10 top tips for prospective franchisees

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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 types 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. So to make sure an informed decision is made as to the most viable structure, both legal and accounting/tax advice should be sought.

2. CONDUCT DUE DILIGENCE

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; and any current or threatened legal proceedings against the franchisor -.
  • the total amount the franchisee will need to invest in setting up the franchised business.
  • 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.

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 relating to the particular location.

Even if the franchisor has signed a lease with the landlord, a prospective franchisee should still seek legal advice; as the franchisee will, 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 FRANCHISOR MEETINGS

A prospective franchisee should take comprehensive notes in each meeting or discussion with the franchisor or its representatives both before and after 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 years later.  If a promise, representation or concession has not been recorded in writing it will be difficult to prove it later.

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 enquiries should include:

  • how the actual set up costs compared to any estimates provided by the franchisor;
  • whether or not 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;
  • what is the relationship between all the franchisees within the franchise system; and
  • where a franchisee has left the system the reasons for the franchisee leaving the system.

6. REVIEW THE KEY DOCUMENTS

According 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.

Among the suite of documents a prospective franchisee may be asked to sign there could be the following additional items:

  • 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 (under  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.
  • where a prospective franchisee is buying an existing franchised business from another franchisee, there will be a contract of sale of business.

All these documents must also be carefully read and understood by the prospective franchisee who should again seek professional (legal and accounting) advice.

7. REVIEW THE FRANCHISE AGREEMENT

The franchise agreement is the most important document as it will govern the legal relationship between the franchisor and the prospective franchisee for the duration of the term of the franchise.

There is no substitute for a prospective franchisee reading the franchise agreement itself and seeking legal advice.  A franchise agreement is usually a long term agreement that does not allow much scope for a prospective franchisee to later withdraw from it.

Some of 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 existing 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 sign a new franchise agreement on the franchisor’s current terms, which again differ from the terms of the original franchise agreement.  If the financial terms have changed (for instance, 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.

8. COOLING OFF

One important matter that is often overlooked is that once a franchise agreement has been signed or money has been paid under the 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.  This cooling off right does not apply upon renewal, extension or transfer of a franchise agreement.

If the prospective franchisee exercises its cooling off right then under the Code, the franchisor must refund all money paid under the franchise agreement, less a reasonable amount for costs incurred. 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 carefully consider 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 before signing any franchise agreement.

10. CONSIDER THE COSTS

In addition to set up costs amongst the types of other 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(subject to retail legislation providing otherwise) the landlord's legal costs associated with the lease documents;
  • the franchisee's own legal and accounting costs.

Raynia Theodore is a principal at Mason Sier Turnbull Lawyers, which is one of the leading law firms providing legal services to the franchising sector.  Contact Raynia on (03) 8540 0200.

Images: Thinkstock

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