Should the franchisor require a shareholders' agreement within the franchised companies?

Introduction: The rationale for a franchise shareholders' agreement

A conflict between partners in a franchised company can destabilize a point of sale just as surely as a breach of the franchise agreement. The franchisor therefore has a vested interest in ensuring that this risk has been anticipated. But how far can they go without interfering in the management of their franchisee? The answer may lie in a distinction: requiring that certain risks be addressed is acceptable; dictating how the partners should address them is much more difficult.

The issue of shareholder agreements in franchises deserves particular attention when the franchisee is operated by a company with multiple partners. Internal conflicts can indeed jeopardize the operation of the outlet and, indirectly, the relationship with the franchisor.

When a franchisor structures its network, a significant part of its contractual documentation aims to ensure the stability of the relationship with each of its franchisees: protection of know-how, use of the brand, respect for the concept, supply obligations, reporting, conditions for the transfer of the business or the contract, approval of a potential buyer.

However, a significant source of instability sometimes remains external to this contractual architecture: the relationships between the partners of the franchised company itself.

The franchisor then contracts with a company whose stability itself depends on relationships to which it is not a party.

Therefore, a question deserves to be asked: should the franchisor not integrate the shareholder stability of the franchisee into its risk prevention policy and, when several partners are present, require the existence of a shareholders' agreement?

1. Conflict between partners of the franchisee also constitutes a risk for the network

Legally, the franchise agreement is concluded between the franchisor and the franchisee company. The relationships between the franchisee's shareholders, however, are governed by its articles of association, company law and, where applicable, a shareholders' agreement.

This legal separation should not, however, mask an economic reality: a conflict between the franchisee's partners can directly affect the execution of the franchise agreement.

Disagreement can lead to paralysis of social decisions, the departure of a key manager or operational partner, interruption of current account financing, a deterioration of management, or even a cessation of operations.

In the most serious situations, it can lead to a hasty sale of the business or securities, a breach of the franchise agreement or contribute to the emergence of difficulties leading to the opening of insolvency proceedings.

The paradox is clear: the franchisor may have perfectly secured its contractual relationship with its franchisee and yet see the latter destabilized from within.

However, the consequences do not necessarily concern only the point of sale. Its disappearance or degraded operation can affect the brand's image, territorial coverage and, more generally, the stability of the network.

2. Should shareholder stability become a criterion for selecting a franchisee?

Franchisors traditionally examine the candidate's financial capacity, experience, operational involvement, alignment with the brand's values, and the quality of their establishment plan.

When the candidate is a company with several partners, this analysis could usefully also focus on its shareholding structure.

A few simple questions can then be asked:

• Who controls the company?
• Who will actually operate the point of sale?
• What happens if the operational partner leaves the company?
• Do the partners have the same investment horizon?
• Who will have to finance the company if new needs arise?
• How will a disagreement be resolved?
• Can a transfer of shares indirectly change the person who controls the franchisee?

These questions certainly fall under company law. But they also directly contribute to the analysis of the franchisee's long-term viability.

The issue could therefore be addressed very early on, from the candidate selection stage, rather than only when a conflict between partners has already arisen.

3. Shareholders' agreement and franchise: a risk prevention tool

The shareholders' agreement will obviously not prevent a conflict from arising.

On the other hand, it can help to anticipate the consequences and to organize a solution before the disagreement leads to the paralysis of society.

Depending on the capital structure, it may include, in particular:

• the rules of governance and majority;
• the financing commitments of the partners;
• the mechanisms for resolving a deadlock situation;
• the conditions for the transfer of securities and the rights of approval or pre-emption;
• the mechanisms for the withdrawal or exit of a partner;
• a buy or sell clause when it is appropriate;
• the consequences of the death, incapacity or departure of a key partner;
• obligations of confidentiality, loyalty or, within legally permissible limits, non-competition;
• mediation or dispute resolution mechanisms.

In a franchised company, these mechanisms have an additional benefit: preventing shareholder conflict from turning into a crisis in operations and, consequently, in the franchise agreement.

But does that mean the franchisor has to impose these mechanisms himself?

4. Demand a result rather than imposing the means

This is probably where the dividing line lies.

The franchisee remains a legally independent entrepreneur. The franchisor therefore cannot use the shareholders' agreement as a tool to indirectly control the franchised company or to organize the relationships between its shareholders.

However, requiring that certain risks have been anticipated does not necessarily mean interfering in their management.

A distinction could thus be made between the requirement of a result and the imposition of the means to obtain it.

Three levels of intervention can be considered.

First level: require the existence of a prevention mechanism.
The franchisor requires that the partners have organized certain situations that it identifies as essential: departure of the operational partner, blockage, change of control, breach of financing commitments or exit of a partner.

Second level: proposing guidelines.
The franchisor identifies the themes that should be addressed or possibly communicates an indicative framework, leaving the responsibility for determining the modalities to the associates and their advisors.

Third level: impose a comprehensive agreement.
The franchisor provides a mandatory template, controls its stipulations and may reserve the right to approve internal relationships between partners.

The further one progresses towards this third level, the greater the risk of interference.

In specific circumstances, control going beyond the legitimate protection of the network to become a genuine participation in the management of the company could contribute, along with other elements, to supporting much more serious qualifications: relationship of subordination, branch management or even de facto manager.

Increased vigilance is required in participatory franchise schemes , where the franchisor or a company in its group already holds a stake in the capital of the franchisee company.

The issue is therefore less about whether the franchisor can be interested in the shareholder organization of its franchisee than about determining how far this interest can legitimately lead it.

5. Shareholders' agreement and franchise agreement: organizing their interaction

That's probably the key point.

A shareholders' agreement that is perfectly designed in accordance with company law may produce effects that are incompatible with the franchise agreement.

The franchise agreement is indeed strongly influenced by thepersonal nature of. The franchisor selects their franchisee based on their qualities, experience, financial resources, and ability to operate the concept.

When the franchisee is a company, this personal relationship can also lead to taking into consideration the people who control it or who actually operate the point of sale.

Let's imagine that a buy-or-sell clause leads a partner to acquire all the shares of the franchised company. What happens if this partner has never been approved by the franchisor?

A forced sale mechanism could similarly lead to the entry of a third party into the capital who would not meet the network's criteria.

An exit clause could still cause the departure of the operational partner on whose consideration the franchisor had agreed to contract.

Conversely, the franchisor's right of approval should not make it impossible to resolve a conflict between partners by effectively locking in their ability to separate.

Therefore, the shareholders' agreement and the franchise agreement cannot be designed separately.

Clauses relating to change of control, approval, pre-emption, forced or voluntary exit and departure of the operating partner must be considered together.

This is undoubtedly where the real added value of reflecting on the shareholders' agreement in franchise networks lies: ensuring consistency between company law and franchise law.

6. What points of vigilance should the franchisor have?

In practice, a franchisor wishing to integrate shareholder risk into the structuring of its network could, in particular:

• analyze the distribution of capital and the effective role of each of the partners from the candidate selection stage;
• identify the partners whose presence is a determining factor in its approval;
• verify that situations involving blockage, departure or change of control have been anticipated;
• coordinate the clauses of the franchise agreement relating to intuitu personae and change of control with the mechanisms provided for by the partners;
• prioritize defining objectives or guidelines rather than imposing a fully predetermined pact;
• re-examine this organization in the event of any significant change in the franchisee's shareholding.

The shareholders' agreement would then not be an instrument allowing the franchisor to control its franchisee more, but one of the tools of a more global policy of preventing network risks.

In conclusion: requiring a partnership agreement, yes; writing it on behalf of the partners, probably not

The franchisor is not intended to organize the relationships between the partners of its franchisees itself.

However, he would probably be wrong to consider them completely foreign to him.

When a point of sale is operated by a company composed of several partners, the stability of their relationships can become a condition for the stability of the franchisee and, consequently, of the network.

The right approach, therefore, probably does not consist of imposing a uniform model of shareholders' agreement.

It could instead consist of identifying shareholder risks that could affect operations, requiring that they have been anticipated, and ensuring that the solutions chosen are compatible with the franchise agreement.

In other words, the franchisor can define the risks from which it wishes to be protected without necessarily dictating to the partners how they should organize their relationships.

Having secured the relationship between the franchisor and its franchisee, shouldn't networks also be interested in what can destabilize the franchisee from within?

ARST Avocats assists franchisors and franchisees in the creation and structuring of networks, the drafting and updating of their contractual documentation, as well as in the prevention and resolution of disputes between partners.

Article written by Morgan Jamet, partner at the law firm Arst Avocats