Avoiding a nasty surprise

By Sarah Stowe | 29 Oct 2015 View comments

Surprises are great _ the unexpected Christmas or birthday present that is just what you needed, some flowers or even finding some money on the street. But getting surprises when you’re in a franchise is rarely this kind of uplifting experience. The best way to minimise nasty surprises is to make sure you do your due diligence before you get into a franchise. Whilst it might sound complicated, due diligence simply means making sure you know all that is necessary to make an informed decision about the business you’re investing in, and are able to confirm what you’ve been told by the franchisor.

But for many who are thinking of getting into franchising, due diligence sounds like a lot of complicated hard work. It neednÍt be. Here is an outline of what you should look for, the work you need to do and the type of questions you need to ask before getting caught up in the excitement of investing in the business you believe will provide your future prosperity.

Read and learn
The first and most important thing is to educate yourself. Recent franchising research found that 49 per cent of franchisees relied heavily on their gut feeling when deciding to go into franchising. Twenty-nine per cent of the franchisees surveyed did not seek advice from a lawyer before purchasing their franchise, while 34 per cent felt they should have been more diligent when gathering information before entering into the agreement.

The study also found that nine per cent of franchisees did not understand the terms of their franchise agreement or other related documents, but still went ahead and purchased the franchise.

To help educate franchisees, particularly those seeking to enter the market for the first time, the ACCC, in conjunction with Griffith University, is offering a short, free, pre-entry franchisee education program.

You can also read some of the ACCCÍs franchise information such as the Franchisee Manual or the Franchisee Start-up Checklist. Reading this checklist and following all the steps is a good start to ensuring you have all the information youÍre supposed to get and have considered a wide range of factors about the business you’re thinking of taking on.

It is also important to talk to professional advisors (solicitors, financial advisers and accountants) who can provide invaluable assistance. For example, they can guide you through the finer points of contracts or the complexities of franchise finances.

Check the basics
There are also a number of factors you should consider as part of your due diligence, before you even get to a disclosure agreement about a particular franchise.

It can be easy, when caught up in the excitement of a new business opportunity, to forget to check basics like customer base and opportunity for expansion. Is the business in a good location, with plenty of visibility, or is it, for example, the smallest coffee shop in a row of coffee shops? Considering the market and potential future market is critical.

Investigate the franchise territory _ is it exclusive, non-exclusive, do you get first option on additional franchises in the area?

What will the leasing arrangements be? Rental costs can be one of your most significant ongoing costs. The ACCC has a checklist for franchisees looking at signing a new lease agreement.

Where possible, seek work experience with the relevant business before signing, to see if their expectations meet with the reality.

Find out about the costs you will be paying. For example, in addition to providing an initial capital investment, franchisees pay ongoing royalties to the franchisor as well as other costs such as marketing. If you can, analyse profit and loss statements or annual reports if they are available.

Other factors that prospective franchisees should be aware of include the finite nature of the franchising relationship. A franchise agreement is a license to operate a franchise for a defined period of time. Depending on the circumstances, parties may agree not to renew an agreement, it could be terminated, or the franchise outlet could be sold to another party.

Not all franchises are compatible with peopleÍs lifestyles. Running a small business, including a franchise, is time consuming and may involve long hours.

Agreement and disclosure documents
There are a number of compulsory disclosure requirements under the Franchising Code which are designed to assist franchisees in making informed decisions.

Under the code, a franchisor, at least 14 days before a franchisee enters into, renews or extends a franchise agreement, must provide:

  • a copy of the code;
  • a disclosure document; and
  • the franchise agreement in the form it is to be executed.

Some of this information provided as part of the disclosure document includes the relevant business experience of the franchisor, details of certain legal proceedings against the franchisor or one of its directors and the franchiseeÍs costs to start operating the business and other payments to the franchisor. Also in the document are details regarding the processes at the end of the agreement _ ie whether the franchisee has an option to renew or sell the business, and whether there are confidentiality obligations that may be imposed on the franchisee.

The disclosure document also contains contact details of current and past franchisees.

Prospective franchisees should contact as many current and past franchisees as possible and ask them a range of questions. This provides the best opportunity to ask some questions of franchisees with experience in the franchise business.

Questions to start off this conversation could be how many hours do you work and are you earning what you expected? It is worth finding out if they have had any disputes with the franchisor and if so, whether they were resolved. What training and support was received? Prospective franchisees can also ask, if you had a choice again, would you buy into the business?

Additionally under the code, the franchisor must provide financial statements including a signed statement that there are reasonable grounds to believe the franchisor will be able to pay its debts; and financial reports for the past two financial years, unless a directorÍs statement is supported by an independent audit.

Consider carefully any representations made by the franchisor about potential earnings. For example, if the franchisor claims that $2000 per week could be earned with a billing rate of $50 per hour, it would seem the franchisee would need 40 billable hours to make that amount.

However taking into account other factors such as time, costs of travelling, ordering supplies, marketing and account keeping, to actually earn $2000 per week it may actually take 80 billable hours.

During the disclosure stage, prospective franchisees have the opportunity to evaluate information about the franchise business and deal with any areas of concern.

If these areas cannot be resolved with the franchisor by negotiation, the franchisee has the option not to enter into the franchise agreement.

A franchise agreement is a legally enforceable contract between the franchisee and the franchisor. Franchisees must understand their rights and obligations under the agreement before they sign. You are entitled to a seven day cooling off period after signing a franchise agreement. You also have a number of ongoing rights to certain information from the franchisor.

A final warning
Before we finish with due diligence, there is one more very important thing that due diligence may find – the scam franchise. These can be ïget rich quickÍ businesses promising high returns quickly, and usually come with some other warning signs. This might be a reluctance to provide written information, a requirement for an upfront payment before releasing information, or providing inconsistent financial information. If you see these signs when conducting your due diligence, walk away as this is not a business opportunity, it’s a scam.

There is no substitute for proper due diligence. While some surprises in business are unavoidable, there is no need to be surprised by some things, especially if information about that part of the business is easily obtainable by reading the franchise agreement, doing some simple research or by asking a few questions of an advisor and those experienced in the business. You should, in short, know and be prepared for what you’re in for.