Franchising Flaws: Buyer Beware.

A Legal Perspective

Franchising is one of the fastest growing sectors in Australia, with over 900 different franchise systems operating in Australia in diverse industries ranging from retail of food, clothing, homeware and other consumables, restaurants, accommodation, real estate, travel, finance and business services , media/telecommunications to health, recreation and personal services. [1] Buying a franchise involves considerable investment of money and time. The cost of a franchise business varies considerably depending on the complexity of the system. It could be as low as $50,000, or as high as $500,000 to over $1million. Therefore it is important to choose the right franchise business and undertake proper legal and financial due diligence to minimize the risk of failure and protect your investment.

Generally, the purchase of a franchise business is less risky than establishing your own business or buying a business that does not have a track record. Most franchise systems are based on businesses that have been operating for at least 5 years and have a proven system and are operating profitably. However buyers should be aware that franchise systems do fail.

In the period between 1990 and 2005, at least 40 franchisors failed. This directly impacted approximately 1090 franchisees and their families and also financiers, landlords and other suppliers [2] . In 2006- 2007, at least 7 franchised systems/ businesses have gone into liquidation or some form of insolvency administration. [3] These figures are relatively low when compared with business failures generally in Australia. According to figures published by the Australian Bureau of Statistics, about 65 per cent of businesses established in 2003 are still operating 3 years later, 35 per cent did not survive [4] . In the year 2005-2006, 275,414 businesses with an annual turnover of less than $2 million failed [5] .

Although the franchise industry is regulated under the Trade Practices Act 1974 (Cth) and franchisors are required to comply with the mandatory Franchising Code of Conduct, unscrupulous franchise operators still continue to exist. Buyer be aware still applies.

From a practical perspective, when buying your franchise, you should undertake the following checks and investigations before seeking legal advice:

• Obtain the following documents from the franchisor or owner of the business that is selling the franchise business:
  • Franchise Agreement
  • Lease Agreement
  • Disclosure Document - franchisors must provide this document to prospective franchisees to comply with the Franchising Code of Conduct as set out by the Trade Practices Act
  • Sale of Business Agreement - in cases where an existing franchise business is being purchased. This will include a Disclosure Document from the franchisor and existing franchisee
• Collect as much information about the franchisor and franchise business as possible (from the press, internet, industry sources). This will help you assess whether it is the type of business you want to be involved in, and its profitability.
• Arrange to spend some time observing, or, if this is possible for you, actually working in the franchise business.
• Speak to other franchisees about the franchise system. Ask them about the level and quality of support provided by the franchisor
• Check the business location, plus the location of other franchises or similar businesses which may compete with and affect your business profitability.
• Check the total cost of buying the franchise, including:
  • Establishment costs
  • Purchase of equipment, stock and supplies. Is a vehicle needed for the business?
  • Rental of premises and/or vehicle including outgoings
  • What franchise fees are payable? Are there ongoing fees involved, such as group advertising, training costs, or any other fees?
• Check the profitability of the franchise business. It is not sufficient just to look at sales turnover figures of the business in isolation. You also need to know what the operating expenses are. You should make an allowance for your salary if you are going to be working in the business and the cost of any financing.
• Compare the profitability of the franchise business that you are looking at buying with key performance indicators relating to existing franchisees and other franchise systems. The franchisor should be able to provide you with figures as to how profitable the business is when compared with other franchisees within the system.
• Check the Disclosure Document provided by the franchisor for anything that may affect the profitability of the business including increases in operating expenses, fees payable to the franchisor and cost of products supplied by the franchisor or third party. If the Disclosure Document is silent or does not make adequate disclosure, make further enquiries.
• Some franchisors require prospective franchisees to pay a deposit before providing them with Disclosure Documents, franchise agreement and other documents or signing the franchise agreement. If this is the case, make sure that the deposit is treated as "trust money" and paid into the trust account of either your or the franchisor's lawyers and not released to the franchisor until you have decided to proceed with the purchase. If you do not take this precaution, you lose your deposit if the franchisor goes into liquidation or administration before the transaction is finalised or you decide not to proceed.

From a legal perspective, the Disclosure Document and Franchise Agreement require careful legal scrutiny to ensure that the franchisee's investment is protected. Having worked in the franchise industry for over twenty years, I have had exposure to numerous franchise systems and franchise agreements. Each system and agreement is different and has to be considered on a case by case basis. The legal issues are complex and review is recommended by lawyers who are experts in the area.

Provisions in Franchise Agreements which would raise concern include:

• Ongoing franchise and marketing fees being out of proportion to the sales turnover and profitability of the business;
• The franchisor being able to increase franchise fees unilaterally by giving written notice to the franchisee, without any cap on the increase;
• The franchisor being able to make major changes to the franchise system, without consulting the franchisee;
• The franchise agreement not giving the franchisee any express right to terminate the franchise agreement in case of breach of the franchise agreement by the franchisor or franchisor becoming insolvent;
• The franchise agreement placing restraints on the franchisee continuing to operate the business under another name or operating in competition, where the franchise agreement has been terminated because of non-performance or breach by the franchisor;
• The franchise agreement placing unreasonable conditions on the sale or transfer of the business including claims to goodwill in the franchisee's business or payment of large transfer fees to the franchisor;
• Requirements that the franchisee pay the franchisor liquidated damages that are in fact penalties, where there is a breach of the franchise agreement by the franchisee;
• Franchise Agreement not containing adequate protection for the franchisee, where the franchisor sells or otherwise transfers the franchise system or intellectual property to a third party.

In conclusion, as a basic rule, the franchise agreement must comply with the Franchising Code of Conduct and be fair and balanced in protecting the investment of both the franchisor and the franchisee. A successful franchise system involves both the franchisor and franchisee operating profitable businesses. The franchisor's success is ultimately dependent upon its franchisees doing well.

Written by Katarina Klaric

For further information contact:

Disclaimer : This article is not intended to be a substitute for obtaining legal advice.

© Stephens Lawyers & Consultants, October 2007