by Lance Hargreaves
last updated 15/10/2023
by Lance Hargreaves
last updated 15/10/2023
Lance Hargreaves of specialist franchise lawyers Goodwin Turner suggests some legal aspects to consider when buying a franchise as a long-term investment
Like most business ventures, buying a franchise is a medium- to long-term investment. That means that, right from the start, you need to be thinking about what happens further down the track. In this article, we’ll look at some of the things you need to consider from a legal point of view when buying, renewing and selling a franchise.
Buying a franchise
When buying a franchise, it’s easy to get caught up in the initial flurry of the mission-critical aspects – all the things you have to do to get started. These include pre-purchase due diligence; understanding the franchise agreement; arranging finance; lease negotiations (if the franchise is premises-based); procuring initial equipment and stock; completing initial training and learning the systems; recruiting staff; agreeing launch promotions … all before you actually get the show on the road. While you’ll have the support of the franchisor team, it's still a lot to think about.
Despite this, though, it is still very important to stand back at the outset and consider the bigger picture, too – what will happen after you have been in the franchise a few years. What are your long-term goals and how can this business help you achieve them?
You therefore need to look at some of the legal and practical considerations around the tenure and renewal process both for the franchise and, if relevant, lease/occupancy arrangements. By understanding what is involved for remaining in the system long-term, you can factor in future costs and outlays, and know what you will have to sell when you choose to move on.
Obviously, there are many things to consider here, and the specifics differ a lot depending on the type of franchise system you are buying into. Key factors include:
- The type of services and/or products being provided;
- Whether it requires large outlay in terms of vehicles and equipment;
- The length of the initial tenure or term;
- The timing, duration and number of term renewals available;
- Whether the system is premises-based or not.
Is it a long-term proposition?
When carrying out initial due diligence into a purchase, it is important to look for signs which indicate a healthy, happy and prospering franchise network that you’d want to stay in long term. One good indicator would be how many franchisees renew at the end of their first term.
You see, a major difference between a franchise and an independent business is that franchises are usually granted for a fixed term, often with rights of renewal. A common approach might be a 5-year initial term with two further terms of 5 years, giving a possible 15 years in total.
Ask the franchisor:
- Do many franchisees stay longer-term (with at least one renewal), or do they tend to exit after the first term?
- What is the average tenure time from purchase to exit?
- What have been the main reasons for franchisees not renewing?
- If you are buying an established business from an existing franchisee, is the franchisor planning any major systems/branding updates in the foreseeable future? This might require a significant cost outlay on signage, advertising, premises, equipment and/or systems.
Common requirements for franchise renewal
Most franchisees do stay in their business for more than one term – surveys suggest that the average period is around 8 years, with many staying for 15 years or more (just look at some of the franchisee profiles in this magazine). This means that, right from the start, you should be aware of what is involved in renewing the franchise term.
Most modern franchise agreements clearly lay out both the requirements and the process involved in renewing. If this isn’t included in the agreement, it could be a red flag.
The requirements usually stipulate that, before a renewal of the term is offered to you, the franchisor will undertake a review of your business for compliance with current standards. This may include field visits, a review of the premises and a check to see if any upgrades or new branding are needed.
Commonly, the franchisee cannot have any outstanding un-remedied breach, including a failure to meet any performance targets. If this is an issue, franchisors may consider allowing an otherwise good franchisee to have a fixed ‘extension’ of, say, up to 12 months to improve performance, with a right to then renew if they meet the targets during that extension.
There might be a renewal fee to pay. This requirement, and the amount should be indicated in the franchise agreement, usually in the schedule of variables.
There is the possibility that a premises or branding upgrade is required, and maybe refresher training on systems for both you and your team.
There will probably also be a requirement to formulate a new business plan for the coming term.
The renewal process
Renewals will usually require you to enter into the franchisor’s then-current franchise agreement at the time of renewal. Technically, the renewal agreement shouldn’t be a complete rewrite of the ‘fundamental terms’ of your franchise arrangement, but exactly what this means can be a grey area.
It should not change fundamentals such as the ultimate end date of your franchise, core requirements, or primary fee structure. However, if there have been significant operational system or legislative updates during your initial term, then the renewal franchise agreement may reflect the new system and law changes – especially if the initial term was on the longer side (ie. more than five years). In turn, this may affect aspects of the fee structure.
We’d suggest that is likely to be a positive thing, because it means you’re probably in a franchise system that is intent on staying modern and compliant. Renewals will often also include a change of certain variables, such as new performance criteria that reflect a more mature franchise business.
The process for actioning a renewal should be laid out in a specific section of the franchise agreement. As a very basic guide, you’ll probably be required to give the franchisor formal notice that you want to renew (there is usually a prescribed timeframe). The franchisor will then put forward the renewal requirements above, and look to action things such as the premises inspection, review of your new business plan, etc.
It’s common for franchisors to work through this process with their franchisees at the time as part of their support function.
Other renewal considerations
A key point to note is that if a renewal or specified extension is not formalised by the renewal date then, by law, the franchise agreement tenure goes into a monthly “holding over” pattern. “Holding over” means the franchise can be terminated by either franchisee or franchisor on 30 days’ notice to the other. For obvious reasons, if you fully intended to renew the franchise agreement, you want to avoid this.
One other point here: in the past, franchisors often granted quite long individual terms (sometimes in the region of 10 years) before the next renewal. Nowadays, such a long uninterrupted term is uncommon unless perhaps it matches a lease (see below), but again, modern leases tend not to grant such a long unbroken term. That’s partly because we live in an age where regulatory requirements and systems technology can evolve quite quickly, and a franchisor’s franchise agreement and manual must evolve with it.
A renewal is also a good time to review your business, ideally with the help of the franchise support team, including general aspects such as:
- Is your insurance coverage up-to-date and does it cover any emerging threats – such as cybersecurity?
- Will your premises, branding, vehicles, equipment, etc, last for the upcoming renewal term?
- Are your systems as good as they can be and fully compliant with all recent legislative changes/requirements?
Premises and lease terms
If the franchise is premises-based, then consideration needs to be given to the requirements for renewing both the franchise agreement and the lease. Usually, the term/tenure and renewal dates of the franchise agreement will run with the lease. This makes sense – after all, your franchise business needs somewhere to operate from, and the premises you lease need a business to occupy it. However, it is not always the case that franchise terms and lease terms coincide so you need to be aware of this.
Consider also whether you as franchisee would enter into a direct lease with the landlord or does the franchise system itself hold the head lease?
If you are buying an existing franchise business rather than a greenfields site or territory (where the new business will be set up from scratch), then technically the purchaser takes the remaining balance of the vendor’s term/tenure. If this results in a short initial term and/or limited renewals left, many franchisors may grant you a term extension (subject to retaining suitable occupancy rights, if relevant). This may incur an additional cost.
Your long-term exit strategy
Before you buy, it’s important to think about what you want to achieve and what your ultimate exit strategy will be when you are ready to move on. What will you actually have to sell at the end?
Bear in mind that the franchisor (not you the franchisee) owns all the systems, branding, intellectual property, know-how and customers. The value in the business lies in how well you have used them to build up a profitable and successful operation.
If the business is premises-based, you will probably assign the lease and the sale price should reflect any geographical goodwill you’ve built up.
For service franchises that are not premises-based, the initial purchase/upfront costs tend to be less, but ultimately so is the value of what you have to sell at the end. A key consideration here is whether you have been granted any exclusive territory rights that you can sell. This allows you to price in a loyal customer base in the area that counts as geographical goodwill.
For some systems, you may be able to assign work in progress, leads or a job pipeline to a purchaser. Again, the franchise agreement will set out the sales process but you need your advisory team to look closely at this at the start, and ask the franchisor how current franchisees go about selling.
Technically, most franchise systems will grant a purchaser a new franchise for the remaining tenure that you (in this case as the seller) have left under your franchise agreement and/or lease (so landlords are relevant here, also).
Your franchise agreement should have a detailed section dealing with sale/assignment of the business and your requirements on exit.
Some key aspects for selling
You must notify the franchisor that you wish to sell, and provide them with a sale and marketing plan. It is worth remembering that the franchisor may already have contact with parties looking for an established business, or be aware of existing franchisees looking for additional opportunities.
When you sell a franchise, the franchisor must first approve both the sale and the specific purchaser – they will want to be sure that the purchaser has the necessary skills and aptitude to run the business successfully, just as they would with any new franchisee.
This approval will come with conditions/requirements, and the purchaser will need to provide an application (including personal financial status) to, and be interviewed by, the franchisor.
You will likely have to pay a specified transfer fee to the franchisor; and maybe train the purchaser and/or pay training fees.
You will need to pay the franchisor all outstanding monies owed including final royalties, marketing, etc, and pay all your suppliers out.
Bear in mind also that, upon exit, most franchise systems will bind the franchisee and guarantors to ongoing covenants around confidentiality, intellectual property, restraints and non-solicitation, and ongoing guarantees regarding any issues that arose before the exit.
As you can see, there is a lot to think about when buying a franchise, but don’t let it put you off – it’s more a matter of being prepared and understanding what’s involved so that you make good decisions right from the start.
By taking a big-picture, forward-looking view, and seeking advice from trusted and franchise-experienced advisors, you can put the right foundations in place for building a business which will serve you well and help you achieve your long-term goals from purchase through renewals to exit – just as many other franchisees have done.
This article first appeared in Franchise New Zealand magazine (Year 32 Issue 2).
Disclaimer: This article is not intended as legal advice and it should not be considered or relied on by any reader as such.
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