Becoming a Franchisee in 2019 - Tricks and Traps

Robert Toth | Partner | Marsh & Maher Richmond Bennison

Becoming a Franchisee in 2019 - Tricks and Traps

I was at a dinner party recently and Jack, who I didn’t know very well, asked what do you do, Rob?

I’m a franchise lawyer Jack, I replied. Then Jack said, that’s a shame who would want to be a franchisee or franchisor these days with all the bad press?

Well, Jack, I said, as a matter of fact, many people still do, for many reasons as franchising is an integral part of a thriving economy, and contributes greatly to employment and is a model that operates around the world.

The banking sector didn’t close down, and people didn’t stop using banks despite the revelations that came out of the Banking Royal Commission. The same applies to franchising.

Franchising will continue to thrive, but franchisors need to be more transparent and ensure they deliver on what they promise. Change is positive, and changes in the laws and expectations can be positive in a sector.

Franchises that take up the challenge and adapt will do well and pick up market share in their sector.

The Franchise Code changes that are likely to come into place after the Parliamentary Inquiry into the franchise sector will likely ensure greater transparency by franchisors when offering a franchise opportunity, but it won’t prevent franchisees failing, that’s a business risk and can happen for a myriad of reasons beyond the franchisor’s control or business model.

These changes also make us as advisors, consider new ways to approach the market and help to ensure franchisors are offering sustainable models that work for both parties.

The media focus on the negative, and franchise lawyers have many a ‘war’ story to recount, but there are practical steps that franchisees can take to limit their risk.

So, what can you as a new and eager prospective franchisee do to limit your risk?

Here are some practical considerations:

  • Do your due diligence on the franchisor just as they do their due diligence on you.
  • Can you honestly see yourself and or your partner working in the business in one year – selling chooks is likely to have a limited life span!
  • Research, research and research and compare like systems - then make a list of pro’s and cons of each, and narrow down the system that may be more suitable to you and your lifestyle, and meets your expectations.
  • Consider the location whether an existing or new ‘greenfield’ site and assess - is it an A, B or C grade site? Are you paying an A grade cost to get into a C grade site?
  • Is the location practical for you to attend work each day? For example, if you live in Bundoora but have to attend the business in Werribee every day - there is a cost, your loss of time, transit costs and inconvenience.
  • Read your franchise agreement.
  • Speak to other franchisees.
  • Seek specialist franchise advice.

Do not assume!

One of the things we often hear as franchise lawyers is that the franchisee assumed all sorts of things prior to signing their agreement, but never documented them. Assumptions are just that. If you don’t understand an issue, say so. If you are promised something by a franchisor, make sure it is in writing and ensure it’s  confirmed as conditions in the agreement.

It is very difficult to rely on a verbal statement.

If the franchisor does not confirm in writing, then follow up with an email in which you can refer to the discussions and recite what was said agreed to or promised.

You can bet that if the franchisor does not agree with what you understood and reflected in your email, they will respond!

Here are the top assumptions we often hear from clients:

  1. That the franchisor would negotiate the best lease terms for me.
  2. The franchisor had negotiated me a rent-free period and landlord contributions to the fit out.
  3. The franchisor would apply for all my licences and permits I need to start operating the business?
  4. The franchisor would supply me with products at better prices than I could source from suppliers.
  5. The franchisor would be there for me all along the way if I had issues with the business and would visit me regularly and support me.
  6.  I wasn't aware that I had to do a re-fit of the business fit-out, which would involve a large capital cost.

Don’t assume that the financial model the franchisor has given you covers all of the operational costs of the business – they may not include a wage for you as the operator or for a manager.

Often the franchisors disclosure document underestimates the working capital you may need to cover the first 6 to 12 months of operation.

So do not assume, do your independent checks and searches, for example, speak to a local commercial agent about the proposed lease terms to see if the rent and terms are reasonable and within the then-current market and ask the questions you need and get it in writing.

Fundamental financial indicators

Two primary indicators will determine whether your business is likely to be viable; that is:

  • Your occupancy costs (rent and outgoings) as a percentage of your turnover and;
  • Your staff costs as a percentage of your turnover.

Assuming the franchisor has given you some indication of your expected turnover (as it is unlikely they will provide you with projections as to profit) you can then readily assess using the above two indicators if the business has any chance of being viable and allow you to:

  • Draw a reasonable salary for your effort out of business and;
  • If you are likely to see any return on your investment (ROI) after paying interest on your borrowings.

Understanding these two basic measures before you commit will allow you to make an informed decision on your risks and reward.

Franchisees who do this simple exercise are astounded, yet some never know these two indicators until years after operating their business.

They were working hard; the revenue was what they expected, but they didn’t know why they were not getting ahead?

I took a client through this exercise recently and calculated her occupancy costs as a percentage of her turnover was 28 per cent, and her wage costs 35 per cent. There was nothing left for her to even take a minimal salary for her 60 hours of effort per week. There lay the problem!

Acceptance

The courts have said that the grant of a franchise does not give the franchisee a right or necessarily an expectation to make a profit.

It is the right to operate under the franchisor’s brand and system to generate sales and revenue.

Therefore, franchisees need to accept that there may be no pot of gold at the end and the best outcome may be simply taking a salary along the way and hopefully paying off interest and debt over time.

There is no guarantee that you will make a capital gain at the end of the day.

Franchisees, therefore, need to test the franchisors financial model (if they provide one) and get financial advice before you commit!

Financial, accounting and legal advice are critical to limit your risk. Although optional, we suggest it should be compulsory and similar to applying for finance where the banks require that the customer seek independent legal advice.

Should I stay, or should I go?

Communication is the key to any ongoing relationship with your franchisor, so if there are alarm bells speak up and raise them as soon as they occur with the franchisor. A responsible franchisor will listen and respond to any query raised, and this will instil confidence in the relationship.

You should never feel obliged to proceed or rushed into making a decision just because you have gone some way down the track in your preliminary discussions.

Once you are in the business, there is no easy way out for a franchisee.

Sometimes it is hard to walk away and take a loss, but it may be less costly than trying to exit once agreements are signed and the business is up and running.

Franchisors have the right to reject a franchisee for example, where the franchisee may not have the capital resources, experience or licenses needed or they do not successfully complete training.

Franchisees also have quite a few opportunities to walk away before being fully committed, and you should bear this in mind:

When can a franchisee walk away?

Franchisees can walk away before being fully committed (although there may be a cost to do so) at the following times:

  • Within the 14-day disclosure period from when the franchisee receives the franchise agreement, disclosure document, copy code and advice certificates. If they choose to withdraw during the 14-day period, they are entitled to a refund of all monies paid to the franchisor or any agent.
  • After the 14-day disclosure period and before they sign the franchise agreement – The franchisee can decide not to proceed and forgo the document fee they have paid and any other fees they have paid upfront to the franchisor at that point provided those amounts are set out in the disclosure document.
  • Within the seven day cooling off period after signing the franchise agreement or having paid any monies to the franchisor, the franchisee may again forfeit some money paid upfront, as set out in the disclosure document, but far better to exit at that point than after the agreement is signed.

Getting the right advice from specialist advisors who know the sector and are members of the Franchise Council of Australia (FCA) is great insurance.

Getting advice from your neighbourhood property lawyer (no offence!) may end up costing you a whole lot more in the long run and getting advice from your friends or neighbours is no advice at all!

Franchise specialist lawyers who are members of the FCA are up to date with the market, and the laws and we know what’s going on in the world of franchising. Specialist advice is knowledge and experience the local lawyer around the corner may not have.

Remember, once you commit to a franchise, there is no easy exit!.

 What to do if you are in strife?

Ask the franchisor for help! Enquire about further training in a specific area, for example, stock control, point of sale, presentation, converting leads to sales.

Identify what you believe is not working for you and tell the franchisor.

Put things in writing - emails are evidence and can be relied on.

It is business, so be professional and business-like. Do not resort to abusive or threatening verbal or written conduct or threaten to go to A Current Affair. Stay professional and focused on resolving the issue.

If a response from the franchisor is inadequate or non-existent, seek legal advice from a franchise law specialist to understand your options.

Knee jerk reactions may lead you down the wrong path and also destroy any ability to resolve the issues with your franchisor.

Identify if it is an operational issue that needs fixing so you can get on with business or is it a deal-breaker ‘end of relationship’ issue.

Clear communication and identifying the outcomes you seek and being realistic is also important.

Consider if mediation may be the right forum for the issues in dispute.

 Lastly don’t threaten litigation, unless you have grounds and you have sought legal advice and all other avenues have failed to resolve the matter.

Litigation is a last resort – As Geoffrey Rush recently said most eloquently at the end of his defamation action he won recently, “There are no winners when you go to court.”