To Buy or Not to Buy
By Raynia Theodore, Principal, MST Lawyers
Franchising continues to be a successful sector of the economy.
One of the main attractions of franchising for new entrants to the small business community is that there is usually less risk associated with buying a franchise in an established and proven franchise system that has achieved substantial brand recognition as opposed to establishing a totally new business.
However, as with setting up any new business, there are risks and many issues which must be considered prior to making the decision and signing any agreements to buy a franchised business.
So if your New Year’s Resolution is to buy a franchise the following are 10 tips that you should consider before buying a franchise.
1. Choose the correct Business Structure
There are a number of different business structures which a franchisee can adopt. A decision as to the business structure to be adopted by the franchisee needs to be made early on. Some of the reasons for adopting the correct structure right from the outset include, minimising personal risk, protecting personal assets and making the purchase and the subsequent sale of the franchised business more tax effective. A prospective franchisee should bear in mind that each type of structure attracts different set up costs, compliance costs, tax rates and personal risk.
The franchisor may also impose restrictions on the structure that can be adopted. Therefore and before any decision is made as to the most viable structure prospective franchisees should discuss and seek franchisor approval of their proposed structure with the franchisor and also seek both legal and accounting/tax advice.
2. Conduct a Due Diligence Investigation
All prospective franchisees should do their homework before investing in a franchised business. Such research should include obtaining information about:
- the particular franchise system in question and the franchisor’s reputation in the market place – a basic Google search can provide useful information about the franchisor;
- the expansion plans of the franchisor;
- the relationship between the franchisor and its franchisees – this can easily be ascertained by talking to other existing or former franchisees of the network;
- any current or threatened legal proceedings against the franchisor;
- the total amount the franchisee will need to invest in setting up the franchised business;
- if the prospective franchisee is considering purchasing an existing franchised business, then historical trading information and financial reports of the franchised business should be sought from the vendor.
A lot of this information will be available in the franchisor’s disclosure document.
Recent changes to the Franchising Code of Conduct (“the Code”), require that franchisors to provide to prospective franchisees a Key Facts Sheet in the form published on the Australian Competition and Consumer Commission’s website. The Key Facts Sheet includes important information from the disclosure document.
The changes to the Code also require copies of any earnings information provided or to be provided by a franchisor to be in the franchisor’s disclosure document or in an attachment to it. If such earnings information is provided it is recommended that accounting advice be sought.
3. Examine the Location
If the franchised business operates from a fixed location, there needs to be additional due diligence performed in respect of the location. Careful consideration needs to be given to the particular area where the franchised business will be based, the demand for the goods and/or services offered by the franchised business within that area and any direct and indirect competition to the franchised business in that area, both immediate and in the future.
Where the franchisor has selected the location, the prospective franchisee should request from the franchisor copies of its site selection policy and details of any demographic or site analysis performed in respect of the particular location.
Even if the franchisor has entered into the lease of the location with the landlord, a prospective franchisee should seek legal advice in relation to the lease as the franchisee will no doubt be bound to comply with the lease under the terms of the franchise agreement or a separate licence agreement with the franchisor.
4. Take Notes in Preliminary Meetings with Franchisor
A prospective franchisee should take comprehensive notes in each meeting or discussion with the franchisor or its representatives both prior to and post entering into a franchise agreement. Any representations or promises made by the franchisor before the prospective franchisee enters into the franchise agreement should be reflected in the franchise agreement.
This may become crucial in the event of a dispute with the franchisor in the future. If a promise, representation or concession has not been recorded in writing it will be difficult to later prove.
As a result of changes to the Code, if a franchisor will require a franchisee to incur significant capital expenditure during the term of their franchise agreement and the expenditure is disclosed in the disclosure document, the franchisor and the franchisee must also discuss the capital expenditure before entering into, renewing or extending the term or scope of a franchise agreement. This discussion must include a discussion of the circumstances under which the franchisee considers that they are likely to recoup the expenditure, having regard to the geographical area of operations of the franchise business. You should ensure that such discussion takes place with the franchisor and also keep a record of the discussion.
5. Speak to Other Franchisees
Other franchisees can be an invaluable source of information about the franchisor, its business and its system. Prospective franchisees should endeavour to make contact with as many former and current franchisees as possible. Their details should be in the franchisor’s disclosure document. The inquiries that should be made should include inquiries in relation to:
- how the actual set up costs compared to any estimates provided by the franchisor;
- whether any estimates or projections provided in any financial information or profit and loss statements provided by the franchisor proved to be accurate;
- the level of support offered by the franchisor, especially to franchisees that are located outside the state from which the franchisor’s head office operates;
- whether the franchisor is accessible, organised and responsive to queries as well as suggestions;
- what the relationship between franchisees within the franchise network is like; and
- where a franchisee has left the system, the reasons for the franchisee leaving the system.
6. Review the Disclosure Document
Pursuant to the Code, the franchisor must, as soon as practicable after a prospective franchisee formally applies for or expresses an interest in acquiring a franchise, provide a copy of the Information Statement required by the Code.
At least 14 days before a franchise agreement is signed or before accepting non-refundable money, the franchisor must provide to every prospective franchisee the following:
- a disclosure document in the form prescribed by the Code;
- a copy of the Key Facts Sheet;
- a copy of the Code;
- the franchise agreement in the form it is to be signed by the franchisee; and
- where the franchised business operates from a fixed location owned or leased by the franchisor or an associate of the franchisor, copies of the lease documents (or at the very least a summary of lease terms) and the document under which the franchisee is granted a right to occupy the location – either a lease, licence agreement or a sublease;
Amongst the suite of documents a prospective franchisee may be asked to sign there could be the following additional documents:
- a confidentiality agreement. This is usually required to be signed before the franchisee can receive any information about the franchise system and/or any of the franchise documents;
- where the franchised business operates from a fixed location which is to be leased by the franchisee, the franchisee will need to sign a lease in respect of the location;
- where a prospective franchisee is buying an existing franchised business from another franchisee, there will be a contract of sale of business.
All the above mentioned documents must also be carefully read and understood by the prospective franchisee and legal and accounting advice should be sought from professionals with expertise in franchising.
7. Review the Franchise Agreement
The franchise agreement is the most important document in the suite of documents as it is the document that governs the legal relationship between the franchisor and the prospective franchisee for the duration of the term of the franchise.
A prospective franchisee should read the franchise agreement in order to become familiar with and understand its terms. Legal advice should be sought especially in respect of areas that the prospective franchisee does not understand.
There is no substitute for a prospective franchisee reading the franchise agreement. A franchise agreement is usually a long term agreement that does not allow much scope for a prospective franchisee to later withdraw from the franchise agreement.
The clauses within the franchise agreement that should be given careful consideration include:
- franchisee obligations;
- franchisor obligations;
- the territory (if any) granted under the franchise agreement, specifically whether it is exclusive or non-exclusive;
- the duration of the franchise agreement, including the initial term and any renewal term. The conditions of renewal are also important – these conditions may include a requirement to make a further payment, upgrade the franchise location and sign a new franchise agreement on the franchisor’s then current terms, which may be different to the terms of the original franchise agreement signed by the prospective franchisee;
- the fees payable;
- any minimum performance criteria;
- any restrictions on the acquisition of goods and services sold or used in the franchise from third parties;
- the circumstances in which each party can terminate the franchise agreement;
- restraints post expiry or termination of the franchise agreement; and
- the ability to resell the franchised business and the conditions associated with such sale, including the granting of a “first option to buy” to the franchisor, an obligation to upgrade the franchise location and the payment of a transfer fee upon any sale. The purchaser franchisee may also be asked to enter into a new franchise agreement on the franchisor’s then current terms, which may differ from the terms of the original franchise agreement that was signed. If the financial terms have changed (e.g. royalties and other payments have increased) this may serve to reduce the value of the franchised business being sold.
In most cases, the terms within the franchise agreement will not be negotiable, however, prospective franchisees should take some comfort from this as it ensures the same treatment of all franchisees within a franchise system.
8. Cooling Off Right
One important matter that is often overlooked is that once a franchise agreement has been signed, a prospective franchisee has a “14-day cooling-off period”. This means that the prospective franchisee has 14 days within which to change his/her mind about the purchase of the franchise and withdraw from the franchise agreement. However, this cooling off right does not apply to a renewal or extension of a franchise agreement.
Under the Code and where the franchised business operates from a fixed location owned or leased by the franchisor or an associate of the franchisor the cooling off period may be extended if the terms of the proposed occupancy are not substantially identical to what was initially disclosed to a franchisee.
In the case of the purchase of an existing franchised business from another franchisee, where there is to be an assignment of the franchise agreement, different cooling off provisions will apply. The cooling off period will expire on the earlier of the period of 14 days starting on the day after the prospective franchisee becomes the prospective franchisee for the purposes of the franchise agreement, or the period ending on the day the prospective franchisee takes possession and control of the franchised business.
A lawyer with expertise in franchising law will be able guide you through your cooling off rights depending on the type of franchise being purchased
If the prospective franchisee exercises its cooling off right, then pursuant to the Code the franchisor must refund all money paid under the franchise agreement, less a reasonable amount for costs incurred by the franchisor. A prospective franchisee should before signing a franchise agreement, ascertain the amount that will be retained. This should also be set out in the franchisor’s disclosure document.
9. Consider Employment Issues
A prospective franchisee should give careful consideration to all potential employment issues which may arise when entering into a franchise arrangement. This includes, but is not limited to, statutory entitlements, terms and conditions of employment, applicable industrial instruments, termination of employment, equal opportunity and occupational health and safety obligations. These issues should be discussed in detail with a legal advisor prior to signing any franchise agreement.
It is critical that a prospective franchisee is aware of the employment issues that will affect it (whether the franchisee is employing new employees or former employees of a vendor). There is a myriad of pieces of legislation, each imposing different obligations on the parties.
10. Consider the Costs
Amongst the types of costs a prospective franchisee can expect to pay are the following:
- the franchisor’s legal costs associated with the preparation, negotiation or execution of the franchise agreement provided the amount is specified in the franchise agreement. The franchisor cannot pass on any amount for the franchisor’s costs of legal services that will or may be provided, after the franchise agreement is entered into, in relation to preparing, negotiating or executing other documents;
- if there is a lease of the premises, and subject to retail legislation providing otherwise, the Landlord’s legal costs associated with the lease documents; and
- the franchisee’s own legal and accounting costs associated with obtaining advice in respect of the franchise and lease documents.
The above aims to give you some preliminary assistance in navigating the process and legal documents which you will be provided with on the purchase of a franchise business. Although the disclosure document follows a standard format and franchise agreements contain common provisions there is no substitute for conducting your own due diligence, reading the franchise documents thoroughly and obtaining professional legal and financial advice. Disclosure documents and franchise agreements are complex lengthy documents and buying a franchise business is a serious and usually long term undertaking. It is one of the most significant decisions you may make in your lifetime. It is therefore essential that you obtain both financial and legal advice from an accountant and a lawyer who have significant expertise in franchising.