Franchising is a contractual relationship. The franchisor and the franchisee each make commitments and agree to operate under certain constraints. In the aggregate, these commitments and constraints constitute the structure of a franchise relationship. That structure must protect the franchisor and all franchisees of the franchise network and afford opportunity and security to the franchisee. There are a number of elements of the structure of a franchise relationship that are critical to its effectiveness as the foundation for an expanding franchise network. The most important elements are discussed below.

1. Control of products and services that franchisees are permitted to sell
Franchisors control the products and services that their franchisees are permitted to sell in order to control the quality of the goods and services sold by franchisees (i.e., by limiting the scope of the franchised business to those products and services that are within the scope of the franchisor's expertise) and to preserve a uniform image (i.e., the means by which a franchisor defines its business). It is common for franchisors to permit some franchisee experimentation and variation because franchisees are an excellent source of innovation, regional variations may be necessary and different customer bases may require variations in product or service mix or different emphasis.

2. Control of operating assets, goods and services utilized and sold by franchisees
Franchisors control the sources from which their franchisees purchase operating assets (equipment, fixtures, furnishings and signs) and goods and services required to operate the franchised business for one or more of four basic reasons: (a) to control the quality and uniformity of the goods and services sold by the franchisee; (b) to assure sources of high and uniform quality goods at prices that are competitive with or lower than those available from other sources; (c) to protect confidential information; and (d) to be a profit center for franchisor.

These are all legitimate reasons for controlling the sources of supply utilized by franchisees, provided that the restrictions (1) do not cause the costs incurred by franchisees to exceed what such costs would be for comparable products absent such restrictions (ideally, and in many franchise networks, supply restrictions are part of supply programs that lower costs to franchisees), or (2) the extra cost is disclosed to franchisees (and is presumably considered to be part of the consideration paid for the franchise). Franchise disclosure laws do require disclosure of such restrictions and the revenue that the franchisor derives as a result. Antitrust law also regulates such restrictions, but under prevailing interpretations, does not have a significant impact on the types of restrictions that a franchisor may impose. As a general proposition, franchisors should limit source restrictions to those products and services that are important to the development and operation of the franchised business and cannot be simply specified by brand, model and/or grade.

A franchisor also can derive revenue from supply programs. Franchisors evaluate the total revenue produced by a franchised business from (1) royalties and service fees, (2) advertising contributions or fees, (3) sales of goods to the franchisee, (4) commissions paid by other suppliers and (5) rental income from leasing real estate. Most franchisors have more than one source of revenue from each franchised business. Some franchisors rely primarily on fee revenue and other franchisors rely primarily on the sale of goods to their franchisees. For a few franchisors, rent is a significant source of revenue.

The aggregate revenue received from a franchised business must be sufficient to support essential franchisor services that maintain system standards and keep the network competitive, and to produce a profit for the franchisor. The aggregate of the revenue a franchisor derives from a franchised business must allow the franchisee to realize a sufficient rate of return on its investment. Several franchised networks have reduced or eliminated royalties and advertising contributions. Such networks rely on sale of products to their franchisees and the sale of services at the franchisee's option. If franchisees elect not to buy such services, the network's competitiveness could be jeopardized. Such franchised networks also rely on advertising paid for by the franchisor out of gross profit on sales of goods to its franchises and/or local advertising by franchisees, which may be partially supported by the franchisor. This approach can be effective if the franchisor sells to its franchisees a proprietary product or a product that it can sell competitively to them. A franchisor might decide to reduce or eliminate royalty and advertising fees in order to aid struggling franchisees and prevent a shrinkage of its product distribution network.

When a franchisor relies primarily on product sales to its franchisees, its revenue base may be less secure and competitors may target its franchised network, but it is less dependent on monitoring its franchisees to insure proper royalty calculation and payment.

3. Control of the franchisee's business premises
Franchisors sometimes control the franchisee's business premises by leasing or subleasing the premises to the franchisee or requiring the franchisee to sign a collateral assignment to the franchisor of the lease for his business premises. Control of the franchisee's business premises gives the franchisor more effective control of the franchisee and his business. The premises continues to be part of the franchisor's network even if the franchisee does not. However, such control increases the capital requirements of the franchisor or involves contingent liability and administrative effort and cost, unless control is implemented by means of collateral lease assignments. It is generally difficult to secure consent to such assignments from regional malls and it may be difficult to secure consent from any landlord without at least some guaranty by the franchisor of the payment of rent and common area maintenance charges for the leased premises.

Control of the franchisee's business premises also confronts the franchisor with a potentially difficult policy issue when the franchise expires. If the franchise is not renewed, the automatic transfer of the premises to the franchisor may transfer the value of the franchisee's business to the franchisor. Such a franchise would have no residual value and a franchisee that is uncertain regarding renewal will be motivated to milk every dollar he can out of his business in the later years of the term of his franchise, possibly severely damaging the business. One possible solution is a policy that enables a nonrenewed franchisee to realize the location Goodwill of his business by selling it to an approved successor franchisee during the last two or three years of the term of his franchise. The franchisor then grants a new full term franchise to the successor franchisee.

4. Grant of exclusive or protected territories
Franchisors grant exclusive or protected territories to their franchisees to facilitate sales of franchises and to motivate effective market development by the franchisee who, theoretically, will be more inclined to invest in the development of his business if he has no same brand competition in his territory. Franchisors should resist the temptation to grant large exclusive or protected territories because they may weaken the market penetration of its network by leaving large areas unserviced or underserviced by franchises. Many franchisors have discovered that they made inflated initial estimates of the population base required for a successful franchised business (once their network trademark became more widely recognized) and that large spaces between franchisees only invited competitors. Large territories also may interfere with adjustment to changing markets and inhibit the offering of additional franchises to productive franchisees. A franchisor should consider reserving from their grant of an exclusive or protected territory the right to sell directly to customers that buy for regional or national facilities, to sell in other channels of distribution (e.g., mail order sales, supermarkets and department stores) and acquire, or be acquired by, a competitor with franchised or company-owned outlets in the protected territories of its franchisees.

Structuring the franchise to enable the franchisor to achieve greater market penetration by granting limited territorial protection and reserving rights to sell to some customers within the franchisee's territory will tend to result in more system expansion conflicts with existing franchisees. The franchisor must be sensitive to these conflicts and develop internal procedures to resolve as many as possible. Such procedures may include participation by existing franchisees in expansion decisions and payment of compensation to impacted franchisees.

5. Control of the geographic scope of the franchisee's business
The corollary of the exclusive or protected territory, a right granted to the franchisee, is a restriction on the area within which and the customers with whom the franchisee may conduct his business. If franchisees have the ability to sell outside their immediate markets and are able to market and sell in the territories of adjacent franchisees, restrictions on such marketing may be necessary to make exclusive or protected territories meaningful. Franchisors also impose such restrictions to force a franchisee to fully exploit his assigned territory and to maintain the quality of the product or the service sold by the franchisee, (e.g., by restricting the distance that a franchisee may deliver perishable products). Such restrictions frequently include a ban on mail and telephone order sales and sales to dealers for resale (in order to restrict the source of the franchisor's product or service to franchised outlets that comply with format, appearance and service requirements).

Confining franchisees to their specific markets can result in troublesome enforcement problems for the franchisor. The franchisor will be expected to enforce the restriction against the invading franchisee (and may have a legal obligation to do so). The invading franchisee may be highly productive, have effectively penetrated his own market and invade the territory of the adjacent franchisee primarily because that territory has not been effectively penetrated. Disciplining a productive franchisee to aid a lazy or ineffective franchisee is not an enviable task. Some competition among franchisees may be beneficial to the network.

6. Exclusive relationship
Franchisors typically prohibit their franchises from having investments in or performing services for a competitive business. This prohibition is intended to protect confidential information, maintain the franchisor's revenue, prevent use by competitors of the franchisor's know-how and focus the franchisee's efforts on his franchised business.

Such prohibitions are sometimes limited to the franchisee's territory or a larger territory, but frequently have no geographic limitation. Prohibited competitive businesses may be defined narrowly (e.g., to include only a business primarily selling the same type of product or service) or broadly, including related types of business (e.g., all fast food service businesses). Such prohibitions typically apply not only to the franchisee but also to its owners and members of their immediate families. Such prohibitions are enforceable under the laws of most states, but not necessarily as broadly as they are sometimes drafted. Many franchisors elect to prohibit both direct and remote competition over a large geographic area, assuming that the prohibition will be partially, if not fully, enforced. Such prohibitions are a deterrent to the franchisee, who risks termination of his franchise if he does not comply.

7. Transfer of the franchise
Franchisors restrict transfers of their franchisees in order to maintain control over the persons who operate them. Such restrictions should apply to the franchise agreement, ownership of franchisee and the assets of the franchisee's business. Typically the franchisor reserves the right to approve the transferee and the terms of transfer. The right to approve the terms of transfer is important to insure that the buyer of the franchisee's business does not substantially overpay for it, or accept burdensome payment terms, which could jeopardize his ability to operate the business in compliance with the terms of the franchise. Some franchise agreements merely provide that the franchisor will not unreasonably withhold approval of a transfer. Others specify in considerable detail the criteria for approval relating to the proposed transferee and the terms of the transfer.

It is common for franchisors to reserve a right of first refusal to buy the franchisee's business on the same terms as are offered by a bona fide purchaser. Franchisors exercise this right to acquire franchised businesses as company-owned outlets and, occasionally, in lieu of denying approval of a proposed transfer (e.g., when the franchisor is unsure that it has sufficient grounds to disapprove a prospective transferee).

8. Expiration
Franchises are granted for a definite term (usually 5 - 20 years), and therefore will expire at the end of such term. Some franchise agreements are silent on the subject of the extension of the relationship upon its expiration or the grant of a successor franchise to the franchisee. Others deal with this significant element of the franchise relationship, providing for the preconditions for the grant of a successor franchise (e.g., compliance during the term of the initial franchise and upgrading the business to meet current standards) and the terms on which it will be granted (e.g., the terms of the franchise agreement used by the franchisor when the franchise expires).

If a franchise is not renewed, the restrictions on the business activities of the franchisee (and its owners and members of their immediate families) is an issue. Some franchise agreements provide for a post-expiration covenant not to compete, which raises the residual value issue discussed above. If the franchisee is prohibited from operating the same type of business in the same market (under a different trademark) subsequent to expiration (even for a relatively short period, such as one-two years) he will lose whatever "going concern" value his business has apart from value of the expired franchise. Such value may consist of location value and the personal goodwill of the franchisee in his market. The franchise will thus have no residual value, which may motivate the franchisee to operate his business for maximum short term gain during the later years of the term of his franchise. As noted above, this problem may be addressed by giving the franchisee the option to sell his business to a successor franchisee during the two or three year period preceding the expiration of the franchise.

Some franchisors reserve an option to buy the franchisee's business upon termination or expiration of the franchise. The purchase price may be determined by a formula or be the fair market value of the business, without any value attributed to the expired franchise (usually determined by appraisal if the franchisor and the franchisee are unable to agree on fair market value). If the fair market value standard is used, the franchisee realizes the value of his business that exists apart from the franchise and his own personal goodwill (i.e., location value).

A Franchisor Must Have Operating and Management Systems, Products and Services That Benefit Franchisees
A franchisor must have effective operating and management systems for use by franchisees in operating their businesses. A franchisor must also furnish valuable services to its franchisees. A franchisor may offer a wide range of valuable services. These include: (1) site selection and outlet development services; (2) effective initial and continuing training (effective training is critical to achieve positive franchisee attitudes regarding system standards, the franchisor and the value of the franchise; inadequate training is a common cause of poor franchisee performance); (3) sensible and complete specifications, standards and operating procedures (system standards) effectively communicated to franchisees (e.g., detailed specifications, standards and procedures for the development and operation of the franchised business and a well organized and readily understandable (i.e., "user friendly") operations manual); (4) procurement programs for equipment, goods, materials and services; (5) advertising and marketing programs to maximize the advantage of the common trade identity of the network; (6) effective field service (knowledgeable and well trained personnel with positive attitudes and a willingness to help franchisees); (7) research and development (e.g., maintaining current information regarding competitors; development of new products and services; and improvements in equipment, formats, operating efficiency and safety); and (8) development and improvement of services with value to franchisees (e.g., customer referral systems, financing, franchise resale programs, insurance programs, and crime prevention programs).

A Franchisor's Management Philosophy and "Culture" Must Be Consistent With the Franchise Relationship
The management philosophy and "culture" of a franchisor is manifest in a variety of attitudes and interfaces between franchisor management personnel and franchise owners. Though the franchise relationship is governed by a contract, a contract cannot anticipate all contingencies or problems. It is essential for a successful franchise relationship that mutual trust and respect develop between franchisor and franchisee, to supplement the contract and enable the franchise network to maintain a competitive position in its market.

Initially, management must develop criteria for identification of high potential franchisees and the patience to select qualified candidates. Management must include good teachers and motivators and must have the commitment and patience to develop and cultivate sound, durable and positive franchise relationships. Such franchise relationships require real two-way and regular communication with franchisees. A franchisee must believe that his opinion is respected and management must be sensitive and responsive to franchisee concerns and problems. Management must have a flexible approach to franchisee problems and a willingness to assist franchisees in solving problems. A franchise network should have impartial internal dispute resolution procedures and genuine efforts should always be made by the franchisor to resolve disputes amicably.

Franchise networks also need systems for obtaining, evaluating and sharing ideas developed by franchisees and the franchisor and should allow franchisees scope for creativity and decision making and permit some degree of innovation by franchisees (who, as noted above, may be the network's best source of ideas and productive innovation). Many franchisors make effective use of a franchisee advisory council or association: (1) to communicate with their franchisees; (2) to resolve individual franchisee, network and competitive problems; (3) for long-term planning; and (4) to give franchisees a sense of participation in the evolution of the franchise and the network. It is perhaps a trite, but nevertheless accurate, observation that a franchisee must believe that he owns his business and that he is in business for himself, but not by himself.

Management must have a commitment to franchisee profitability and equity growth and the creativity to maintain the value of the franchise. A franchisor's management must sometimes be willing to sacrifice short-term profitability of the franchisor to ensure franchisee success. A franchisor and its franchisee each assume a responsibility to support a network of businesses that operate under a common trade identity (the performance of one reflects on all of the others). In the most successful franchise networks, the franchisor and the great majority of the franchisees do not view their responsibility and commitment as limited by their contract. They think of it as being whatever level of effort is required to assure that the network continues to be a leader in its industry.

A Franchisor Must Expand Its Network at A Manageable Rate
Initially, a franchisor must determine the markets in which the franchised business is most likely to be established successfully. These usually will be markets that meet most of the following criteria: markets in which (1) franchisees can be effectively monitored and supported, (2) in which good sites are available at affordable costs, (3) that are not saturated with competitive businesses, (4) that are not dominated by one or more large competitors, (5) in which suppliers can effectively and economically deliver essential products and materials and (6) in which the network trademark is recognized. It is generally advisable to concentrate expansion in one or a few markets where "critical mass" can be achieved quickly in order that the network have in such markets effective advertising, support and assistance and effective monitoring of franchisee performance. A franchisor's ability to expand is limited by its financial, management, supplier and field service resources. Franchisors who fail to understand the limitations on their ability to effectively expand are more likely to fail in improvidently selected expansion markets.

In mature franchise systems, decisions by the franchisor to establish additional outlets in proximity to existing franchisees is seen by those franchisees as encroachment on their businesses. Franchisees resent and resist such perceived encroachment and the franchisor is confronted with a choice between fully penetrating the market and preempting competition, at the cost of impairing existing relationships, and accepting a lower level of market development.

Encroachment problems also arise when a franchisor attempts to penetrate franchised markets through nontraditional outlets or distribution channels (distribution in department, grocery, convenience or general merchandise stores, on college campuses, on military bases, at interstate highway rest stops, through mobile carts and kiosk facilities and in combination or dual branding arrangements). Achieving the optimal balance between effective market penetration and good franchise relationships is difficult. Even the best managed franchised networks have difficulty resolving the problem of balancing the imperatives of network expansion and competition with perceived interests of existing franchisees.

A Franchisor Must Develop and Implement Effective Systems to Secure High Quality and Consistent Operations at Franchised Outlets
A franchisor generally has less control over franchised outlets than it would over company-owned outlets. Maintenance of high and relatively uniform standards throughout a network is of significant value to those franchisees who voluntarily maintain system standards and perceive system standards as a valuable element of their franchise. If a franchisor fails to establish and maintain system standards, its competitive position and the value of its franchise will decline. The most productive and successful franchisees may break away and the ability of the franchisor to sell franchises and to expand will be impaired.

The franchise relationship can be inflexible. Franchises may resist changes needed to adapt their businesses to changing markets by upgrading their business facilities, changing the product/service mix, modifying operating procedures, adopting different marketing strategies and modifying the image of the franchised business. If changes involve capital investment or higher operating costs, franchisees may disbelieve that higher sales or profits will result. Franchisees may also resist change due to satisfaction with a low level of market penetration and competitive effort.

It is, therefore, imperative that a franchisor develop the abilities and programs to motivate franchisees to voluntarily comply with system standards and implement the changes that the franchisor determines necessary to adapt to a changing market and meet competitive challenges. The first step in developing such abilities and programs is an understanding of the causes of franchisee noncompliance. These include failure by the franchisor (1) to furnish effective and complete training; (2) to effectively communicate system standards; (3) to inspect and communicate appearance and operational deficiencies to franchisees; (4) to assist franchisees to correct deficiencies; and (5) to observe standards at company-operated outlets. A franchisor must implement policies, systems and procedures that help maintain standards by rewarding compliance (e.g., by recognition and awards and the grant of additional franchises) and enforcing system standards where positive motivation proves to be insufficient. Many franchisors make effective use of peer pressure by other franchisees to achieve compliance with system standards. Inspection reports should be reviewed with franchisees and realistic timetables should be determined and agreed upon for correcting appearance and operating deficiencies. Follow-up inspections should be timely conducted and a franchisor should be prepared to offer assistance to a franchisee who is making a bona fide attempt to bring the appearance and operation of his business into compliance with system standards.

The tension between a franchisor's need to control the appearance and operation of the franchisee's business and the heavily promoted "independence" of the franchisee is not always satisfactorily resolved. Independent business ownership is asserted and promoted as a positive aspect of the franchise relationship, but the requirements of quality control and uniform image impose limits on such independence. If a franchisor fails to secure voluntary compliance from the great majority of its franchisees, it faces potentially difficult and costly enforcement obligations. Longstanding neglect of system standards can result in loss of ability to effectively implement those standards. Noncomplying franchisees may damage the reputation of a franchised network. Termination of franchise relationships can be difficult and expensive. Some state laws give franchisees broad rights against termination and nonrenewal. In some instances, a franchisor may have to buy a noncomplying outlet at a premium over its value to achieve a quick end to substandard appearance and operations.

A Franchise Must Maintain Its Value to Franchisees
The benefits and services furnished by a franchisor must have continuing value to franchisees relative to the cost of the franchise. A franchisor faces several obstacles in achieving a general perception among its franchisees that the value of the services furnished by the franchisor are equal to the fees they pay. Fees payable to a franchisor typically increase with increases in franchisee revenue. The scope and frequency of the services furnished to maturing franchisees may remain level or decrease and franchisees may perceive a declining need for and value of the services furnished by their franchisor. This problem can be compounded by the tension inherent in a fee based on gross revenues. The franchisor's interest is perceived to be to maximize sales and the franchisee's interest is to maximize profits. Services designed to increase sales may not be perceived by franchisees as likely to increase profits, especially when the sales enhancement program involves a capital investment by the franchisee or higher operating costs.

Even a high level of benefits and services will not always overcome disaffection of some franchisees with the franchise network. Over time, some franchisees are likely to lose interest in the franchised business or be satisfied with a low level of market penetration. The profits of a franchised business may be invested in other businesses, leaving the franchised business with insufficient capital, and the attention of a franchisee may be diverted to other business interests. Though no level of service or benefit may entirely prevent such problems, the franchisor that fails to maintain valuable services and benefits will encounter franchisee disaffection, including break-away franchisees, on a greater scale.

A franchise network is at some risk when it loses an effective franchisee. Each franchisee is a potential competitor when the relationship ends. The franchisees know the franchisor's business. It is difficult and expensive to enforce covenants not to compete (such covenants are not universally enforceable and are never enforceable for more than a short period (1-2 years). Confidential information of the franchise network is difficult to protect and vulnerable to disclosure and use by competitors.

Dispute Resolution
The franchise relationship has a high potential for disputes. A franchisor has business relationships with scores, hundreds and, in some networks, thousands of franchisees. The franchisees of a network entered into their relationships with the franchisor at different times and with differing expectations and goals. The franchisor must operate its business for the benefit of its owners and its franchisees and steer its network in what it determines to be the right direction. Some franchisees are likely to disagree with the balance the franchisor chooses between its owners and its franchisees or with the direction that the franchisor charts for the network. Therefore, it is essential that a franchise network develop effective dispute resolution procedures. Such procedures may include any combination of negotiation; an ombudsman; internal dispute resolution procedures involving participation by neutral franchisees and members of the franchisor's management; and third party, non-binding mediation. These are all nonbinding methods used to resolve a dispute without resort to some form of binding dispute resolution (i.e., litigation or binding arbitration). Nonbinding dispute resolution methods are generally effective in resolving disputes, but will not always produce a mutually satisfactory resolution.

A franchisor should consider arbitration as the method of binding dispute resolution instead of relying on litigation. Though arbitration is not without problems and costs, it is, on balance, a faster and less costly method than litigation of resolving a dispute that cannot be otherwise resolved. The accelerated resolution and lower cost of arbitrated disputes results from the elimination of most discovery (e.g., interrogatories and depositions) and various techniques commonly used in litigation to narrow the issues to be resolved. Cost is further reduced and a final result achieved more quickly because an arbitrator's decision may only be appealed in limited circumstances. The ability of franchisees to join together in a lawsuit, or of one or more franchisees to bring a suit against a franchisor on behalf of a class of current or former franchisees, can probably be precluded by a well drafted arbitration clause, though the law on these issues is not well developed. However, inability to narrow the issues in dispute and to learn by pretrial discovery the other side's theories and factual support, and the limited scope for appeal of an arbitrator's decision, is viewed by some as a significant disadvantage of arbitration. Nevertheless, if a franchised network's formally decided disputes are projected over an extended period, and assuming that the franchisor's management has the good sense to informally resolve disputes in which the franchisee's claims or position is reasonable or the facts do not strongly support the franchisor's claims or position, arbitration is likely to prove an effective dispute resolution method from the perspective of cost and minimizing the strain of disputes on the franchise relationships of the network.

Other elements of dispute resolution that a franchisor should include in its franchise agreement are a waiver by the franchisee of a right to a jury trial and to recovery of punitive damages and a provision for a period within which claims may be asserted substantially shorter than the period provided by statute or common law (to cut off claims that could otherwise be asserted long after they allegedly arose).