Hoping won’t make it so – the need to do due diligence when you buy a franchise

By Sarah Stowe | 05 Oct 2018 View comments

When you start looking into buying your own business you will hear the phrase “due diligence” – it sounds important and it is.  It just means doing research and investigation about the business you are looking into.

If you were buying a house you would inspect the house thoroughly, get a pest and building report, check the prices of similar properties and have your lawyer do the usual council and title searches before you handed over the money.

Franchised businesses are a significant expense and you should take your time to do the research and get the expert reports and advice as you would with buying a house.

There is a lot of advice online with checklists and questions to ask when assessing a business or a brand. Google is your free personal research assistant and online resources such as Franchise Ed (www.franchise-ed.org.au) are a great start.

An experienced franchise lawyer and accountant will also be able to help you assess the business and the franchisor. Time and money spent now can save you from making a serious mistake. Some franchises (particularly retail ones) cost as much as a house and yet many people do very little research or get no advice.

Essentially you are assessing the degree of risk associated with your proposed purchase and considering if there are ways to limit the risks and whether you are comfortable with the risks you have identified. Some people are more comfortable with a higher degree of risk and may choose a new brand or a “greenfield” site. Others will want to see an established  history of trading figures for the actual business they are buying.

While the franchisor will be interviewing you and assessing your potential as a franchisee you are also assessing the franchisor, its brand and the suitability of the franchise for your needs.

Financial due diligence

Do the numbers stack up? If you have actual trading figures take them to an accountant or financial advisor with small business experience. Ask questions about the expenses and the sales/turnover. Try and verify what you can. For example, does the wages amount include a salary for the owner working in the business? How many staff hours at what hourly rate does it represent? Check this against the award rates and staffing levels. Is the profit enough for you to recoup your investment within a reasonable time (taking into account a salary for you and paying loan costs)?

If the site has never traded then you may be given figures for comparable sites but you should ask if these are actual figures of real businesses or “averages” or “adjusted” figures.

A lot more investigation should be undertaken in this case and you should speak directly to other franchisees with similar sites to understand if their experience matches the figures provided.

Legal due diligence

The Franchising Code of Conduct requires the franchisor to give you a disclosure document and a franchise agreement at least 14 days before you sign. Reputable franchisors will have no problem with giving you the documents well in advance of this.

Do not be rushed or pressured into signing. Read everything and take your time. The franchise agreement may be more than 100 pages long but it is important that you know what is in it. Mark everything you don’t understand to ask your lawyer.  It is worth paying a franchise lawyer for an hour or so to go through the documents page by page to explain it to you.

The disclosure document contains some extra information not in the franchise agreement. It will have a history of the franchisor and its directors and summarise some of your rights and obligations such as territorial limits.

It will contain information on terminations or transfers within the system in the last three years and the contact details of current and past franchisees.  This information is given so that you can contact any of them and ask their view of the franchise system and franchisor. Choose a random selection and call them. The Franchise Ed website has a list of potential questions you could ask.

Leases

If it is a retail business you will likely have a lease for the premises. The terms may be already agreed by the franchisor with the landlord but you should at least be satisfied that you understand the commercial terms and the remaining lease term is sufficient. If not you may need to negotiate a further option or extension.

Retail landlords are required by law to provide a lessor’s disclosure statement and you should ask for a current copy if it is not provided. It will give you details of the outgoings budget if applicable and information about any redevelopment plans for the shopping centre.

Always introduce yourself to the centre manager and ask relevant questions about the centre, customer traffic, any new tenants or changes planned. Neighbouring tenants are also a good source of information.

Many sad stories we hear of business failure or people choosing a business which is not suitable for them or their risk profile could have been avoided if those people had taken the time to do the research, ask the right questions and take the steps to ensure that they enter the transaction with their eyes open.

Crossing your fingers and hoping for the best is not sound business practice and the surprises you receive may not be the ones you wished for!