What Does Due Diligence Really Mean?
A specialist franchise lawyer and business advisor tell you what to look out for when buying your franchise.
The Franchise Business Advisor
When looking to buy a franchise in Australia, you will often hear the phrase “Make sure you do your due diligence” from family, friends and advisors. While most people realise it involves an investigation into the business, many people don’t realise or appreciate what that actually involves.
Due diligence will vary from business to business, however here are some key areas you need to consider when looking to purchase any business. The financials The most important consideration is whether the business is a sound financial proposition, so you need to be sure that the financial data you are given makes sense. You will want some kind of business plan that includes a financial model, preferably a P&L and ask the franchisor what the numbers are based on other franchisees and/or corporate store performance? Break the numbers down so that you know how many products or services you need to sell and how many clients you need to service per day and what would they have to spend on average to break even, after meeting all your overheads. If you don’t have the information, ask the franchisor for the average ticket price or the number of clients they service a day. This will allow you to see if the financial assumptions being put forward add up, and also whether the franchisor has a good understanding of their own business. It will also assist you to determine whether a site will generate enough revenue. For example, will there be enough passing foot traffic to ensure you make sufficient sales. This may mean that you sit in a shopping centre and literally count the number of people that walk past your intended site at different times of the day and on different days of the week.
You will want to get a good understanding about the operating costs of the company as well. As a rule of thumb, rent should not be more than 10 per cent of sales. A current franchise system that has recently experienced some major financial problems was rumoured to be paying in excess of $300,000 a year in rent for some of their sites. This would be fine except their expected sales were about $1.5milion. In this case the franchisor did not put any thought into the financials that they put forward to prospective franchisees, and unfortunately for many of these franchisees, they did not do their due diligence.
Another aspect you need to consider in your due diligence is the amount of time that you will be required in the business. Is this a seven day a week business, such as a quick service food business when you may be required to work public holidays and nights? Will you need to employ staff? Will members of your family work in the business or be giving up a job to work with you?
This will impact not only your lifestyle but also the lives of your family and may not be ideal if you have a young family.
But there are many kinds of franchises, such as work from home and mobile opportunities that allow greater flexibility as do many B2B businesses that only require a Monday to Friday commitment.
An area that a lot of potential franchisees don’t always think about is what the trade cycle of a business looks like. Are sales consistent throughout the day or are they focused on specific times? Do sales vary significantly throughout the week/year? These considerations will impact how you staff the business, the hours that you should work and also whether the franchisor has considered a product or service offering for all parts of the day/month/year. Is there any seasonality to the business? This is important as it can impact your return on investment. It can also vary the time it takes for your business to be profitable.
Assess the documentation
A critical part of your due diligence is to examine every piece of information the franchisor provides as this is should outline what you are purchasing. The Operations and Procedures Manuals should tell you exactly how to run your business with all the systems and procedures clearly explained. How will training be delivered, will there be an additional cost, what about training your staff and what ongoing support is offered? What marketing will the franchisor do, what marketing collateral is provided and how will you be able to use that to market your business locally?
As part of your due diligence you should also consider whether the culture fit of the franchise network is right for you. While this may seem less important, as a franchisee you will be spending on average seven years in this network. It is important that you are aligned with the company’s vision and that you support and believe in the company’s values, so that you don’t end up working with people you might not respect or whom you deem incompetent.
The core of your due diligence is to ask questions (and get answers!). You should speak with the franchisor (or recruiter) with any concerns and see what independent verification you can get for what they tell you. And very importantly speak with other franchisees, former franchisees (and even competitors of the franchise you are considering), to gain as much information as possible. Other franchisees in the network can tell you how long it took to become profitable, how much operating capital they needed, about seasonality, staffing, what the training and support are like and how the franchisor is to deal with.
At the end of the day, you want to make the most informed decision possible before committing your money and a sizeable portion of your life. So the final piece of the due diligence process should be to consult a franchise lawyer and an accountant and/or business advisor who understands franchising.
My lawyer colleague will discuss the Franchising Code provisions of the Disclosure Document about taking legal and financial advice, and I will add – take professional independent financial or business advice because together with what you can do – this is the best risk mitigation policy to ensure your success.
The Franchise Lawyer
You know you need to do your due diligence – but what does this actually mean from a legal point of view? You will get a lot of legal documents so let’s start by looking closely at the Disclosure Document (“DD”). The DD is legally required under the Franchising Code of Conduct and will give you important information about the franchise you are thinking about buying.
The DD has a list of current and previous franchisees as well as their contact details. You should contact at least three existing franchisees and a number of former franchisees who have left the network. Some important questions to ask them are the level of support given by franchisor, the level of training provided and the financial performance of their individual franchises.
The DD will also let you know about any litigation or disputes past or present so you will know if there are any serious issues between franchisees and the franchisor. Experience of directors Be sure to look at the experience of the directors and officers of the franchise. A franchise system that is run by professionals with years of management experience should be more secure than a franchise that has been operated for a short period of time or one where the directors do not have much experience in management or the nature of the franchise system. But you need to exercise your judgement as every system starts out small and sometimes even established networks can experience difficulties, retraction or even collapse.
An important issue when purchasing a franchise is the intellectual property. Some franchise systems do not own the trademarks they use, especially if the franchise is not yet well established. If no registered trademarks appear in the DD or if the trade marks have only been applied for and are not yet registered, this could mean that third parties are using similar trademarks which could compromise the business model and reputation of the franchise network. You should make sure that the system you invest in has exclusive ownership of the trademarks they use.
You should ask for access to the Operations Manual. The Operations Manual will often include the minimum performance criteria and other legal obligations, which you are required to comply with. Remember, a breach of the Operations Manual is also a breach of the Franchise Agreement and could lead to termination of your franchise. Therefore it is really important that you read the Operations Manual carefully. Franchisors are often reluctant to provide you with a copy of the Operations Manual before you sign the Franchise Agreement because it contains confidential information. However, you should be able to look at the Operations Manual at head office.
If you are purchasing an existing franchise, you need to check the details of any lease or licence agreement to make sure there is enough time left on the lease to get a reasonable return on your investment. A large number of franchisees have purchased existing franchises without realising there is only 1 – 2 years left on the lease. It is also important that you make sure there is no plan for demolition or redevelopment by the landlord. If the landlord needs you to relocate for redevelopment this would be very disruptive to your business and may mean you are left with large unexpected costs. The person selling their franchise should give you a Disclosure Statement which will have information about demolition and redevelopment. However it’s a good idea to contact centre management personally and confirm there are no plans for redevelopment that will impact your business for the rest of the lease.
Fit Out Costs
Fit out costs are also one of the most overlooked parts of a franchise. You should check with the franchisor whether the fit out costs are fixed or just rough estimates that could change at any time during the fit out period. If the costs are only estimates (as they often are), you should contact the fit out contractors directly to make sure you understand how the costs could change and make sure you have enough finance to deal with any unexpected increase. Some franchisees have been left with very large unexpected invoices during the fit out period and this has caused serious issues with their finance as they only borrowed enough money based on a lower estimated fit out cost. Franchisor interview Finally, your interview with the franchisor (or recruiters) should not just be one where you answer questions about your background and ability to run the franchise. It is also a chance for you to ask the franchisor questions about their business plans, the level of support they give franchisees and the details of training including where it will take place and what expenses may be involved.
Due Diligence and your Protection under the Franchising Code
Purchasing a franchise in Australia is an exciting opportunity however it is important that you do your due diligence so you’re comfortable with any decision you make. The Franchising Code of Conduct requires franchisors to recommend that you seek legal and financial advice. This is because it is understood that entering into a franchise is a serious investment and requires the input of legal and accounting professionals. If you choose not to take professional advice, you have to sign a statement saying that you’ve decided not to.
The Franchising Code of Conduct is there to protect you so it is a good idea to take the opportunity to speak to a lawyer and an accountant/business advisor who specialises in franchising. This could potentially save you thousands of dollars through negotiation of the Franchise Agreement and give you peace of mind that you’re making an informed and legally and commercially sound decision.
For over 30 years DC Strategy has been the region’s leading end-to-end franchise consulting, legal, recruitment and branding firm. Our multi-disciplinary team is committed to providing professional, practical advice and ongoing support to clients.
Christina Andrews is a lawyer in the law firm at DC Strategy who specialises in franchise documentation and franchisee reviews. She is also an experienced intellectual property lawyer.
Contact Christina on: P: 02 8220 8704
Ben Hemphill is a senior consultant involved in business development, strategic analysis, franchisee recruitment and client management. With experience in accounting, financial services and budget responsibility, he has a detailed understanding and hands-on experience in running and growing successful businesses. Ben has strong skills in building relationships with team members, clients, business partners and institutional stakeholders.
P: 61 2 8220 8714