What do you need to know about capital expenditure for your franchisees?

In 2015, the Franchising Code of Conduct (Code) was amended to limit the circumstances in which a franchisor can require a franchisee to incur significant capital expenditure.

The amendment was made to address concerns that some franchisors were imposing unreasonable requirements in relation to significant capital expenditure, which were poorly planned and executed by the franchisor and/or meant that the franchisees were not able to recoup their capital investment due to the insufficient term remaining under  the franchise agreement.

What the rules say about franchisee capital expenditure

Under clause 30 of the Code, a franchisor cannot now require a franchisee to incur significant capital expenditure unless:

1. the expenditure has been disclosed to the franchisee in the disclosure document that is given to the franchisee before entering into or renewing the franchise or extending the term or scope of the franchise agreement;

2. the expenditure is to be incurred by all or a majority of franchisees, and a majority of those franchisees have approved it;

3. the expenditure is required to comply with legislative obligations (eg. health and safety laws);

4. the franchisee agrees to the expenditure; or

5. the franchisor considers the expenditure necessary as capital investment in the franchise business and is justified by a written statement given to each affected franchisee of the rationale for making the investment, the amount of expenditure required, the anticipated outcomes and benefits and the expected risks associated with making the investment.

What is significant capital expenditure?

Other than to state what it excludes, the Code does not define “significant capital expenditure”.

In practical terms, significant capital expenditure usually includes the acquisition of fixed assets such as the refurbishment of a franchisee’s business premises or upgrades to equipment such as point-of-sale systems. It does not include non-capital expenditure such as operating expenses (rent, insurance, wages etc) or non-significant capital expenditure such as ongoing maintenance costs.

The obligation to incur significant capital expenditure and the estimated amount of such expenditure is often foreseen and disclosed by a franchisor to prospective franchisees in the disclosure document. For example, the obligation to refurbish a franchisee’s business premises is usually required under the terms of the premises lease.

However, there can be instances where such expenditure may be unforeseen and therefore not disclosed in the disclosure document. For example, this may occur where there is an unforeseen change in technology which requires the business to acquire and use that technology in order to remain viable.

This possibility is increasing with the fast pace of change and the number of businesses facing disruption. In some cases, affected businesses will need to invest in order to survive. A good example of this is innovations in food delivery which are having a significant impact on food franchise businesses.

Comply with capital expenditure rules

In general terms, in order to comply with the requirements relating to significant capital expenditure, franchisors must:

1. Ensure the franchise agreement entitles the franchisor to require franchisees to refurbish the business premises, upgrade or acquire new equipment or otherwise incur the relevant significant capital expenditure. Franchisors should review the franchise agreement clause by clause to ensure that every possible requirement is included.

2. Disclose all foreseen significant capital expenditure in the franchisor’s disclosure document. The information disclosed should be meaningful and as precise as possible. For example, it is not helpful to disclose that a premises refurbishment may cost between $0-$500,000. Franchisors should be able to disclose approximately when the expenditure will be required and a meaningful range of expected costs which can be referable to the size of the premises or other relevant factors. It can also be noted that costs may be different at the time when the expenditure is required to be incurred.

3. Regularly (at least annually) review the costs in their disclosure document to ensure they accurately reflect current actual expenses and include all possible costs to be incurred.

4. Regularly communicate with franchisees as to what significant capital expenditure will be required in the future, why it will be required, when it will be required and how franchisees can prepare and budget for this. Franchisors could also consider assisting franchisees with budgeting for the expense by seeking contributions from suppliers, applying rebates to such costs or imposing a voluntary levy which would be applied to such costs when due.

5. Ensure the franchisor has done adequate due diligence and prepared a business case for the expenditure. This should include a cost benefit analysis and risk management assessment. Franchisors have been criticised for failing to do this because it is not the franchisor’s money that is being invested. Franchisors should also ensure the proposed change which requires the expenditure has been properly and adequately tested before requiring franchisees to incur the relevant expenditure.

6. If the proposed significant capital expenditure has not been disclosed in the disclosure document, agreed by a majority of franchisees or is a legal requirement, the franchisor must prepare and give each affected franchisee a written statement of the rationale for making the investment, the amount of expenditure required, the anticipated outcomes and benefits and the expected risks associated with making the investment.

7. Be flexible in regard to applying requirements to incur significant capital expenditure. For example, consider not imposing the requirement if a franchisee will not have adequate time to recover their capital investment due to the insufficient remaining term of the franchise agreement. Also consider timing expenditure requirements to coincide with other requirements, such as landlords’ requirements.