by Scott Goodwin and Nicole Duncan
last updated 10/09/2019
7 things your lawyer should tell you before you buy a franchise
by Scott Goodwin and Nicole Duncan
last updated 10/09/2019
Scott Goodwin and Nicole Duncan outline the most important factors
Taking up a franchised business can be a stressful yet exciting experience. Buying any business, franchised or not, can be risky, and entering into a franchise agreement is a serious undertaking. It’s a binding legal contract which sets the basis of your relationship with the franchisor for the next 5, 10 or even 20 years, so you shouldn’t take it lightly.
Getting advice from an experienced franchise lawyer is therefore a must. Here’s a list of seven of the most important things your lawyer should tell you – and there are many more!
1 Doing due diligence is important
‘Due diligence’ is like the pre-purchase inspection you might do on a house or car. Make sure you undertake thorough due diligence prior to entering into any franchise agreement. Some of this you will need to do yourself, but much should also be done by professional advisors who have specialist knowledge and have been here before.
Apart from your lawyer, your research should include talking to an accountant experienced in franchising. This will help ensure the business is financially and operationally sustainable and viable; validate assumptions applicable to costs and forecasts provided by the franchisor; and compare debt-to-equity ratios.
Also, don't be scared to talk to other franchisees to evaluate their experiences with the franchisor and the system, and ask the franchisor questions about (among other things) the franchise system and the franchisor's background and experience. Here’s a list of Over 250 Questions to Ask and specialist lawyers such as Goodwin Turner provide clients with a checklist of items to discuss with the franchisor. These include, for example, whether a franchisee has ever failed, the expected cost of fit-out, the level of ongoing support to be provided by the franchisor, and so on.
2 Review the manual
The manual, (or often a set of manuals), lays out the systems and tools which enable franchisees to operate their business on a day-to-day basis. Ask the franchisor for a copy of the manual which you can see and read before you sign the franchise agreement. Expect them to require you to sign a confidentiality agreement before they do so – after all, the manual contains their ‘trade secrets’.
It is important that you are sure that you can comply with the manual from day one (as well as at all times during the operation of the business). Most franchise agreements will note that the terms of the manual are incorporated into (and form part of) the franchise agreement, and that a breach of the manual is deemed to be a breach of the franchise agreement. In other words, if you don’t comply with the manual then you will likely be in breach of your franchise agreement. This is never a good thing as it could expose you to risk of the franchise agreement being terminated.
3 Ensure you can comply with the system
Many people buy franchises with a dream of ‘being their own boss’. While owning and operating a franchised business does allow this to a certain degree, you need to be prepared to follow the franchisor’s systems and rules strictly. Franchisors rarely tolerate any departure from their system and their rules because ‘rogue’ franchisees who deviate from the correct standards risk exposing the franchisor and other franchisees to significant loss and damage.
Prior to buying any franchised business, then, you’ll need to ask yourself whether your long-term goals align with the franchisor’s. Are you prepared to work within the system, and are you certain that you are the right fit for this particular franchise?
4 Don't be scared to ask for amendments or clarifications to the franchise agreement
It is fairly common for a franchisor to tell prospective franchisees that they won’t agree to any amendments to the franchise agreement and to effectively ‘take it or leave it’. However, while most franchisors are unwilling to make substantial/material changes to the franchise agreement, they often may agree to record clarifications or special conditions to the franchise agreement so long as those clarifications or variations are reasonable and don’t conflict with the operation of the system and the fundamental rights/obligations of the parties. We have seen this recently with service-related franchise systems. An experienced franchise lawyer will know what to look for and what is or isn’t reasonable.
5 Know what you're buying
Consider all of the things that may expose your business to a loss of profits or put you at risk of losing your investment altogether. For example, is there a franchise territory? If so, is it exclusive (ie. limited to you only) or non-exclusive (ie. can/does it include other operators of the same system)? Can the franchisor operate any business within your franchise territory or online? Would you have first right of refusal on a new outlet in a neighbouring area? What restrictions and safeguards do you have?
Are there any events that might trigger the termination of your franchise agreement by the franchisor? Common clauses might include not being up-to-date with ongoing franchise fees (royalties), not making payments to third parties (eg. suppliers) on time or not meeting minimum performance criteria such as hygiene, brand standards or sales volumes.
6 Don't focus your inquiry solely on the franchise agreement
In addition to the franchise agreement, there are a number of other important documents that you should carefully review and seek legal advice on. For example, documents that deal with the occupation of premises from which the franchised business is or will be operated, and documents outlining the terms and conditions of supply/trade, etc.
Leases generally are relational contracts (like franchise agreements). Entering into any lease often requires you to make a long-term commitment to relatively onerous obligations and usually requires personal guarantees to be provided to the landlord. Your lawyer should review all relevant occupation documents and provide you with advice on them.
If you require a lease or sublease of premises from which to operate the business, then it is wise to ensure that the lease period(s) marry up with the franchise period(s)/term(s). This is because you will want to avoid the risk of having a franchised business with no premises to operate from, or the danger of having to pay rent after the franchise term is at an end.
7 Have an exit strategy
As with any business venture, it is important to consider at the outset what your exit strategy might be if your circumstances change and/or you become no longer willing or able to operate the business. This is no different in franchising; however, most franchise agreements prevent franchisees from being able to terminate the franchise agreement after any initial cooling-off period and prior to the end of the franchise period/term (ie. due to a change of circumstance, change of mind or change of ability or willingness to work).
That doesn’t mean you can’t sell the business – in fact, many people choose to buy a franchise precisely because the brand makes it a more valuable asset when the time comes to sell. However, simply ceasing to operate the franchised business would be likely to expose a franchisee to (among other things) a risk of the franchisor taking legal action against the franchisee, especially the case if the franchisor expected to receive royalties for the duration of the franchise period/terms.
Prior to buying any franchised business, then, prospective franchisees should take advice on their potential exit strategy: that is, how they might be contractually entitled to exit the franchise prior to the end of the franchise period/term without causing the franchisee to be in breach of the franchise agreement.
For example, does the franchise agreement allow the franchisee to terminate the arrangement at any time before the end of the franchise period/term? Does the franchise agreement allow the franchisee to sell the business during the franchise term? If so, what is the process and the likely cost involved? Are there any fees associated with selling the business? Does the franchisor have a first right to purchase the business? Does the franchisor have to approve the purchaser? (this is a common requirement). What happens to the business and the franchisee’s rights under the franchise agreement if you become seriously ill (or die)?
If the proposed exit strategy is achieving a sale of the franchised business, then the franchisee should be realistic about the sale price that the business could achieve. Franchisees often make their money while they are operating the business rather than upon sale, although this varies according to industry and brand. The sale price may also vary depending upon how near the sale is to the end of the franchise period/term (although some franchisors will grant a new term to an incoming purchaser).
Don’t make assumptions
Whatever type of franchise you are buying, it pays to get proper advice from an experienced franchise lawyer before you sign anything. Franchising can be a great way of getting into business, but there are no guarantees – you need to take care and take advice to protect yourself and your investment.
It’s dangerous to assume that a business will succeed because it has a good name, or because it seems to be everywhere, or because your brother/cousin/friend/person you met at a party is doing OK. Every franchisee is different, every location is different and markets change over time.
The seven areas above are just some of the many things you need to get checked out by specialist advisors. It makes sense to get the experts to do some of the work for you before you make your final decision.
This article can also be read on page 78 of the digital issue of Franchise New Zealand magazine Year 28 Issue 03
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