At some point in most franchise sales conversations a prospective franchisee will ask “So, what’s the size of my territory?” Some franchisors grant franchisees a geographic area, or territory, in which the franchisor agrees not to conduct certain competitive activity, like placing another unit. For some types of businesses, the territory is the only area where the franchisee can conduct marketing or serve customers.
If a franchisor decides to grant franchisees a territory, it will disclose critical details about territory protections and size in Item 12 of its Franchise Disclosure Document (“FDD”).
Below we have listed five questions that every franchisor should answer when considering whether to offer a territory to franchisees or when considering how to modify its territory structure.
- Should franchisees receive a territory at all?
The decision to award a territory is strongly dependent on the nature of the franchised business. Many franchisees do not receive any territory protections and face competition from the franchisor, its affiliates, or other franchisees from any location or method. These franchisees tend to be in industries that are convenience-based or relationship-based. Some of these franchises are operated in areas with high-density populations or areas with a captive audience like a university campus or sports stadium. In these situations, it is impractical to define a territory because the location of the outlet is driven by the convenience to the customer. If a territory is not awarded, the franchisee is dependent on the franchisor’s judgment in determining how close is too close for another outlet.
In contrast, brands that provide goods and services at the customer’s locations typically do award territories. Doing so incentivizes franchisees to fully develop their markets and helps prevent conflict between outlets claiming ownership of a customer.
The important thing to remember is that a franchisee is not entitled to a protected territory and the franchisor should create a territory structure that works best for its system.
- Will the territory be exclusive?
In the FDD, a franchisor will disclose if the territory is “exclusive.” As defined by the FTC, a territory is exclusive if “the franchisor promises not to establish either a company-owned or franchised outlet selling the same or similar goods or services under the same or similar trademarks” in the territory. This type of protection is one that the franchisee is likely most interested in.
Even if the franchisor agrees that no other company or franchised unit will be established in the territory, the franchisor should still reserve other competitive rights. What rights are specifically reserved will vary from system to system. They will also depend on the nature of the franchisor’s other business interests.
Commonly, franchisors reserve the right to use other channels of distribution to sell their goods and services within the territory. For example, a restaurant with a signature sauce may reserve the right to sell the sauce in grocery stores in the territory. This action technically competes with the franchisee but is not establishing another unit within the territory. Another very important channel of distribution for many businesses e-commerce and most franchisors reserve the right to make these sales to customers in the franchisee’s territory.
- How will the size of the territory be determined?
An ideal franchisee territory is one that is big enough to allow the franchisee to be financially successful and small enough that the franchisee can fully penetrate the market. A franchisor should examine data to determine how many customers are necessary to be successful and where those customers are located. Using this experience, the franchisor then defines the territory, which can refer to (1) population size, (2) distance, (3) number of target customers in the territory, or (4) well-defined regions like city boundaries of zip codes, among other options.
Examples of these definitions are below:
- A population of no less than 75,000 people, as calculated using US Census data.
- A three-mile radius from the location of the franchised business.
- Containing no less than 20,000 qualified households.
- Including the following six zip codes.
- Will there be circumstances when the franchisor can modify the territory?
Franchise agreements often have substantial term lengths and a lot can change in five, ten, or fifteen years, especially in a region with significant new development. Some franchisors reserve the right to re-evaluate the size of the territory during the term to account for anticipated or unanticipated changes. These adjustments to the territory are not typically unlimited and usually adjust the territory to the size that was originally intended. For example, if a suburban area has a significant population increase, the territory would be adjusted to an area containing the original population size.
Additionally, franchisors may reserve the right to change the size of the territory if a franchisee is not in compliance with its obligations under the franchise agreement. This remedy allows the franchisor to take strong action to encourage compliance, short of termination. One obligation that is often the trigger for changing territory rights is the franchisee’s failure to achieve a certain performance level like a minimum sales obligation.
- What are the restrictions on franchisees operating outside of the territory?
The FTC requires the franchisor to disclose in Item 12 the restrictions on what a franchisee can do outside of its territory. Consider if the franchisee will be able to:
- Conduct advertising and marketing that occurs or targets customers outside of the territory,
- Accept orders from customers who live outside of the territory,
- If goods and services are normally provided only at the location, provide goods and services at off-site events, whether through the franchisee’s employees or through a third party (like a delivery service),
- Provide services to an out-of-territory customer if the area is not currently under a franchise agreement with another franchisee, or
- Use another channel of distribution to make sales outside of the territory.
Establishing these rules for your franchisees helps to focus their sales and marketing efforts and can reduce friction between franchisees as they compete for customers.
Discussing these questions with qualified franchise counsel will help you to structure franchisee territories in a way that balances the rights of the franchisor with the interests of the franchisee. If you are looking to implement franchise territories or have questions about what approach works best for you, reach out to Manning Fulton to assist you with determining the right strategy and drafting your Franchise Disclosure Document (“FDD”).