How to Conduct Due Diligence when Buying a Franchise
Three specialist franchise experts – a business consultant, a lawyer and a recruiter each provide practical advice to guide you through the due diligence process of assessing a franchise purchase.
Even the phrase ‘due diligence’ can be intimidating especially when you know so much rests on getting it right when you’re buying a franchise business. Accountants and lawyers often use it to mean simply the investigation or appraisal of a business undertaken by a prospective buyer to evaluate its commercial potential.
Here the financial consultant, the lawyer and the franchise recruiter each examine why this is important and explain what you need to consider and do during this vital process.
Assessing and containing risk
For each of our three panelists, this is all about managing risk. The statistics tell the story: 4 out of 5 independent small businesses fail in the first five years and about half of them in the first year. In contrast, just less than 1 out of 5 franchise businesses fail in that period. So although that is definitely a significant decrease in risk – how do you reduce your chance of being one of the almost 20 per cent who fail?
Most franchisees buy into a proven business network rather than establish their own business because they want to improve their chances of being successful. However simply buying a franchise doesn’t ensure you will be!
Even in profitable networks, there are franchisees who thrive and others who struggle. So you need to gather as much information as you can to assess the opportunity, weigh up the variables and understand how YOU will manage the risk to the very best of your ability.
Yes, there are specific characteristics and concerns associated with certain sectors and industries. But whether it’s a retail, quick service restaurants (QSR), financial services, trades, professional, hospitality, IT, health and beauty, mobile or bricks and mortar, B2B or B2C business, our advisors will tackle the key issues to guide you through. They will show you how to evaluate the quality and value of the franchise you are considering, what processes you should follow and who to turn to for professional advice to best protect yourself when buying a franchise business.
A BIG Decision!
RECRUITER: With about 1400 franchise systems in Australia, the first question is probably: “which franchise is the right one for me?” Typically franchisees invest around seven years of their lives and many borrow quite heavily - often against the family home - to invest in their franchise. So there’s a lot on the line here.
CONSULTANT: I agree, so let’s look at commercial considerations in deciding first what kind of business you should buy and then, whether the business you are looking to purchase meets the criteria.
How much will you need to invest?
RECRUITER: Your investment will be your time as well as your money. QSR franchises can operate 12 or more hours a day, seven days a week. And here’s the most important thing: to be successful, franchising is an owner/operator proposition. So you need to be aware of how much time it will take to operate the business properly and whether this fits in with your other commitments - family and other obligations.
CONSULTANT: How much you can really afford? Work out the total investment including operating capital for rent, staff and operational costs until the business is profitable. Include interest on loans, your wage as an owner operator and the period it will take to recover your capital costs. Can you service your existing home, car, credit card or other loans and still maintain your lifestyle if you buy into a franchise business? It may take several months to build up enough turnover to make a profit or match your current income.
How do the financials stack up?
CONSULTANT: First up you will want some kind of business plan that includes financial data or a financial model, preferably a Profit & Loss statement (P&L) to figure out if the business is a sound financial proposition.
RECRUITER: Ask the franchisor what the numbers are based on – preferably other franchisees’ and/or corporate store performance.
CONSULTANT: Does the financial data you’ve been given make sense? Break the numbers down so that you know how many products or services you need to sell, 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 (ATP) or the number of clients they service a day. And ask for the average unit volume (AUV) or turnover of a range of businesses.
This will allow you to see if the financial assumptions in the data add up, and also whether the franchisor has a good understanding of their own business.
RECRUITER: You also need to figure out if a site will generate enough revenue. Let’s say you’re thinking of locating in a retail shopping strip or mall. Thursday night would be very different to Sunday morning, so visit at various times during the day and the week. Even the best franchise business concept won’t work if there is not enough passing foot traffic to make sufficient sales. And yes, that could mean sitting in a shopping centre and literally counting the number of people that walk past your intended site at different times of the day and on different days of the week.
CONSULTANT: Next you need to get a good understanding of the operating costs. As a rule of thumb, rent should not be more than 10 per cent of sales; cost of goods (COGS) about 30 per cent and wages no more than 30 per cent of turnover.
How do you figure out how much operating capital you will need?
CONSULTANT: This will vary from business to business. Operating capital is the amount of money you will need to cover your overheads such as rent, wages, utilities, cost of goods, loan repayments, franchise fees etc until the business starts to be profitable. And don’t forget your salary during that time so you can meet your rent/mortgage, school fees, etc and maintain an adequate standard of living. A QSR (fast food business) in a busy mall may only take a month or two, but in the financial services sector where revenue may be commission based – it may take 9-12 months. Be realistic about what the business can return, factoring in all the outgoings for as long as it will take to return a profit ensuring you can survive that period.
RECRUITER: Ask other franchisees in the network how long it took them to be profitable and estimate how long you could survive if the business didn’t turn a profit as quickly as you may have anticipated.
How will you calculate your return on investment (ROI)?
CONSULTANT: The next consideration should be the ROI. In simple terms, working on the numbers you have obtained and verified as closely as possible, how long will it take you to get back all the money you have invested? This includes any interest you may be paying on the loans you have taken to fund the investment in your franchise and the operational capital you put up. And remember the business will need to pay you a reasonable and fair salary during this period.
Generally the larger the investment, the longer the period to realise the return will be. As a very rough guide businesses under $100K should return the investment in 12-24 months. Businesses from about $180-400K should see the return in 2.5 to 3.5 years. Businesses from $500-$850K or so may take over four years and investment over the $1M mark may take five or more years. But the higher the investment, the higher you would generally expect your reward to be on an annual basis. An investment under $100K may return a $50-70K annual return whereas a $1.2M business may see annual returns of $250-400K.
RECRUITER: But be realistic! If you can service the debt, pay your interest and a reasonable wage, by the end of the first year – great, you have the foundation of a good business. Typically your business should grow most rapidly over the next 3-4 years and your ROI will maximise as your business becomes fully established.
CONSULTANT: That’s right. The aim is to pay down residual debt more quickly from this point and to be debt free in five years. So long as you understand the period and ensure the term of your franchise agreement (and your lease) are sufficient, not only to give you time to get your initial investment back but hopefully to build some capital as well as the eventual goodwill you will achieve when you sell.
LAWYER: Ideally the term of the lease should line up with the term of the franchise agreement which in retail or QSR is generally five or six years.
CONSULTANT: So if we take an average of about 3.5 years to see the return on the capital investment and franchisees average about seven years in any system, You should get the initial investment (plus your annual salary) back in your first average five year term.
LAWYER: So definitely look for a second five year term option in your franchise agreement as you’ll be a couple of years into that term when you may want to exit and crystallise the capital gain that is the reward for your hard work.
How much time can you truly commit?
RECRUITER: The successful franchise requires an owner/operator to be truly profitable. So be real about much time you have to invest and the amount of time that 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?
Running your own business impacts not only your lifestyle but also the lives of your family and may not work if you have a young family and a seven day business. Or are you looking for a part time opportunity to fit with children at school or a semi-retirement plan? There are many 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.
CONSULTANT: However, if you are looking for a part-time opportunity, be sure that the numbers you are working on to assess your returns relate to the amount of time you intend to work. For example, operators in a mobile food concept might be earning good revenue because they work on weekends and Friday evenings at sporting events and markets. But if you’re only looking to work on weekdays then break down the potential earnings from the financial data to calculate exactly what can earn in the hours you intend to work, and what proportion in the period you don’t, and still see if that is enough income for you.
Look for possible trading cycles and seasonality
CONSULTANT: Is the business seasonal; do sales vary significantly throughout the week/year? Are sales consistent throughout the day or are they focused on specific times? Knowing this will govern 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 or month or year.
RECRUITER: Yes, like ice cream and frozen desserts. In warm climates, revenue will not fluctuate as much from summer to winter as in a cold climate where there can be a significant drop off in winter sales. But provided the summer trading is profitable enough to cover the lower income months then the numbers should average out for the year to create a profitable business.
CONSULTANT: Or in some cases, the business may offer say a hot beverage range which may form 25 per cent or more of revenue in the winter months. So break the numbers down to each of the revenue streams and understand whether the fluctuations in trading still create an overall profitable business model.
Location, location, location
RECRUITER: The location of your franchise business will obviously affect the profitability and there can be significant variation between sales in units in the same network. This includes mobile as well as bricks and mortar businesses. Go to the site or suburb where you want to operate. Are potential customers in the area?
LAWYER: Do you have an exclusive operating or marketing territory in your franchise agreement?
CONSULTANT: Who are your competitors? Look carefully at the factors that have made the most successful operators profitable and what may be the factors for those who are less so. Is being in a mall or the high street, or near another high volume business or a seasonally based tourist attraction part of any business’ success?
RECRUITER: If it is a shop or premises, how far will you have to travel from your home? A couple of hours travel a day on top of your labour commitment could be a deal breaker after a few years. See if you can get an outlet in your district which also has advantages of being part of the community and market you know.
Always assess the documentation
LAWYER: A critical part of your due diligence is to examine every piece of information the franchisor provides as this should outline what you are purchasing and the terms. More on this later.
Check out the Operations Manuals
CONSULTANT: The Operations Procedures and Training 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?
LAWYER: What are your responsibilities to the franchisor regarding financial reporting, attendance at conferences and minimum performance criteria? Assess and consider whether all the tasks required match your skills and whether you can outsource the tasks that you are not good at, or don’t want to do. Ensure you have access to the Operations Manual and read every line as your ability to comply with the Operations Manual is generally part of your compliance with the Franchise Agreement. You may find that a breach of the Operations Manual may also be a breach of the Franchise Agreement and could potentially lead to the termination of your franchise. So it’s really important that you read the Operations Manual very carefully.
RECRUITER: 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 and note the sections relating to performance criteria and legal obligations
Assessing the brand and cultural fit
RECRUITER: Does the business match your experience and skills? Are you passionate about the industry, service and products? You need to be, as you are not only stumping up some serious money, you’re potentially committing seven years of your life! You need to believe in what you are doing to be really successful. Cultural allegiance drives performance so it’s important that you support and believe in the company’s values and are aligned with the founder’s vision.
CONSULTANT: Your genuine commitment to the brand will drive your employees’ commitment, your customers’ loyalty and ultimately your profitability. This applies to the franchisor and to the other franchisees - you want to work with competent people you respect and who are as dedicated to the brand’s success.
Assessing your own compliance
RECRUITER: A franchise is not a democracy. Yes, you have an opportunity to run your own business, but the reason you are buying into a franchise is to reduce the risk of establishing your own business.
LAWYER: You are buying access to franchisor’s intellectual property; their operational systems and procedures; brand and marketing; proven products, services and supply; and training and support. Your success is dependent upon your willingness and ability to comply fully with every aspect of the franchise business as outlined in the operations manuals and the franchise agreement. So understanding what that requires entirely and being prepared to comply operationally, legally and personally is fundamental to your success.
Get verification of everything you can
RECRUITER: The core of your due diligence is to ask questions and get answers! Speak with the franchisor (or recruiter) with any concerns and see what independent verification you can get for everything they tell you. Research the business on the internet, look up old press releases and stories, visit several outlets and watch how the staff and customers interact. Most importantly, speak with other franchisees, former franchisees (and even competitors of the franchise you are considering), to gain as much information as possible.
CONSULTANT: Other franchisees can tell you how training was provided when they joined and if it was sufficient. They can confirm whether it was available for their employees, at whose cost the training was provided and what ongoing access and support is available. They may verify financial performance: how long it took to become profitable, how much operating capital they needed, about seasonality, rents and staffing.
RECRUITER: Ask other franchisees about the franchisor (or recruiter) - what they are like to deal with for support and how responsive they are to individual franchisees. Speaking to a range of franchisees is useful as franchisees’ experiences can differ greatly and you want to get a balanced view of the franchise network.
The Franchise Agreement
LAWYER: You may get a stack of documents 10-12cm thick (seriously!), so let’s break them down and examine them one by one. It’s imperative that you (and your business partner/s) read every line in every document. Don’t be intimidated by the language. Get a highlighter and highlight anything you do not understand or agree with. Make notes on the margins with questions to ask your accountant or lawyer as you’ll get the best response from your advisors by being as proactive as you can in gaining that understanding.
The Disclosure Document (DD)
RECRUITER: 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.
LAWYER: The DD has a list of current and previous franchisees as well as their contact details. You should contact at least three current franchisees and a number of franchisees who have left the network and ask the questions outlined in the ‘Get Verification’ section above.
LAWYER: The DD will also let you know about any litigation or disputes past or present so you will know if there have been any serious issues between any of the franchisees and the franchisor.
Experience of directors
LAWYER: Look at the experience of the directors and officers of the franchisor. A franchise system whose operators have management skills and years of experience in their chosen or a related business is more likely to be secure than a business that has been operating for a short period of time or where the directors do not have much experience in management or business. You need to exercise your judgement as every system starts out small and sometimes even well-established networks can experience difficulties, retraction or in some cases, collapse.
Intellectual Property and Trade Marks
LAWYER: The intellectual property (IP) of a franchise business is fundamental to your due diligence as you are essentially ‘renting’ access to use the brand for the term of your franchise agreement. A trade mark is a key piece of the franchisor’s IP and you need to be certain the franchisor owns the trade mark in the relevant jurisdiction, especially if the franchise is not yet well established. It is important to check that any registered trade marks appear in the DD, and that you review the scope of protection which has been sought. If a trade mark has only been applied for but is not yet registered, this could mean a number of things. If this is the case, it is important to obtain legal advice as you want to be sure that the system you invest in has exclusive ownership of the trade marks and can grow the brand and the value of your (and their) investment.
IP Licence Deed
LAWYER: This document gives you the right to use the franchisor’s IP, so taking legal advice will ensure the trade marks and any other IP (for example any patents, designs or copyright) are in order.
Franchising Code of Conduct
LAWYER: You will also receive a copy of the Franchising Code of Conduct (commonly referred to as the Code). This document outlines all of the measures, guidelines and procedures the government regulator ACCC (Australian Competition and Consumer Commission) has provided that govern the way in which franchisors and franchisees conduct their business and their franchise relationship. You should read this document as well as it is important to understand your obligations and what recourse you and the franchisor will have in the (hopefully unlikely) event of a dispute.
RECRUITER: This is a mandatory document also provided with the agreements that give some broad information about franchising in general. It will be part of your learning journey as you decide whether a franchise business is for you.
CONSULTANT: 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
LAWYER: Yes, I’ve seen a number of cases where franchisees have purchased existing franchise businesses without realising there may be only 1-2 years left on the lease. When buying an existing business, you may need to arrange for the lease to be transferred (or negotiate a fresh new lease) and will also need to consider negotiating a further option term. Ideally the term of the lease should line up with the term of the franchise agreement which in retail or QSR is generally five or six years. If the franchise is an existing mobile business with a vehicle lease – check the terms of the vehicle lease and any renewal options for the same reasons.
CONSULTANT: It is also important that you make sure there is no plan for demolition or redevelopment by the landlord as relocating your premises for redevelopment even temporarily could be highly disruptive and possibly even permanently damaging to your business. It may reduce access to your customers and therefore your sales; it may incur large unexpected fit-out costs and ongoing operational costs such as re-printing brochures, modifying your website etc with your new location.
LAWYER: The person selling an existing franchise should also give you a Lessor’s Disclosure Statement which should have information about any plans for demolition or 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 duration of the lease. And if you do proceed with a lease in a centre where redevelopment is scheduled, be certain you, the franchisor, a leasing agent or your lawyer have negotiated adequate compensation and that the franchisor is party to that understanding.
A Head Lease and a Licence to Occupy
LAWYER: In many cases (such as large shopping malls) where a lease on premises will be required, the landlord (also referred to as lessor) does not lease directly to a franchisee. Instead, they require that the franchisor takes the (head) lease and grants occupancy rights to the franchisee. This may be in the form of a Licence to Occupy or a Sublease. In these circumstances, the franchisee will be responsible for the franchisor’s obligations to the landlord (for example, bonds, guarantees, payment of rent which the franchisee provides directly to the landlord). You should take professional advice that this is in order and your rights and obligations are clearly explained.
A Lease and a Step-in Deed
LAWYER: This is another lease arrangement you may encounter when leasing a premise to operate a franchise business. In this scenario the landlord grants a lease directly to the franchisee. Franchisors may request that the landlord enters into a step-in-deed with the franchisee and the franchisor. The deed provides that the franchisor has the right (but not the obligation) to have the lease transferred to the franchisor (to take over or ‘step-in’) in the event that the franchisee abandons the business or their franchise agreement expires or is terminated. Again, take professional advice so that you understand your rights and obligations.
Fit Out Costs
CONSULTANT: Fit out costs are often overlooked in the due diligence phase and can lead to a major fall-out between the franchisor and franchisee before the business is even launched. 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), contact the fit out contractors directly to either pin them down to a contractual arrangement for the fit out or manage how the costs could change and ensure you have enough money to deal with any possible increase. Some franchisees have been left with very large unexpected invoices during the fit out period which has seriously impacted their financial capacity to launch and operate the business as they did not have access to more funds.
LAWYER: It is a good idea to check the Disclosure Document (DD) in relation to Establishment Costs and see if this is broadly aligned with the fit-out costs quoted. The DD may have a range (as there may be different layouts depending of the franchise location) but try and pin the franchisor and their contractors down contractually on costs, the time frame and who will be managing the process.
What happens at the franchisor interview?
RECRUITER: 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. It is also an opportunity to understand their vision for the brand and the culture of the network to see if your values are aligned.
Protection under the Franchising Code of Conduct
LAWYER: The Franchising Code of Conduct requires franchisees to seek independent advice from a legal adviser; a business adviser; or an accountant. Franchisees are required to provide a signed statement to the franchisor prior to entering into the franchise agreement confirming that they have sought the advice from the relevant advisers (either signed by the advisers or signed by the franchisee). If you choose not to engage any of these adviser(s), the Code requires you to provide to the Franchisor a signed statement that you have been told to seek that advice but have decided not to. This underscores the serious nature of the relationship between you and the franchisor.
CONSULTANT: But you wouldn’t buy a house without professional input such as a building or pest report or without engaging a professional conveyancer/lawyer to handle the contracts. Buying a franchise is no different – it is simply common sense to pay the relatively small amount to engage professionals to assist and protect you. Be certain to get the commercial and legal advice in writing and try to negotiate a fixed fee for the services.
Understanding and Managing Risk
CONSULTANT: The commercial, legal and screening processes outlined above give you systematic guidelines about how to conduct your due diligence from the period where you are considering buying a franchise to the final execution of the legal documentation. It is quite simply gathering and assessing as much information as you can to evaluate the risk of going into that business and deciding if it acceptable or not.
RECRUITER: Although buying a franchise is less risky than starting up a business on your own, there is no guarantee that your franchise business will be a success based solely on the fact that it is a franchise.
LAWYER: The Franchising Code of Conduct is there to protect you so speak to a lawyer and an accountant/business advisor who specialise in franchising. Not only could it save you thousands of dollars in potential litigation, it will assist you in negotiation of the Franchise Agreement and give you the peace of mind that you’re making a legally informed and commercially sound decision.
This editorial appears in the 11th issue of Business Franchise Guide.
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