As we head into 2023, supply chain issues remain a significant concern for many business owners. This includes many franchisees. While franchisees can rely on their franchisors’ systems and support to an extent, they face the same market and economic risks as independent businesses.
The supply chain disruptions triggered by the COVID-19 pandemic are continuing to affect franchisees in all industries. From automotive dealers dealing with chip shortages to home services franchisees dealing with shortages in lumber, garage doors and other materials, many of these disruptions have to do with slow-downs (or halts) in production.
But many franchisees are dealing with delays caused by disruptions further down the supply chain, as well. Ultimately, however, the reason why a particular franchisee is dealing with a supply chain disruption isn’t particularly important. Rather, what matters far more is the consequence of the delay.
Franchisees Can Face Termination for Non-Payment of Royalties and Other Issues
This is due to the nature of the franchise relationship. While franchisees are independent business owners, they are beholden to their franchisors. Franchise agreements give franchisors broad termination rights, including the right to terminate for non-payment of royalties—among many other “defaults.” While the pandemic has changed the way that many companies account for contingencies in their contracts, most pre-pandemic franchise agreements do not account for the possibility of a major supply chain disruption. As a result, most franchisors’ rights to terminate for non-payment are unbridled, and this is proving problematic for franchisees who are now struggling due to factors beyond their control.
Along with their royalty obligations, various other franchise agreement provisions are proving problematic for franchisees as well. For example, many franchisors require their franchisees to maintain certain inventory levels, stock certain products or even purchase their inventory from certain suppliers. Due to the supply chain disruptions caused by the pandemic, many franchisees are finding compliance with these requirements to be extremely difficult—if not impossible. While some franchisors have been willing to show some grace, others have not. In some cases, franchisors are also using the economic impacts of the pandemic to get rid of their “problem” franchisees.
This means that while many franchisees are continuing to struggle with the economic impacts of the pandemic in 2023, many are also finding that their franchisors are unwilling — even if able — to lend a helping hand. Franchisees who had found success prior to 2020 are now facing the risk of default and termination — with the possibility of liability for “lost future royalties” and enforcement of post-termination non-competition covenants hanging overhead.
What Can (and Should) Franchisees Do?
Given these considerations, what can (and should) franchisees do if they are struggling to cope with supply chain disruptions?
Ultimately, this is a question that franchisees must answer on a case-by-case basis. For franchisees who are struggling to purchase inventory from their franchisors’ designated suppliers, now may be the time to leverage their collective weight to seek a change in policy. For those that are dealing with delays or increased costs from non-designated suppliers, continuing to weather the storm may prove more challenging. Struggling franchisees should use any leverage they may have—whether their goal is to secure concessions that provide more flexibility or they are ready to try to get out of the system and move on.
Given the legal implications involved, franchisees who are facing supply chain issues need to make informed decisions based on the advice of legal counsel. This is not an easy scenario, and it does not have an easy solution. Even if franchisees can leverage their way out, doing so could mean realizing significant losses. Similarly, while seeking to negotiate short-term concessions could provide a resolution, it could also trigger a decision to declare a default and pursue termination.
Managing Supply Chain Risks Going Forward
For prospective franchisees, the supply chain disruptions caused by the pandemic offer some important lessons learned. When negotiating franchise agreements, prospective franchisees should take the risks of a major supply chain disruption into account. The once-obscure force majeure clauses in franchise agreements (and other commercial contracts) have taken center stage since the start of the pandemic, and negotiating these provisions so that they provide appropriate protections in relevant circumstances could be critical for franchisees moving forward. As franchisors will likely balk at taking on additional risk based on factors that are beyond their control as well, securing these protections will require skilled negotiation. Ultimately, however, the effort will be well worth it if it helps to insulate franchisees from the issues that many are facing today.
Jeffrey M. Goldstein is a franchise lawyer and the founder of Goldstein Law Firm.