The new Franchising Code of Conduct, which commenced on 1 January 2015, has altered the rights and obligations between parties in relation to end of term arrangements.
This article focusses on the transfer rights and obligations when a franchisee sells their franchise business.
Transfer Rights and Obligations under the new Code 2015
Clause 24 of the Code, provides that a franchisee can request, in writing, the franchisor’s consent to a transfer which must be accompanied by all information that the franchisor would “reasonably require and expect to be given” to make an informed decision.
The information to be provided is not specified in the Code and therefore common sense should prevail. If the franchisor requires further information before making an informed decision whether to consent to the transfer, the franchisor can (in writing) request that further information from the franchisee.
A franchisee cannot assert a franchisor is acting unreasonably or withhold consent if the franchisee does not provide the requested information to the franchisor. The franchisor must advise the franchisee in writing whether it gives its consent or not.
If consent is not given in that period (42 days), the franchisor must give reasons why. If consent is given, the franchisor must indicate whether the consent is subject to any conditions.
The franchisor must not unreasonably withhold consent to the transfer of a franchise.
The new Code provides a positive obligation on both parties to act in good faith. Acting in good faith is determined by whether a party acts honestly and not arbitrarily, and cooperates to achieve the purpose of the agreement.
This is balanced by clause 6(6) of the new Code, which provides that a party is not in breach of their obligation to act in good faith by acting in their own legitimate commercial interests. The key word is “legitimate interests”.
A franchisor can reasonably withhold its consent in various circumstances under clause 25(3) as follows:
(a) the transferee is unlikely to meet the financial obligations under the Franchise Agreement. For instance the franchisee does not have sufficient working capital to acquire the business or is too highly geared.
(b) the transferee does not meet a reasonable requirement of the Franchise Agreement for transfer this is open to broad interpretation.
(c) the proposed transferee does not meet the selection criteria of the franchisor. This may relate to the requirement to speak the language, and other reasonable criteria to conduct the business such as licenses or qualifications.
(d) the transferee does not agree in writing to comply with the obligations. The transferee cannot seek to renegotiate the terms and seek concessions from the franchisor. If it does so, the franchisor can refuse to consent to the transfer.
(e) the franchisee has not paid or made reasonable provision to pay amounts owing to the franchisor.
(f) the franchisee has not remedied a breach of the Franchise Agreement.
(g) the franchisor has not received from the transferee a statement that they have received, read and had a reasonable opportunity to understand the Disclosure Document and the Code.
The above are not the only circumstances where a franchisor’s consent can be reasonably withheld. There may be other legitimate reasons for a franchisor to refuse consent.
If the franchisor does not respond to the request for consent within 42 days of:
• the date the request is made; and
• the date the last of the further information is provided to the franchisor;
the franchisor is taken to have consented to the transfer. Franchisors must therefore give this their attention and ensure they respond within the 42 day period and diarise the date of request.
The franchisor may revoke its consent within 14 days (in writing) giving reasons why consent has been revoked. This is only where it has given its consent within the 42 day period. The franchisor must not unreasonably revoke its consent. The circumstances set out in clause 25(3), maybe reasonable circumstances for consent to be revoked.
End of term arrangements under the new Code
Clause 18 requires a franchisor to give notice (in writing) to the franchisee not less than six months before the end of the franchise term whether it intends to extend the Franchise Agreement or enter into a new Franchise Agreement. A failure to do so carries a civil penalty of 300 penalty units, which equates to approximately $8,800 which can be imposed by the ACCC.
Importantly, under clause 18.3, the franchisor’s six months’ notice must state that the franchisee may request a Disclosure Document under clause 16.
The failure to extend the franchise term may have a significant impact on the franchisors right to enforce any restraint of trade provision against the franchisee.
What does this mean to franchisees?
• The Code does not give the franchisee a right to transfer the Franchise Agreement. It is often assumed that such a right exists. It is important to ensure that these rights do exist in the Franchise Agreement.
• The process of transfer involves balancing the rights between the franchisor to legitimately protect its interests, brand and reputation against the rights of the franchisee to sell its business and recoup any goodwill it has generated from their efforts.
So, is there a good time to sell your franchise in light of the new Code arrangements? Franchise Agreements are for different terms. The Code does not regulate what term should be offered. A franchise right can be granted for 12 months (or less), 3 years, 5 years or 20 years.
There may be options, but there is no right to an option. There is no obligation in the Code for a franchisor to grant an option to the franchisee, save for the new obligations under Clause 18.
As with any business, it takes some time to settle into and generate the returns and rewards that one might expect. Most business plans provide for a return on investment within, say, three years as the upfront capital costs are generally amortised over the first two to three years.
Selling a franchise within the first two to three years is not ideal and is likely to crystallise a loss to a franchisee on its investment. It is unlikely a franchisee will be able to recover any goodwill in that period as it has not had enough trading history. Attempting to sell your franchise business within the last two years of the term, is also likely to impact on a franchisee’s ability to recover any goodwill as any good will be tied to the term left to sell.
It is often the case that the lease term may not coincide with the term under the Franchise Agreement and one or the other may affect the value of the business.
So when is the best time to sell my business?
Although the new Code has sought to address the imbalance between franchisors and franchisees, in relation to the ability of a franchisee to maintain its business as a going concern towards the end of the franchise’s term, it will be interesting to see how matters develop in the future.
Although the franchisor must indicate to a franchisee whether it will extend the term or enter into a new Franchise Agreement, the risk still remains for a franchisee that a franchisor may not extend the term. If the history between the franchisor and franchisee was difficult or the franchisee had been in regular default through the term it is unlikely the franchisor will want the franchisee to remain in the system.
If the term is not extended and other circumstances set out in clause 23 of the new Code exist, the franchisee will be free from the restraint of trade provisions (unless the franchisor has made a genuine payment of compensation to the franchisee). The franchisee could then continue operating in competition with the franchisor without using the franchisor’s brand, confidential information and intellectual property. The best time to sell a franchise business is shortly after a renewal of the Franchise Agreement, whilst there is a reasonable term left.
Selling your franchise business
The process of obtaining the franchisor’s consent and selling a franchise business is a complex matter and usually involves a number of parties including landlords, their agents and lawyers and the franchisor’s lawyers.
Preparing to sell a business takes considerable planning. Ensure that you are up to date with your payments to the franchisor and landlord, and that your financial returns are up to date and accurately reflect the financial position of the business.
It would be unreasonable to expect a franchisor to be cooperative and provide consent to a transfer if you are in default of your obligations at the time of your sale. The franchisor may also have a first right of refusal which needs to be dealt with. So communicate with the franchisor well before placing your business on the market for sale and tidy up any outstanding issues with them.
Engaging an experienced franchise lawyer and your accountant early in the process is essential to guiding you through the process.
Costs of selling your franchise business
Before engaging an agent or broker, factor in the costs of sale and exit fees so these can be taken into account in your negotiations with the buyer. The cost of selling your franchise can be considerable and include the following:
(a) business agents commission and advertising;
(b) landlord’s legal costs and agents costs to approve the incoming franchisees;
(c) the franchisor’s costs of providing consent – this can be a fixed fee or expressed as a percentage of the gross sale price and expressed as a “Transfer Fee”;
(d) any capital gains tax liability to you on sale of the business; and
(e) your own legal and accounting costs – often underestimated.
In addition to the above direct costs, there are the indirect costs of your time and attention and stress of going through the transaction process and don’t forget you may also recover any security deposit or bank guarantees you provided to the landlord or franchisor.
• Plan to sell your business and get your house in order before you go to market.
• Seek early expert advice from your franchise lawyer and your accountant well before you go to the market.
• Ensure you have your documents in order, up to date and available including employment records; material contracts, licenses, permits, lease documents and financials to enable the purchaser to undergo their due diligence efficiently.
• Don’t accept the first purchaser that may come along! Do your due diligence on the buyer just as the buyer will do their due diligence on you.
• Be prepared for disappointment as it often takes two or three buyers before you find a purchaser that will actually stick.
• If you don’t think the purchaser is suitable to operate the business, it is unlikely the franchisor or landlord will.
• Do they have the finances necessary to acquire the business? Do they need to obtain finance? If so, how much? Do they need to make an offer conditional on finance? Will they likely be approved by the landlord?
• It is always preferable to enter into a sale which is not conditional on finance.
• If you have to offer vendor’s terms to sell the business; will you hold any security? Will you be prepared to go back into the business if the purchaser defaults?
By asking these questions at the earliest opportunity you may save yourself considerable time, cost and disappointment.
Robert Toth is a Partner of Marsh & Maher Lawyers, with over 30 years of experience in franchise law. He is an Accredited Business Law Specialist with expertise in franchising, licensing and distribution and franchise dispute resolution (acting for both international franchisors and franchisees).
T: 03 9604 9400