Franchising continues to be a buoyant 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 franchise system that has achieved substantial brand recognition as opposed to establishing a totally new business.
However, as with setting up any new business, many issues must be considered prior to making the decision and signing any agreements to buy a franchised business.
The following are 10 tips that a prospective franchisee should consider before buying a franchised business.
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 to make sure an informed decision is made as to the most viable structure, prospective franchisees should discuss 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;
– the expansion plans of the franchisor;
– the relationship between the franchisor and its franchisees – this can easily be ascertained by talking to other franchisees;
– any current or threatened legal proceedings against the franchisor;
– the total amount the franchisee will need to invest in setting up the franchised business; and
– 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.
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, under the terms of the franchise agreement or licence agreement with the franchisor, be bound to comply with the lease.
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.
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, responsive to queries as well as suggestions;
– what is the relationship between franchisees within the franchise system; and
– where a franchisee has left the system the reasons for the franchisee leaving the system.
6 Review the Disclosure Document
Pursuant to the Franchising Code of Conduct (‘the Code’), the franchisor must, at least 14 days before the franchise agreement is signed or before accepting non-refundable money, provide to every prospective franchisee the following:
– a disclosure document in the form prescribed by the Code;
– a copy of the Code; and
– the franchise agreement in the form it is to be signed by the franchisee.
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 leased by the franchisor, the franchisee may be asked to sign either a licence agreement or a sublease (pursuant to which the franchisee is granted a right to occupy the location;
– 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 professional (legal and accounting) advice should be sought.
7 Review the 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 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 a more 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 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;
– 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 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 again 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. 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 or money has been paid pursuant to a franchise agreement, a prospective franchisee has a ‘seven-day cooling-off period’. This means that the prospective franchisee has seven days within which he/she can 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, extension or transfer of a franchise agreement.
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 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 and/or administrative costs associated with the drawing of the franchise documents;
– if there is a lease of the location, 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.
MST Lawyers has over 25 years’ experience in franchising, representing clients throughout Australia and internationally in a variety of industries. Written by Raynia Theodore, Principal, in the Corporate Advisory and Franchising Team at MST Lawyers, please contact the Corporate Advisory and Franchising Team for assistance or further information.
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