How do you ensure whether an existing agreement between a licensor and a key licensee is a license agreement or a franchise agreement? There are subtle but real differences in how one determines what is a license or a franchise.
Let’s take a look at some general franchising background first. In order to meet the standard test for a franchise agreement, the following three key components must be present:
Key aspects of a franchise agreement
- A grant of use of a trademark and/or other associated intangible assets
- The charging of an ongoing fee for the use of those assets
- Third, and most importantly, a prescribed operating system describing most, if not all, aspects of the franchisee’s conduct of its business
The first two tests listed above are generally accepted to be components of both license and franchise agreements. However, the third test regarding a prescribed operating system is the key area of differentiation between license and franchise agreements.
Summary of important clauses of a license agreement
Clause 1: Best Efforts
The best efforts clause is contained in virtually every license agreement. Unlike a detailed operating system found in most franchise agreements, the best efforts clause requires the licensee to exercise due care and due diligence, which is particularly important in view of the fact that no specific operating system or operating standards have been prescribed for the licensee. This best efforts clause is the heart of each license agreement. It ensures that the licensee executes and performs at least to the level that the licensor would themselves, given the licensor’s need to maintain the highest standards for its intellectual assets, and licensing programs.
Clause 2: Books, Records and Reports
It is customary, standard and usual practice in the licensing industry for licensors to require licensees to maintain current books and records, and to report their activity on a monthly, quarterly and/or annual basis; and to provide for the licensor to monitor their performance. This type of clause is necessary to ensure that each party is aware of the efforts being set forth by the licensee, in order to achieve the desired goals of the license agreement.
Clause 3: Quality Control
Every well-considered license agreement should have one or more clauses to specify the quality standards and quality review of the merchandise or services being produced by the licensee.
Clause 4: Advertising Requirements
The requirement in most agreements is that the licensee advertise to a minimum level. This is (and has been) usual and customary in license agreements today. Furthermore, requirements that the licensee contribute to advertising in specific media is also standard practice in many licenses, and in particular in fashion, sports and the corporate licensing programs. Most major licensors require advertising from each licensee.
Clauses 5 and 6: Product Approvals and Design Approvals
Again, it is customary and standard practice in the licensing industry for the licensor to require and impose approvals for all products and all product designs on their licensee. These requirements are necessary to ensure that the licensee’s level of product design, product quality, and product planning meets the standards, goals and production criteria and design criteria of the licensor.
These clauses represent some of the licensor’s mechanisms not only for defending the image and quality of its overall product line, but also for ensuring that the licensee produces quality products of which both the licensor and licensee can be justifiably proud. Such requirements do not turn a licensor into a franchisor. Instead, they represent an effort by both parties to ensure standards of quality for public consumption.
Summary: the key difference
Taken individually, and/or out of context, many clauses in a license agreement can appear to be applicable to a franchise agreement. It is the overall system under which the licensee/franchisee is operating that is the critical component. In other words, a franchise agreement will have a specific operating system requiring that the franchisee meet very specific standards, and requirements to use certain operating systems, procedures, materials, manuals, etc. in the operation of its franchise. The key difference between a license and a franchise agreement rests in the operating system requirements embedded within the franchise agreement. Amongst those elements oftentimes prescribed in a franchise operating system are the following:
- Product formulations
- Specific accounting systems
- Product sourcing requirements
- Specific advertising formats
- Signage requirements
- Specific promotional materials
- Training manuals and employee performance requirements
- Product supply requirements and standards
- Product preparation standards
- Manufacturing standards
- Store display and layout requirements
Therefore, looking at the agreement clauses in detail will determine whether the intent, construction and management content supports whether an existing agreement is a license, or that of a franchise.