Buying a franchise: limit contractual penalties before you sign

Franchising brings together independent business owners whose shared operating practices are protected by contracts. A contractual penalty can help ensure, for example, that the network’s branding is used properly, but it also creates a financial risk for the buyer. Before signing, establish what triggers a penalty, whether a single incident can lead to several charges and whether you can put a mistake right before a penalty applies. Simply checking the amount in euros is not enough.

1. Understand what a contractual penalty means in practice

A contractual penalty is a consequence of breaching a contract, agreed in advance in that contract. Its purpose may be to encourage compliance with an obligation and reduce the need to prove the amount of any loss. Unlike a claim for damages, payment does not generally require proof of actual loss in the same way. However, the wording of the clause is decisive: what kind of breach triggers the penalty, and under what conditions?

Do not look only for a heading labelled ‘contractual penalty’. Similar consequences may be described as a breach fee or fixed compensation. Read the schedules to the agreement and any clauses referring to the operations manual as well. In particular, check whether the penalty relates to a precisely defined obligation or to compliance with all the network’s instructions in general.

Prepare a brief summary of each penalty provision:

• What act or omission triggers it?
• Who must pay: the company, the franchisee personally, or both?
• Is the charge one-off, recurring or increasing with the duration of the breach?
• Does payment depend on deliberate conduct, negligence or a written warning?
• Can other charges be claimed for the same incident?

For example, a penalty for failing to stop using the network’s branding is an understandable safeguard. Even so, the buyer needs to know whether an overlooked online directory listing is treated in the same way as deliberately continuing to trade under the network’s name. The risks involved, and the scope for putting things right, differ between these situations.

2. Test the penalty against everyday situations

Ask the franchisor to work through the clause using concrete examples. Useful test cases include an employee accidentally publishing an old logo, a late report and a delay caused by an external service provider. The aim is not to play down the obligations, but to establish whether the agreement distinguishes human error from a serious or repeated breach.

Where possible, agree that a written warning and a reasonable period to remedy the breach will be required before a penalty becomes payable, provided the breach can be remedied. Also define what the warning must contain: the obligation breached, the conduct identified, the action required and the deadline. A vague notice does not help a franchisee bring the business back into compliance.

A remedy period is not suitable for every breach. Disclosure of confidential information, for example, may be impossible to undo. Even then, the clause can distinguish between the seriousness of the breach, the extent of the franchisee’s control and the steps taken to limit the damage. Avoid assuming that the same procedure will suit every contractual obligation.

Also check how notices must be delivered. If the remedy period starts when an email is sent, the business needs an effective system for receiving contractual notices during holidays and sickness absence too. Ask for a designated address for warnings and a procedure for updating contact details. A good clause is one the business can comply with in practice.

3. Calculate your total exposure, not just a single penalty

The biggest surprise may be the way penalties accumulate. Establish whether ‘each breach’ means a single set of related events, each location, each publication or each day. If the same mistake appears across several channels, an unclear basis for calculating penalties could produce a much larger claim than the buyer expected.

Ask for a written calculation showing what happens when one mistake continues for several days and affects several locations. Check whether there is a defined endpoint for a continuing breach and how completion of the remedial action is confirmed. Otherwise, the parties may disagree even about when the penalty stopped accruing.

At the same time, establish how the contractual penalty relates to damages. Does it replace damages, is it deducted from them, or can the franchisor also claim for loss exceeding the penalty? Check whether the agreement’s general limitation of liability covers penalties or specifically excludes them.

During negotiations, you could propose limits such as:

• an overall cap on penalties arising from the same set of related events;
• a clear basis for accrual and a cap on penalties for a continuing breach;
• a warning procedure for mistakes that can be remedied;
• an unambiguous rule governing the relationship between penalties and damages.

Do not assume that your business insurance covers contractual penalties. Ask the insurer for a written explanation of how this particular contractual liability is treated under the policy. Your own risk assessment should also allow for the possibility that the business will have to bear the full cost. Arranging funds to pay penalties is no substitute for clarifying an ambiguous clause before buying.

4. Understand Finnish regulation and finalise the clause in writing

Finland has no specific franchising act and no statutory requirement for a franchise disclosure document in a prescribed format. Franchise agreements are not registered in a dedicated franchise register either. Agreements within a franchise network are governed by general legislation, including the Contracts Act, the Unfair Business Practices Act, the Competition Act and the Trademarks Act.

Section 36 of the Finnish Contracts Act is central to the assessment of contractual penalties. It allows an unreasonable contract term to be adjusted or disregarded. However, any adjustment depends on an assessment of the circumstances as a whole. In a business-to-business agreement, it should not be treated as an automatic safety net or a right to ignore a clause you have signed.

The Finnish Franchising Association’s Code of Ethics is a form of industry self-regulation, not law. Compliance with the code as part of association membership does not, on its own, determine whether a particular contractual penalty is acceptable. The clause must still be assessed in light of your own business’s obligations and risks, and the agreement as a whole.

If the franchisor says that penalties are not applied to minor mistakes in practice, ask for that limitation to be written into the agreement. A verbal promise does not remove the uncertainty created by a broadly worded clause. Have a lawyer experienced in commercial contracts review personal liability, cumulative penalties and exceptions to liability limits in particular.

Practical checklist: sign only when you can explain what triggers each penalty, how it is calculated, the procedure for putting things right and its relationship with other compensation. If you cannot calculate the total exposure even in an example scenario, the clause needs clarification.