Updated October 2024
A penalty clause in a franchise agreement is a provision that imposes specific penalties on the franchisee if they fail to meet certain contractual obligations. Penalty clauses are important aspects of franchise agreements, particularly in jurisdictions where there is no franchising legislation in place such as Newfoundland & Labrador, Nova Scotia, Quebec, Saskatchewan and the territories.
While these clauses lay the groundwork for penalties, their most important function is to act as a deterrent for franchisees who may be tempted to breach their franchising agreement. Potential franchisees should be careful to understand the penalty clauses in order to avoid unnecessary legal complications later down the road.
Enforceability of Penalty Clauses
Penalty clauses can be tricky because they need to serve as effective deterrents without discouraging prospective franchisees. Additionally, the penalties must be enforceable, which means that they can’t be overly punitive or difficult to quantify in court. For example, in jurisdictions like Quebec, courts have the power to reduce penalties if they are deemed excessive or if the franchisor has already benefited from partial performance.
5 Tips for Navigating Franchise Penalty Clauses
#1 – Seek Legal Advice
Franchisors must strike the right balance on which clauses in the franchise agreement should include a penalty and how much that penalty should be. Since this requires careful legal drafting, franchisors will employ an experienced lawyer to help with this.
Furthermore, if you are thinking about buying a franchise, you should seek legal counsel before signing a franchise agreement containing a penalty clause. A franchise attorney can help you secure fair terms while ensuring that the punitive clauses are reasonable. This will set you up for success as a franchise owner.
#2 – Understand Penalty Amounts
Penalty amounts generally aren’t calculated on a per-day business because not all breaches can be measured in terms of days (e.g. breach of confidentiality covenant).
Also, the amount of the penalty is likely to exceed any potential profit or gain that a franchisee hopes to obtain from their breach, but not by too much. This keeps the franchisee from deciding the penalty is worth breaching the agreement. The franchisor’s goal is to maximize the deterrent effect of the penalty clauses without being too excessive.
#3 – Negotiate Grace Periods
It’s often possible to negotiate grace periods before certain penalties take effect because franchisors are interested in long-term success rather than immediate penalties. Grace periods give you the ability to resolve issues without legal consequences. For example, if a franchise agreement imposes a fine for late royalty payments, you might be able to negotiate a grace period that gives you a certain amount of time to get back on track.
Having a lawyer advise you regarding the franchise agreement will ensure that these grace periods are clearly defined and reasonable for both sides.
#4 – Keep Communication Open With the Franchisor
Regular communication builds trust and transparency, reducing the likelihood of disputes escalating into formal penalties. For example, if you are having operational challenges in your franchise or if you anticipate that you might breach an agreement (such as missing a sales target), you should notify your franchisor in advance. This will give you the opportunity to find a solution together and avoid the use of the penalty clause altogether.
#5 – Document Everything
Thorough documentation can be your greatest defense if a legal dispute arises. If the franchisor claims you have breached the agreement, having documented evidence—such as emails, contracts, or proof of actions taken—can help prove your case or minimize penalties. Having a clear history of events and interactions can also make it easier to address potential misunderstandings.
Ready to Get Started as a Franchise Owner?
Obviously, the best way to avoid any penalty clauses is to have a good working relationship with your franchisor. The best way to have a good working relationship with your franchisor is to choose the right franchise from the start. FranNet is here to help you get started off on the right foot. Our expert franchise consultants will match you with the perfect franchise and walk you through the process from start to finish. Schedule your free consultation today!