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MAKING A FAIR DEAL

by Maurice Walker, Peter Woods and Janine McCartney,
last updated 23/07/2009

Maurice Walker, Peter Woods and Janine McCartney discuss the ways franchisors and franchisees should communicate before any franchise is sold in order to avoid later disappointment

'If it sounds too good to be true, then it probably is.' That's the message for both franchisees and franchisors when it comes to pre-sales discussions. 

Currently, the most common cause for litigation between franchisors and franchisees arises from statements and representations made by the franchisor during discussions and negotiations for the sale and purchase of the franchise. The franchisor will try to make the franchise package as attractive as possible for the franchisee. The franchisee will be looking for information on which to base their decision to purchase.

However, if a franchisor makes representations which are wrong or untrue and the franchisee relies on them, the franchisee will be able to claim for misrepresentation and recover substantial damages for any losses suffered.

There have been two recent cases concerning misrepresentation - Valda Video Limited v United Video Franchising Limited and Dillon Holdings Limited v Stirling Sports Franchises Limited. These cases provide a very useful insight into the pre-contractual discussions and negotiations between franchisors and franchisees. As will be shown below, the facts in these cases are not unusual and a number of lessons can be learned from them.

Valda Video Limited v United Video Franchising Limited

In this case, the franchisor provided the franchisee with a document containing estimated operating costs. It set out the figures for weekly turnover, cost of sales, gross profit, operating expenses and the net profit before interest and tax. The weekly turnover was stated to be $10,000.

United Video claimed they had given the franchisee a written disclaimer relating to the financial projections. They claimed it stated there was no guarantee the franchise would achieve the figures projected and that those figures should not be relied upon. They also claimed it advised the prospective franchisee to make their own independent enquiries and that United Video would not be held responsible for any losses based on the projections provided.

When the store opened, it achieved an actual turnover of $4,000 to $5,000 per week which was less than half of what had been predicted.

United Video could not produce any evidence that the disclaimer had been given to the franchisee.

An experienced United Video franchisee gave evidence as to how he would assess the likely turnover for a franchise. He told the Court he would obtain population figures and examine location, including traffic flows, competition and demographic considerations. He would then calculate the potential earnings in the area based on his assessment of expected earnings per household.

The Court decided that United Video had represented there was a proper factual basis as to the turnover figures given to the franchisee and that a turnover of approximately $10,000 per week could confidently be expected. In reality, United Video had no factual basis for their turnover figures. They had not undertaken any of the activities which had been given in evidence as being necessary to establish proper projections.

The Court found that the franchisee had relied on the representation as to turnover and that it was a material factor in persuading the franchisee to sign the franchise agreement.

The Court awarded damages of $552,990 to the franchisee for the misrepresentation by United Video. The damages were calculated to put the franchisee in a position they would have been if the representation had been true.

 

Dillon Holdings Limited v Stirling Sports Franchises Limited

In this case, the franchisor gave the franchisee turnover estimates for a proposed new franchise of $700,000 for the first year and $850,000 for the second year. The estimates also included a 39% gross profit margin assumption.

Although the shop achieved a 39% gross profit margin it failed to reach the turnover figures contained in the estimates.

The franchisor had based their representations as to turnover after:

1 Becoming familiar with the local market

2 Discussions with other operators

3 Contacting wholesalers who gave them information about the goods sold in the area 

4 Assessing market share which the store could capture based on their experience from their other stores

5 Obtaining local data which included foot traffic statistics and census figures 

6 Forming a view on the local economy

7 Looking at the average figures of 26 stores of the 41 in place 

 

The Court accepted that the representations as to turnover and profit were based on reasonable assumptions and therefore accepted that there had been no misrepresentation by the franchisor.

Different Methods

The assessment undertaken by Stirling Sports to evaluate their turnover estimates was based on criteria different from those which the Court considered appropriate in Valda Video. This shows that there are different methods for predicting turnover. As long as a franchisor can show any projections or predictions are based on an extensive investigation and reasonable assumptions, they are unlikely to have been guilty of misrepresentation.

Tips for Franchisors

From the different outcome of these two cases we can offer the following tips for franchisors.

1. Proceed with Caution

Be careful about the statements you make to franchisees. Back up any representations with factual information or data. Assumptions made must be reasonable having regard to the factual information or data on which they have been based.

2. Take Notes

Take notes of all meetings with prospective franchisees. Make sure you retain these notes and that they are an accurate record of what was said and agreed.

3. No Promises

Do not make any promises. When discussing financial turnover and profit projections, have evidence available to back them up and keep copies on your file. Tell the prospective franchisee you are not making any promises.

4. Success and Failure

Stress the reality of success and failure. Make it clear to prospective franchisees that success or failure will depend on how good they are at operating the business. Although the franchise provides a very good basis on which to run a successful business, it is not a guarantee. Emphasise what is required and expected of a franchisee to make their franchised business successful.

 5. Independent Enquiries

Encourage the franchisee to make their own enquiries about the franchise. Get them to talk to other franchisees and encourage them to obtain independent legal and accounting advice. Give them a list of all franchisees and do not make any suggestions as to which franchisees should be approached. Leave it to the prospective franchisee to make that choice.

6. Schedule of Documents

Keep copies of all documents which you give to prospective franchisees and record the date, time and circumstances in which you gave them.

7. Evidence of Independent Advice

Insist on the franchisee taking independent advice from a lawyer and accountant who have experience in dealing with franchises. Obtain a certificate from the franchisee's professional advisors stating they have advised the franchisee and that the franchisee has not relied on any representations made by the franchisor.

8. Separate Disclaimer Document

In the Stirling Sports case the Court accepted it was not unreasonable for a franchisor to set out to protect itself against allegations of misrepresentation. It is worth considering the use of a separate disclaimer document. Ask the franchisee to sign the disclaimer document prior to entering into the franchise agreement. The Court clearly indicated that a disclaimer should be brought to the attention of the franchisee at an early stage in the discussions and negotiations, and that it was preferable for it to be a separate document rather than part of a lengthy franchise agreement.

9. Tailor the Agreement

Make sure the franchise agreement is relevant to the particular franchise which you are offering and clearly defines the nature of the franchise and the relationship between you and the franchisee. In the Stirling Sports case the Court made it clear that if franchise agreements and other documents relied upon by the franchisor do not accurately reflect the nature of the franchised business and the relationship between the franchisor and the franchisee, it will be difficult for a franchisor to rely on any clauses which exclude the franchisor's liability for misrepresentation.

 Tips for Franchisees

Just as there are lessons for franchisors in the two cases, so prospective franchisees can take some tips to help them avoid getting into trouble.

1. Obtain Legal Advice

Before you sign any documents, obtain legal advice from a lawyer who specialises in franchising. They will be able to advise whether the terms of the franchise agreement are reasonable and can alert you to the issues you need to consider before making the final decision to enter into that particular franchise.

2. Engage an Accountant

Do not rely on the financial projections given by the franchisor. Obtain independent accounting advice from an accountant who understands and specialises in franchising. Your accountant will be able to carry out an independent financial analysis of the business against which you will be able to measure the accuracy of the franchisor's financial projections.

3. Take Notes

Keep an accurate written record of all of your discussions with the franchisor and any other persons involved in the sale of the franchise to you. Take particular note of any representations made to you. If you are intending to rely on those representations or they are likely to have a material influence on your decision whether or not to purchase the franchise, advise the franchisor. Record the date, time and circumstances in which that advice is given by you to the franchisor.

4. Explain Expectations

Advise the franchisor of your objectives in entering into the franchise. Advise them what your financial expectations are, the lifestyle you want to lead and what you want to achieve by joining their franchise system.

5. Verify Statements

Any statements which the franchisor makes to you should be checked as much as possible from independent sources. Do not accept any statements made by the franchisor at face value. Test them and check them with independent sources if possible.

6. Representations in Writing

If the franchisor makes any representations to you, have them recorded in writing and signed by the franchisor. Written representations are much easier to prove than oral representations.

7. Consult with Other Franchisees

Obtain a list of all the franchisees from the franchisor. Make contact with as many of the franchisees as possible. Be wary if the franchisor tries to discourage you from contacting particular franchisees. Ask the franchisees what problems they have faced in establishing their businesses and how well the franchisor has assisted them. Ask the franchisee if the franchisor's projections or predictions about financial performance were correct. Question the franchisees about the relationship with the franchisor. You must be assured the franchisor will be reliable and supportive throughout your time as a franchisee and will respond to your needs.

8. Make Checks

Try to make as many enquiries as you can about the franchisor and the franchise system. Obtain independent credit checks and contact as many different people as you can who may have had dealings with the franchisor.

Check also to see if the franchisor is a member of the Franchise Association. If the franchisor belongs to the Association, they will be bound by the Franchising Code of Practice. This requires a franchisor to provide disclosure documents which contain valuable background information about the franchisor and the franchised system.

9. Check for Disclaimers

Always presume the franchisor will try to disclaim any liability in respect of information given to you. If you are not presented with a separate disclaimer document, check the franchise agreement to ascertain whether there is a disclaimer provision in it. Ask the franchisor whether they are relying on the disclaimer clauses and if so ask them to provide you with copies so that you can obtain independent advice in respect of them.

10. Timely Action

If you do have a complaint about any representations made by the franchisor, make them as soon as possible. The longer you let misrepresentations go unattended, the harder it will be for you to establish your reliance upon those representations and therefore the harder it may be for you to claim compensation.

11. Copies of Agreements

Keep copies of all drafts of the agreements presented to you by the franchisor together with copies of the final agreements.

12. Understanding

Make sure you read and understand all documents given to you by the franchisor. If necessary, ensure you receive explanations from the franchisor in respect of anything you do not understand fully.

You should make sure that the franchise documents accurately define the scope of the franchised system and clearly identify your obligations to the franchisor and the franchisor's obligations to you.

If you have relied on any representations and the franchisor has acknowledged that you have relied on those representations, ensure they are recorded and that they have not been negated by virtue of any exclusion clauses contained in the franchise agreement or disclaimer documents.

 Conclusion

 Representations are a necessary part of any negotiation for the purchase of a franchise. The franchisor wants the business to look as attractive as possible and the buyer wants to believe it all. However, both sides must take some responsibility. The franchisor should ensure that all representations made can be verified and are based on reasonable information and data. The franchisee should not take the franchisor's word at face value. Any representations made by the franchisor should be independently verified wherever possible. If they are fundamental to the franchisee's entry into the franchise system, they should be recorded and the franchisor should acknowledge the franchisee has relied upon them.

If a franchisor wishes to exclude their liability from any representations they make, they should ensure the franchisee understands this at an early stage in the negotiations and should obtain a written acknowledgement from the franchisee that those representations will not be relied upon.

A franchisee should take measures to protect themselves from business disappointments by making their own enquiries and independently verifying all of the representations made by a franchisor. They should obtain legal and accounting advice from professionals who specialise in franchising.

Remember - if it sounds too good to be true, then it probably is.

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