Franchise buyers can often have many common misconceptions about franchising.
On Saturday 1 June 2019, Luke McKavanagh of the Stone Group Lawyers team busted some of the fake facts in franchising during a seminar at the Brisbane Franchising & Business Opportunities Expo.
Presenting alongside Sarah Stowe, Editor of Inside Franchise Business, Luke worked the audience through some of the key things a franchisee should know before they enter into a franchise agreement.
It’s important to first go back to basics and note that the Australian franchising industry is governed by stringent regulations in the form of the Franchising Code of Conduct (Code). The Code aims to set a balance in the power held between franchisors and franchisees. Someone who is new to franchising can often be confused by many of the terms used in this unfamiliar industry, leading to certain misinterpretations.
Myth 1: The 7 day cooling-off period means I’ll get all my money back
The right to “cool-off” can be a favourable option for nervous franchise buyers who view it as a “get out of jail free card”. The myth here is if you buy a franchise and change your mind within a week, then you can step out and recoup your money.
The 7 day cooling-off period does in fact have some strings attached. Yes, you can walk away from a franchise agreement within 7 days of signing it and you don’t need to provide a reason. Within 14 days, the franchisor must give you back any money you have paid.
However, the franchisor is entitled to retain their reasonable expenses, provided those expenses or the method for calculating them has been set out in the franchisor’s disclosure document. These expenses generally include:
The franchisor’s legal costs connected with preparing the franchise agreement. These can usually be a couple of thousand dollars, or sometimes more, depending on whether there’s also a lease involved.
An amount representing the reasonable costs the franchisor has incurred in recruitment, administration and management time towards you. This is usually a specified figure within the franchise agreement or the disclosure document.
The costs of providing any training to you. This is generally a pro-rata proportion of the franchisor’s standard training fee. For example, if their standard training fee is $5,000 for 5 day’s worth of training, and you only completed 1 day of training, then the franchisor will generally keep $1,000. If the franchisor incurred expenses in travel and accommodation to provide you training, then those expenses may be recovered from you in addition.
If the franchisor hasn’t provided you training but they’ve already booked flights and accommodation, then the costs incurred in cancelling these would also normally be included.
Other expenses that the franchisor might retain can also extend to losses the franchisor would incur if their “opening package” couldn’t be re-used for another franchisee. For example, if the franchisor has spent money towards registering your business name and arranging stationery, signage and marketing materials with your name on it. If you’re keeping the premises’ lease and the franchisor has fitted out your premises, then they’ll also be looking to recover those costs.
These amounts can quickly add up and can sometimes be rather high, depending on the particular franchise system.
Always remember, cooling-off only applies to a new franchise grant. It won’t apply to a renewal, the purchase of an established business or the variation to an existing franchise agreement.
Myth 2: “Good Faith” means that my franchisor can’t force me to do something
This can often be a difficult one and involves looking at the roles of each party, and how good faith relates to the franchisor-franchisee relationship. The starting point is to look at what “good faith” means in legal terms.
Asking what the limits of “good faith” are can be like asking “how long is a piece of string”. The Code doesn’t define “good faith”, so it’s determined on a case-by-case basis. It will include acting honestly in dealings with one another and not acting arbitrarily, and cooperating to achieve the purpose of the franchise agreement. Importantly, it doesn’t prevent a party from pursuing their own legitimate commercial interests.
What this essentially means is that the franchisor needs to act reasonably. If the franchise agreement clearly gives the franchisor the right to tell you to do something, then you generally need to do it. It’s then up to you to assess whether what you’re being told to do is in fact reasonable.
For an example, let’s use a restaurant franchise, and let’s assume that the franchise agreement permits the franchisor to give these certain directions:
If the franchisor tells you that you need to use their menu, decorate in a certain way, and offer table service, then that’s probably reasonable. Franchisors need to maintain uniformity within their franchise network. However, if the franchisor was asking only you to do this, and none of their other franchisees, that might not be acting in good faith.
If you only accepted cash payments from customers, then it would be reasonable for the franchisor to direct you to install an EFTPOS facility, given that’s the way people generally now expect to pay for services. It probably wouldn’t be good faith for a franchisor to direct you to accept Bitcoin payments, given that’s not a common form of currency for the restaurant industry.
If the restaurant was located in a shopping Centre next to a movie theatre, it would probably be reasonable for the franchisor to direct you to trade late-nights. It probably wouldn’t be good faith to direct you to stay open until midnight if you weren’t in a location with justifiable foot traffic, or late-nights weren’t common for your particular style of restaurant.
Asking you to obtain a liquor licence would probably be reasonable if you offered sit-down dining, but it probably wouldn’t be reasonable if you were a standalone ice-cream store.
Myth 3: Everything important about the franchise is in my franchisor’s disclosure document
When you’re looking into buying a franchise, there will be many things to consider, and information to absorb. The franchisor’s disclosure document is just one of these.
A disclosure document will contain some of the key details that you’ll need to make an informed business decision about whether to enter into a franchise. It’s up to you to use the disclosure document as a starting point for your own due diligence enquiries. There are many other important things to consider:
Yes, the disclosure document should ideally list the key expenses that you will foreseeably incur during the course of the franchise, but it shouldn’t be a substitute for you coming up with your own budget in consultation with an accountant and business advisor. Just look at the way that things like the costs of petrol and electricity can fluctuate – always plan that the costs of running your business may change.
One of the most valuable things in the disclosure document will be the contact details for the current and former franchisees. Don’t just look at a list of 50 names and think the franchise system must be growing well, and then stop there. It’s how you contact these people and what you ask them that is important. Contact as many of the current franchisees as possible and ask for their honest feedback about the franchise system. Are they happy in their business? Does the franchisor offer good support? Where would they like to see improvement? For those people who have left the system, why did they leave?
The disclosure document will contain a current snapshot in time of the franchise system. It won’t show you what things might be like in 2 or 5 years’ time. Do your research and your planning into the industry and have a thorough business plan. What might be a booming industry today could be a forgotten fad tomorrow. Ensure that your investment in the franchise will deliver a return.
Finally, don’t rule out other opportunities just because you’ve obtained a copy of the disclosure document for your ideal franchise. Continue to explore your other options. Push to get the disclosure documents for the franchise systems that are second and third in line on your list. You might identify something that’s a deal maker (or a deal breaker) that you had never even considered.
Myth 4: My franchisor has nominated a site/territory, so I don’t need to do my own investigation into its viability
Just because something looks great on paper doesn’t necessarily mean it will work well in practice. Yes, your franchisor is probably very experienced in site selection and will know what works (and what doesn’t) for their franchise model. However, this is no substitute for your own independent investigations into your proposed site or territory.
There’s a few things you can do as homework to assess the viability of the franchise offer:
If you’re being granted a territory, first establish whether it’s exclusive, non-exclusive or a mix. Exclusivity generally means the franchisor won’t grant another franchisee the right to, or won’t themselves, operate within your territory. From there, work out the size of your potential customer base. Get as many demographics as you can about the area. The number of prospective customers could differ greatly between an established city block with strict zoning (so, without population growth potential) compared to an up and coming urban area that’s quickly being developed and growing.
If there are performance targets that you will need to meet under the franchise agreement, ensure that your potential customer base will allow you to achieve those targets.
Do your research on the area’s local council. Order a town planning search and a main roads search to look for factors that might interrupt or decrease the desirability for your location.
If your franchise will be site-based, then loiter!
- Visit that site as often as you can during different times of the day on different days of the week. Look at the foot traffic. Is the site in a standout location, or is it hidden away? Do the types of people fit the style of franchise?
- Speak to other business owners in the area – what are their busy times and what are their quiet times? Do school holidays affect their trade in a good or a bad way?
Examine the lease with a fine-tooth comb. Are the annual rent increases sustainable? Are you granted exclusivity in the Centre (meaning the landlord can’t grant tenancies to competing businesses)? Are there plans for Centre redevelopments?
Myth 5: Legal and accounting advice isn’t compulsory before I sign my franchise agreement, meaning I don’t need it
Rather surprisingly, the recent parliamentary inquiry committee didn’t recommend legal and accounting advice to be mandatory in their report “Fairness In Franchising”. Regardless, many franchisors and professional advisors encourage franchisees to get advice.
Your franchisor will have spent a lot of money on getting their own legal and accounting advice over the years in order to put themselves in a certain position – and that’s a position to protect themselves.
You need to obtain your own independent advice so that you fully understand the differences between the franchisor’s position, and your own position.
Legal advice will ensure you understand the meaning of what your franchise agreement says, and where the benefits sit, as well as the risks.
Accounting advice will ensure that your business is set up in the correct way from the outset to reflect your circumstances, and assist you to assess whether the business will be financially viable to maximise your return.
Think of both these forms of professional advice as an investment. Without this advice, you’ll be at a disadvantage as you’re not going into the business with both eyes open.
Not getting the advice at the right time can really restrict your ability to exercise and take advantage of your rights in the future.
A lawyer or accountant with franchising experience will have read franchise documents from dozens of different franchise systems, and will have guided dozens of franchisees through various transactions. We know what to look out for and the advice you need to fit your circumstances.
Myth 6: My franchisor has already built the brand’s reputation, meaning I don’t need to work hard in my business
One of the biggest myths in franchising is thinking that you don’t need to work hard because a brand has a good reputation. When you buy into a franchise, you’re pigging-backing onto the franchisor’s reputation, giving you a degree of competitive advantage. However, you can’t afford to sit back and let the brand do all the work.
The success of a franchised business will be largely dependent upon a franchisee’s own business efforts. Yes, your franchisor has done some of the groundwork to get your first customers through the door, but it’s up to you to keep those people as repeat customers.
Don’t expect a business to run itself. Like any business, a franchised business will take hard work, time and dedication for the business to be successful. If you can’t see yourself working in the business daily and being happy doing that, then a franchise might not be the right choice for you.
Every franchisor is different. Some franchisors will be happy to give you guidance, support and hold your hand every step of the way. However, some won’t. Yes, if the franchisor provides you with a comprehensive operations manual and a great training program, that will be a great start. It’s up to you to take those systems and procedures onboard and apply them in practice.
Depending on how the particular franchise model will operate, you’ll generally be expected to conduct your own local area marketing. Don’t think of this as a burden, but rather, a benefit. It’s up to you to set your business apart from your competitors and to get customers through the door. Always remember that even though your franchisor may operate a marketing or advertising fund, they generally won’t have an obligation to allocate any specific funds towards marketing your business or your territory.
Myth 7: My accountant told me to set up my business using a company/trust therefore I have no personal responsibility to the franchisor
Just because you may be operating your business through a company and/or trust, doesn’t necessarily mean you won’t have any personal responsibility. This is where legal and accounting advice at the right time is key.
Most franchise agreements include what’s called a personal guarantee. This means that the company’s directors and shareholders can be held personally liable to the franchisor. If your company owes the franchisor money, then they can demand you to personally pay something overdue. If the franchisor ever becomes entitled to sue your company, they can sue you personally.
Even if your franchise agreement doesn’t contain a personal or director’s guarantee (which is uncommon), there is usually a provision that says one of the company directors needs to be nominated as the day-to-day manager of the business. That person will then be personally responsible for overseeing the business and ensuring it’s operated in accordance with the franchise agreement. There will usually be a requirement for that manager to devote a specified amount of time working in the business each week. If the person named as manager doesn’t fulfil their duties, then this can place the franchisee in breach.
Therefore, ensure you carefully read the franchise agreement before you sign it. Many franchisees don’t understand the implications of giving a personal guarantee. If the business fails and the company is wound up, then the company directors can continue to remain liable to the franchisor.
Myth 8: I’m sure my franchisor will be flexible if I want to sell different products/services and use different suppliers
Entering into a franchise agreement involves a certain degree of give and take. The franchisor is handing you a proven business model for success – you’re not starting from scratch as if this were a new independent business. In exchange, a franchisee agrees to abide by the franchisor’s rules, regulations and restrictions for running the business. Entering a franchise therefore means you give up a certain degree of control.
Most franchise agreements place restrictions on a franchisee’s ability to introduce changes into their business. Generally, any change needs to be approved by the franchisor, who has the discretion to say yes or no. Think back to what we said earlier about good faith – if the franchise agreement gives the franchisor control over something, then they will generally be entitled to exercise that control.
It’s in the franchisor’s best interests to ensure that there’s uniformity across their franchise system, but it’s also in their best interests to grow the system through innovative new ideas. Therefore, every franchisee generally needs to be using and offering the same products and services, and this can extend to suppliers. If one franchisee is doing things differently, then this can disrupt the uniformity and the success of the entire franchise model.
Sometimes your suggested change will be a great idea, and the franchisor will allow the change, and even ask the other franchisees to adopt and follow your example. However, some franchisors aren’t this flexible. If you want to introduce a change, then when asking for permission, be prepared to make a case to justify your reasons. Remember, generally, one of the benefits of investing in a franchise is the opportunity to enjoy discounts and preferential deals with approved suppliers. One franchisee introducing a change can have a ripple effect across the entire franchise system.
Be mindful of whether other franchisees would have the capacity to adopt the same change in their business. For example, you may have found a supplier who can supply your ingredients for a cheaper price:
Your new supplier may not have the capacity to also supply products to the rest of the franchise network. They might not be reliable in delivery frequencies. They might not be able to deliver consistency in quality. These are all factors that would usually have gone into the franchisor’s original decision to nominate their preferred supplier.
On the other hand, if franchisees stop buying some products from the franchisor’s nominated supplier, this may disrupt rebate and discount schemes. Franchisors generally have arrangements in place with their nominated suppliers who will supply different things to franchisees. Sometimes whilst one product may be available elsewhere for cheaper, in exchange for charging that premium price on one product, the supplier may sell another product to the franchise network at discounted rates.
In other circumstances, a rebate might be paid back to the franchisor in exchange for all franchisees using the preferred supplier. Many franchisors will then reinvest this rebate back into the franchise system, for example, into marketing. The franchisor may not want to disrupt this rebate scheme.
Doing some homework and getting professional advice at the right time is an essential step before you commit to a franchised business. It’s not meant to deter you from the franchise, but rather, it ensures you are fully prepared to know both the benefits and the risks of the deal.
Luke McKavanagh is a regular contributor to online and print media for Inside Franchise Business. Stone Group Lawyers thank Sarah Stowe for her contributions towards the original seminar on this topic.
DISCLAIMER: This article is only meant to give you general information and should not be relied on as legal advice. Speak to one of our lawyers for more information.