10 Questions to Ask Before Buying a Franchised Business
Purchasing a franchise is often considered to be less risky than purchasing a business that is not part of a franchise system. This might be true, but no matter how profitable a business appears, there are many issues to consider prior to signing an agreement to buy a franchised business.
Below are 10 questions that a prospective franchisee should ask before buying a franchised business.
1. Where do I start?
Commence by arming yourself with resources to enable you to make an informed decision. Here are some freely available resources about franchising that are essential reading:
- Information Statement prescribed by the Franchising Code of Conduct: www.accc.gov.au/system/files/Information%20statement_0.pdf
- The Franchisee Manual: www.accc.gov.au/publications/the-franchisee- manual
2. What documents do I need?
Before signing any documents (other than a confidentiality deed), you should obtain the necessary documents to enable you to understand the full implications of the purchase.
From the franchisor you must obtain the current franchise agreement and disclosure document. In addition, the Franchising Code of Conduct (“Code”) requires that the franchisor gives you the Information Statement mentioned above and a copy of the Code.
From the vendor of the business (if you are buying an existing business) or agent selling the business, you need to obtain a copy of the contract of sale of business and the existing lease of the premises (if relevant). In some States of Australia, a vendor of a small business is required to provide a disclosure statement about the business which includes information about the financial situation of the business, verified by an accountant. In Victoria, this applies to all businesses sold for $350,000 or less. Even if your purchase price exceeds this threshold, you should ask to see financial statements for the last three years for the business.
Now that you have the documents, read them!!
“It is imperative that you understand the grounds upon which a franchise agreement can be terminated by a franchisor and ensure they comply with the code.”
3. What other research should I do?
In addition, you should undertake your own research about the particular franchise system including:
- the franchisor’s reputation in the market place;
- the relationship between the franchisor and its franchisees;
- the expansion plans of the franchisor, specifically whether the expansion plan includes setting up any other franchise system which could compete with or divert the franchisor’s attention from the system being considered; and
- any current or threatened legal proceedings against the franchisor.
4. What should I ask other franchisees?
Speak to other franchisees about the following:
- how the actual costs of investment (set up costs) compare to any estimates originally provided by the franchisor;
- the level of support offered by the franchisor to its franchisees, especially to franchisees that are located outside the state from which the franchisor’s head office operates; and
- whether the franchisor is accessible, organised, responsive to queries as well as suggestions.
5. The agent is calling me, should I sign the contract of sale of business?
If you are purchasing an existing business, the vendor will ask you to sign the sale of business contract. Vendors and agents sometimes apply pressure to secure a quick sale. However, it is important that you fully understand the implications of all the relevant documents before you do so.
6. I’ve tried reading the documents, but I don’t fully understand them. I think I need a lawyer and an accountant to help me. What should I ask them?
Seeking the advice of a lawyer and an accountant who are experienced in franchising is the key to making an informed decision. The Code requires franchisors to obtain a statement from all franchisees that either they obtained the advice of a lawyer, accountant and/or business adviser, or they were advised to do so, but chose not to.
The balance of the questions in this article are questions you should ask your lawyer and/or accountant.
7. What are the most onerous aspects of a franchise agreement?
The franchise agreement is the most important document in the suite of documents as it will govern the legal relationship between the franchisor and the prospective franchisee for the term of the franchise. The obligations of both the franchisee and the franchisor should be read carefully. The following types of clauses can have onerous implication for the franchisee:
Payments under the Franchise Agreement, operating costs and unforeseen capital expenditure
Typically, fees are specified in a schedule at end of a franchise agreement. However, sometimes some fees are located inconspicuously within terms of the franchise agreement. Some franchise agreements provide that certain fees may be changed at the franchisor’s discretion.
Term and Renewal
After the term of the franchise agreement, there may be an option to renew the agreement for a further term, subject to you complying with certain conditions, including payment of a renewal fee, refurbishment of premises and entering into the ‘then current’ franchise agreement which may be different from the franchise agreement you signed.
Some franchise agreements are limited to a particular site, some grant a territory. A territory may be exclusive or non- exclusive. Some franchise agreements purport to have exclusive territories, but may actually only give exclusive rights to market in an area. In certain circumstances, exclusive territories can become non-exclusive.
Minimum Performance Criteria
Consequences of failure to meet minimum performance criteria typically include requirements to attend further training, after which there may be a right to appoint other franchisees to the territory, to force the franchisee to sell the business or to terminate the franchise agreement.
It is imperative that you understand the grounds upon which a franchise agreement can be terminated by a franchisor and ensure that they comply with the Code.
Franchisees can terminate a franchise agreement by exercising the cooling off right within seven days after signing the franchise agreement or paying money under the agreement. After the cooling off period, unless the franchise agreement provides a right of termination, usually the only way for a franchisee to exit prior to the end of the term is to sell the business or to obtain the agreement of the franchisor. Not only is the franchisor not obliged to agree to end a franchise agreement, the franchisor may be entitled to claim damages from you for the profit it would have otherwise made, such as via royalties, until the end of the term, or at least until they can find a replacement franchisee.
“In order to make an informed decision, it is critical to read all the documents and undertake extensive research, ask questions of the franchisor and other franchisee.”
Most franchise agreements provide for a period after the end of the franchise agreement during which the franchisee is restrained from being in any way involved in a competing business within a specified area from the territory or premises. The Code provides limited circumstances in which restraints will not be enforceable. Franchisees need to be aware that in the absence of such circumstances, such restraints may be enforceable.
Franchise agreements often give the franchisor the ability to change the agreement unilaterally in ways that may not be obvious at first glance. Look for the ability for the franchisor to change things such as menus, approved goods and services, standards, intellectual property and fees from time to time, or in accordance with the Operations Manual. These types of clauses enable the franchisor to make changes to the system that may ultimately require you to incur cost, either directly such as in the case of an increase in fees, or indirectly, such as in the case of a requirement to refurbish your premises or replace signage. You may be able to argue that the ability for the franchisor to make unilateral changes constitutes an unfair term.
The unfair terms legislation which came into effect on 12 November 2016 has given franchisees some leverage to negotiate with franchisors about terms in franchise agreements that may be unfair.
If a franchise agreement is presented on a ‘take it or leave it’ basis, it may meet the criteria for a standard form contract. If so, and if either party has less than 20 employees and the upfront cost is less than $300,000 (or less than $1 million for a term longer than 12 months), there may be an argument that certain types of terms are unfair and should be changed.
For example, terms that enable one party (but not another) to terminate the agreement, terms that penalise one party (but not another) for breaching or terminating the agreement, and terms that enable one party (but not another) to vary the terms of the agreement. You should seek legal advice about such terms and, to the extent possible, negotiate fairer terms.
8. What about employees?
A prospective franchisee must be aware of the employment issues that will affect it (whether the franchisee is employing new employees or former employees of a vendor).
For example, the Fair Work Act 2009 (Cth) not only sets minimum terms and conditions of employment for employees, but also may impose onerous notification requirements upon purchasers, transferees or assignees of businesses. Breaches of these provisions in the Fair Work Act 2009 (Cth) may result in severe penalties.
If purchasing an existing business and taking on the Vendor’s employees, ensure you are clear about what employee entitlements, such as long service leave and sick leave, are being transferred to you under the contract as the new employer.
9. Is this the best location for this business?
If the proposed franchised business operates from a fixed location, due diligence in respect of the location will be necessary.
Understanding the lease and other related documents is critical to that process. If the franchisor is the tenant and licenses the premises to you, you may also need to review the license agreement. In addition, in a retail premises, there may be a disclosure statement given by the landlord.
Furthermore, 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, details of any demographic analysis performed in respect of the particular location. If the location is within a shopping centre, the prospective franchisee should request traffic flow information in respect of the shopping centre and specifically, in the area near the proposed location.
10. What is the best business structure for me?
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 and certainly before signing the contract of sale of business or franchise agreement. 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.
The possible structures which can be adopted include: sole trader; company; partnership; trust; or a combination of a company and a trust structure. A prospective franchisee should bear in mind that each type of structure described above attracts different set up costs, on-going compliance costs, tax rates and personal risk. Arranging for your lawyer and your accountant to speak with each other will assist in achieving the best outcome.
There are many things to consider before signing an agreement to purchase a business. In order to make an informed decision, it is critical to read all the documents and undertake extensive research, ask questions of the franchisor and other franchisees and seek the advice of an experienced franchising lawyer and accountant.
Louise Wolf is a Senior Associate working within the Corporate Advisory and Franchising Team at MST Lawyers. Her main areas of expertise are franchising, intellectual property and privacy. She has acted for national and international clients providing advice and training in relation to franchising in Australia. She has written the Australian Chapter of the International Franchising Handbook which provides information on franchising in almost 20 countries.
MST Lawyers has over 30 years’ experience in franchising, representing clients throughout Australia and internationally in a variety of industries. Please contact the Corporate Advisory and Franchising Team for assistance or further information.
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