by Michael Bright
last updated 26/04/2018
12 tips and traps for franchise buyers
by Michael Bright
last updated 26/04/2018
Franchise lawyer Michael Bright explains how to get off to the best possible start in your new business
A franchise is a legal contract and you have to abide by it or possibly lose the franchise. That’s a good reason why you should always consult a franchise-experienced lawyer before you sign anything.
Over the years, though, the odd conclusion I’ve come to is that although the legal detail of the agreements is important, the areas that most often cause grief are the commercial issues. Usually, when a franchisee fails or gets into strife with their franchisor it’s those other issues that are the underlying cause. Here are some suggestions for franchise buyers that could avoid problems later on.
1. Don’t mentally commit to a franchise opportunity until you’ve thoroughly investigated it. The initial stage of finding out about a franchise is exciting. The franchisor will give you lots of attention and do all they can to attract you to their system. You will learn about the benefits of being part of the franchise and eagerly imagine life as an independent business owner. You realise there will be some challenges but with your energy and skills and the nice people in front of you, you’re sure to overcome them – right? Well … maybe. Unfortunately, some franchisees get so enthusiastic in this early stage that they don’t put enough effort into properly researching the business. Remember that during this time, the franchisor is a salesman. Be sceptical about what the franchisor tells you. Get as much information as you can to help you independently assess the opportunity and whether it is a good fit for you.
2. Use advisors who specialise in franchising. This may sound self-serving, but franchise specialists are less likely to waste your time and money asking pointless questions. Ultimately, they can also help you make a smarter decision by knowing which issues really matter and which are less important.
Every franchise lawyer has stories about new franchisees who make up their minds too early and won’t listen to any advice. Every franchisor has stories about non-specialist advisors who either ruined an opportunity or charged far too much, due to their own lack of understanding about franchising. Taking good legal and accounting advice isn’t just ‘ticking the box’ to satisfy the franchisor’s requirements – it’s essential for your future.
Give your lawyer and accountant the opportunity to teach you things. They won’t have all the answers, but they can help you ask great questions as you work through your ‘due diligence’ investigation process.
3. The financial figures, operational details and other hard data are important, but don’t focus just on those: it’s also important to assess the character of the franchisor. To help maintain standards, the franchise agreement will be very one-sided in favour of the franchisor. This imbalance isn’t bad in itself (provided it doesn’t go too far), but it can be used responsibly or irresponsibly. Whether the franchisor uses their power for the overall benefit of everyone in the franchise network or whether they abuse it largely depends upon their character and your ability to build a strong relationship with them.
We suggest you ask existing franchisees a few questions that target the franchisor’s people skills and motivations. How effectively does the franchisor communicate? How do they react when their ideas are challenged? Can they admit if they are wrong? Do they respect others’ opinions? Do they make good use of the ideas and innovations that franchisees come up with? Do their marketing initiatives actually increase profits, or just sales? What does the franchisor do to support a franchisee who suffers a personal emergency? There are lots of questions you might want to ask franchisees – rather than list them all here I recommend the article at www.franchise.co.nz/article/view/935.
When you get the answers, listen not just to what is said but also how it is said. Do the answers come quickly or enthusiastically, or is there a sense of reluctance, awkwardness or omission? After a few discussions like this, you should start to form an impression of the franchisor’s character and what the culture in the franchise system is really like.
4. You must also take responsibility for building the type of relationship that good franchising requires. A key part of this is accepting that you must operate your business in accordance with the franchisor’s system and rules, and commit to having a transparent relationship with the franchisor. Some honest self-assessment could save you a lot of trouble. If you struggle with taking correction and don’t like someone ‘watching over your shoulder’ and giving you instructions, you’ll probably struggle with being a franchisee. A good franchisor will allow their franchisees to express differing opinions and will use their franchisees’ individuality and ideas to generate innovation for the benefit of everyone. But, equally, you need to be able to compromise and accept direction.
5. It is important to remember that a franchise gives you the right to use a business system for a limited time. If your franchise agreement expires or is terminated, you will be left with nothing but the physical assets of the business. You can sell these assets, but they probably won’t have much value compared to the potential value of your business if it were sold as an ongoing franchise. Therefore the only way to extract full value from your business, in terms of capital gain, is to sell the business as an operating and profitable business within a current franchise term. All of this is normal in franchising, but it does mean that:
(a) You should assess your investment return against the length of just the initial franchise term; and
(b) You must build a good relationship with the franchisor and comply with the franchise system throughout the life of the franchise so that you have the best possible chance of extending the life and value of your business.
Location and premises
6. For many franchises, location is extremely important. Usually, the franchisor will find a site for you, or at least have the right to approve or decline any site you propose. Because there are many factors that affect success, they will still disclaim responsibility for whether or not the site performs as expected. However, poor site selection does happen and can have a serious impact on your business.
Reduce this risk by finding out how the franchisor chose a potential location. Ideally, they should have followed a robust process that has been reliable in the past (or, if they don’t have much history in New Zealand, has at least been carefully thought out). Get them to explain the process to you and their findings in relation to the site you’re considering. Similar principles also apply in relation to franchise territories. The key thing is to find out how many assumptions have been made about a site’s potential and whether there seems to be a good basis for them. While we’re on property …
7. A common leasing issue is the tenant’s responsibility to reinstate or ‘make good’ the premises at the end of the lease. This can be a significant expense. Even if the landlord is planning to gut the premises anyway, they may invoke these or other redecoration clauses in order to extract a cash payment from the tenant upon expiry of the lease. It helps if the franchisee can have their redecoration and reinstatement obligations reduced, perhaps by excluding any redecoration obligation during the last two years of the lease term and removing any obligation to remove their fit-out upon expiry of the lease. Landlords will often accept some watering down of these clauses. If the premises start out damaged or in poor condition, it’s also a good idea to record that (with photos) before signing the lease, otherwise the franchisee might be required to reinstate the premises to a condition better than when they started.
8. After the Christchurch earthquakes, a number of premises remained in good enough condition that they could have been used to continue the tenant’s business – except for the fact they were in the ‘red zone’ behind the security cordon. Because the premises had suffered relatively little damage, the tenants were unable to terminate their leases and were forced to continue paying rent on premises they could not access. To make it worse, they also had problems claiming upon their insurance. The latest version ADLS Deed of Lease – which is in common use – now has ‘No Access’ provisions to provide some relief in this situation. However many custom leases still haven’t been updated.
Fit-out and assurances
9. Many franchisors project-manage the fitting-out of their franchisees’ retail premises. Usually the franchise agreement will be open-ended as to the final cost – the franchisee will simply be required to pay the full cost of the fit-out. However it is increasingly common for franchisors to agree upon a fixed cost or maximum cost for the fit-out, if a franchisee asks for it. Cost over-runs on fit-out and equipment will starve the franchisee of operating capital needed to get the business established. It is always worth asking for these costs to be capped, and clarifying exactly what is and is not included in that capped cost – then writing all of this into the franchise agreement.
10. If the franchisor gives you some assurances that are important to you when deciding to buy the franchise, you must have these written into the franchise agreement before it is signed. Every franchise agreement contains a variety of disclaimers which have the effect of denying representations or statements made by the franchisor, so if you do receive an assurance or commitment by the franchisor and want to be able to rely on it, you must have it included in the franchise agreement. If it isn’t included, it will be much harder (if not impossible) to enforce it later on. Note that even if the franchisor does not agree to include something in the franchise agreement, working through the process will help you clarify what assumptions you may validly hold in respect of the business.
11. Some franchise agreements contain such wide and sweeping disclaimers of liability that the franchisor isn’t really committing to do anything at all. Their ‘franchisor obligations’ may sound attractive but will usually be very much at the discretion of the franchisor, and may be overlaid by clauses stating that the franchisor is not liable for any loss suffered by the franchisee for any reason – including even breach of the franchise agreement by the franchisor.
Clearly this sends a bad signal with regard to the franchisor’s commitment to their franchisees. The distinction can be fairly subtle: all franchise agreements will include disclaimers benefiting the franchisor. However, these should be targeted at cutting off claims arising from unforeseeable or unmanageable circumstances. They shouldn’t be drafted so widely as to also potentially deny claims arising from the franchisor’s own breach of contract.
You should also be aware that you can’t just ‘walk away’ from a franchise. I have heard some franchisees say that they will cancel the agreement and abandon the franchise if they decide they no longer want to be part of the franchise group. Unless the franchise agreement gives you that right (which is very rare), then you don’t have any right to leave the franchise system until the franchise expires. Franchising is a relationships game: pick your partner carefully and then commit for the long term.
12. Some franchise agreements – and particularly ‘regional’, ‘master’ or ‘area developer’ type agreements – include minimum performance criteria. Usually this is a required number of sales, or level of revenue, that the franchisee must generate during specified time periods. The franchisor might be required to consult with the franchisee before setting or adjusting the minimum performance requirement, but often the franchisor will make the final decision on what level of performance they will require from the franchisee.
Although there is nothing wrong in principle with having minimum performance criteria, franchisors can be overly optimistic about the franchisee’s prospects and set unrealistic criteria as a result. This problem is made worse if the franchise agreement also states that failure to achieve the minimum performance criteria can result in immediate termination of the franchise agreement. I haven’t yet seen a situation where that was actually appropriate.
Much better is to establish a process such that, if the minimum performance criteria are not met, the franchisee and franchisor each participate in a programme designed to lift the franchisee’s performance to the necessary level. If the performance level is still not achieved after completing this process, then other options (apart from termination) include reducing the size of the franchisee’s territory or placing another franchisee into the area, while also reducing the minimum performance criteria. Termination of the franchise should always be kept as a last resort.
Once you’ve asked lots of questions, thought carefully about the opportunity and finally decided to buy the franchise, abandon scepticism and jump in with both feet. Commit fully and enthusiastically to working with the franchisor, being a positive contributor to the franchise network and making your business successful. If you do this you’ll earn respect, build useful and rewarding relationships and give yourself the best possible chance of success.
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