Evaluating a Franchise
Franchises are becoming increasingly common in Australia. Well-known names such as McDonalds and Kentucky Fried Chicken started trading with franchised outlets during the 1960s. Today there are franchises which cover all types of goods and services – from fast food to car repairs. But what is it that actually distinguishes a franchise from other types of business?
A franchise can involve:
- A product, where the franchise acts as a wholesaler or retailer (as in motor vehicle retailing and petrol reselling)
- A system, where the franchisor permits the franchisee to use a unique method of doing business (as in fast food outlets, laundries and motels)
- A manufacturing arrangement, where the franchisor provides an essential ingredient or know-how (as in the soft drink industry)
What is a Franchise
A franchise is a contract, agreement or arrangement between two or more persons in which one or more of the following obligations exist:
- The right to use a trademark or trade name
- The expectation that prescribed marketing, business or technical plans/systems will be followed
- Marketing, business or technical assistance during the operation of the agreement.
Other terms applied to the franchise arrangement include ‘licence’, ‘exclusive dealership’ and ‘dealership’.
The ‘franchisor’ is the seller and the ‘franchisee’ the buyer.
What are the advantages of a franchise system?
For the franchisee
- A franchise gives access to the franchisor’s experience and the factors which have led to the success of the business.
- A franchise provides the opportunity to trade in a larger business with the support of extensive cooperation marketing arrangements such as advertising/promotion, which may normally be beyond the financial and organisational capacity of an independent small business.
- A franchise provides a structure for recording transactions, financial management and control and operations manuals; this can be a major benefit for people who have not previously operated a business.
- A franchise provides access to ongoing management assistance and training which can reduce the risk of failure or enhance the prospects of business growth.
- The profitability of successful franchises may be higher than that of an independent small business because of the quantity purchased, and group discounts on goods and services to the group.
- The franchisor provides market research and development of new and/or complementary products which means that the franchisee can keep up-to-date with the best products and trends in the industry.
- A franchise provides the opportunity to expand the business without major capital investment and the risk of overextending management capacity.
For the franchisor
- As franchisees have their own money invested in the business, the franchisor obtains conscientious and dedicated personnel who work hard in their franchised outlet, thus keeping the standard of excellence for the franchisor.
- The franchisor can achieve bulk product/service discounts allowing the business to be more profitable.
- A network of outlets means a broader market impact, ensuring a higher profile in the market with limited financial outlay for the franchisor.
- Franchises create long term, high-volume customer base for the franchisor’s product (for example Fasta Pasta – all franchisees must buy pastas and sauces from the franchisor).
What are the disadvantages?
For the franchisee
- The terms of the franchise agreement may place franchisees in a position where they cannot achieve the return on investment they expected.
- Assistance promised by the franchisor to the franchisee does not always occur.
- Threat of termination by the franchisor may be used as a lever against franchisees, putting them at a disadvantage in negotiations and forcing them to accept company decisions which they see as disadvantageous.
- Some franchisees have been falsely persuaded they can make quick profits with little work.
- There is a risk that the franchisor may not be able to support the franchisee because the product is new, and the systems are untried or undercapitalised.
- Poor performance or illegal activities by fellow franchisees and/or the franchisor will have negative impacts upon the franchisee that operates un der the franchise ‘brand name’.
- The franchisee may be closely controlled by the terms of the agreement. Some franchisees feel hampered by the constraints and resent the ongoing payments.
- The franchisor may have no interest in the franchise other than selling as many outlets as possible in as short a time as possible, and may sell outlets which have little chance of success.
For the franchisor
- Franchisees may not operate their business up to the franchisor’s standards, thus risking the franchisor’s name goodwill.
- There is a risk that a franchisee may use the systems and knowledge of the franchisor and set up in competition.
- A dishonest franchisee may try to understate gross revenue to limit fees paid to the franchisor.
- Maintaining a motivated and dynamic relationship with the franchisee over many years may be very difficult.
Assessing a franchise
For many people investment in a franchise represents a commitment of all of their financial resources. Such a step should not be taken lightly. It cannot be too strongly stressed that independent, professional advice about the proposal is essential. Don’t be rushed into signing an agreement. A genuine franchisor will be checking your suitability and will expect you to be investigating the franchise operations just as thoroughly. It may cost you some hundreds of dollars in legal and accounting fees to assess a franchise, but it may save your house, a lot of heartache and hundreds of thousands of dollars. Business consultants specialising in franchises should be approached for advice before you make a commitment.
You should ask for a copy of the franchise agreement and have it examined by a lawyer who specialises who specialises in franchises and related law. Visit the small business agency in your State and Territory and discuss the agreement in further detail. Familiarise yourself with current legislation and the voluntary Franchising Code of Practise. A copy of the code is included at the end of this publication.
The five major areas which need to be considered in assessing a franchise are:
- The franchisor
- The financial outlay
- The agreement
- The product or service
- The franchisee
Regardless of how well known the firm might be, it so important to check up on the franchisor’s reputation, taking the following steps:
- Contact some of the other franchisees and talk to them about all aspects of their business. They can provide you with first hand up-to-date information on how the franchise operates, it profitability, and any other problems which have been experienced with the franchisor. As a franchisee, you will probably be relying on the franchisor to help you stay ahead of your competitors through the use of the latest advertising techniques and through product research and improvements. Will the franchisor honour the agreement in this respect?
- Your own bank, or the local branches of some of the bigger banks, may be able to provide general information about the franchisor.
- Every company (including foreign-owned) must register with the Australian Securities Commission if operating within Australia. If the franchisor is an Australian company it is obliged to lodge certain company information with the Australian Securities Commission. For a small fee, you can inspect the last final statement of the franchisor, see that the directors are, and obtain other general information on the structure of the company. This will help give a history of the franchise business.
- More detailed information about the credit standing and trading prospects of the franchisor can be obtained from a reputable credit agency. This information can cost you up to $300, depending on how much you wish to know. If the franchisor is not financially viable then your franchise will become a worthless investment.
These steps are important as many small investors have lost their savings and have incurred debts through dealing with unscrupulous or incompetent promoters of franchise schemes. Ask yourself whether, on the basis of what you have learnt, the arrangement you are investigating fits any of the following patterns:
- Operators who do not really have a franchise package only an idea and a name. If you carry out a thorough investigation, as advised above, it should not be too difficult to see through such schemes.
- Inexperienced franchisors with ideas they firmly believe in and, probably, franchise arrangements which appear to be fair to the franchisee. Unfortunately, the franchisor may neither the skill nor the finance to make the arrangement work, and both franchisor and franchisee stand to lose their investment.
- ‘Pyramid’ distributors selling you the right to recruit other sub-distributors. Profits would be derived not from the sale of the product, but from the sale of the sub-distributorships. (This method of distribution is generally prohibited in Australia.)
- Promoters of expensive equipment (such as vending machines) may offer the equipment as part of a franchise distributing package. In fact, there may not be a workable franchise arrangement and the purchaser can then be left with the equipment – and substantial losses.
- Franchisors who have workable franchise packages but who do not allow franchisees to make a reasonable profit. Instead they use their superior negotiating strength to ‘milk’ the franchisees of their profits by insisting on a fee far too high or by giving an area far too small.
Other ‘danger signals’ are:
- A brochure describing the franchise arrangement, giving estimates of what profits can be earned from the franchise, relating success stories of other franchisees and giving other well-sounding statements, which the franchisor is unable or unwilling to substantiate.
- Advertisements giving only post office box numbers for reply.
- Promises of being able to ‘get rich quick’ with little work.
- Being unable to obtain a copy of the proposed agreement without payment of a non-refundable deposit (In this case you would be wise to forget the offer. Such a restriction sets the tone of the future relationship – in favour of the franchisor.)
- Refusal to show the franchisee certified profit and lose statements.
- ‘High pressure’ tactics to close the sale (for example the claim that this is the last available territory or that it is an opportunity the representative ahs been reserving for a personal friend etc.)
What is your own opinion of the franchisor, based on your dealings so far?
Has the franchisor investigated you in order to judge whether you are likely to make a success of the business?
If not, why not?
What exactly can the franchisor do for you that you cannot do for yourself?
Remember that franchisors, to perform their part of the agreement, generally have to carry out the management, advertising or research program on which franchisees depend. Does the franchisor in fact seem to have the skills and resources to back up the franchisees? If not, you would be wise to look for an established firm with a record of success in franchising.
The financial outlay
With a franchise agreement, as with any other business deal, you are looking for a profitable return on investment in addition to a fair salary/profit for the time you spend working in the franchise. In order to evaluate what this is likely to be, you need correct information, particularly about costs to you and services which the franchisor will provide. Such information must include answers to the following questions:
- Is the ‘franchise fee’ only a deposit? What is the total cost of the franchise, including: royalties and whether these can change in the future; payments (through purchase, lease or other arrangements) relating to land, buildings, leases, signs, equipment or supplies; any special start-up costs; insurance, rates power etc; contributions you will be expected to make to advertising programs or minimum expenditure required to be spent on advertising and working capital?
- What is the expected length of time between signing the franchisee agreement and opening the outlet? Who will pay for the business rent, light, power, your wages and any other expenses incurred?
- What is the franchisors plan for expansion? Is the market going to be saturated to the point where you can no longer make a living? How many other franchises are going to be sold, and in what areas? How many outlets are operating at present? Will you have the first right to operate new outlets which your franchisor proposes to open close to you and which impact on your sales?
- What is the annual profit projection for the outlet?
- What accounting practises are being used by the company? Could they give an inflated picture of the profits franchisees are making?
- How is the wages component of costs made up? Does it assume that you, and perhaps your family, will work exceptionally long hours at low rates of pay?
- What financing help (if any) will be providing by the franchisor?
- What costs may be associated with training – such as airfares and accommodation to the franchisor’s head office interstate?
- What help will be provided to the franchisee in an emergency or on special occasions (for instance, at an opening promotion)?
- What precisely will advertising assistance consist of?
- What are the expected dollar returns from advertising programs?
- How often will the franchisor’s personnel visit your outlet? Do you have to pay for this service?
- If you are taking over an existing outlet there a number of important factors to consider:
- The inventory: an independent valuation should be performed at the time you take over the franchise;
- The furniture, fixtures, equipment: what is the real market value of these and how useful are they going to be to you?
- The accounts receivable: how old are these? Do they indicate that a large proportion of customers are slow payers? If so, how is this going to affect your working capital?
- The customer lists and business records;
- Supplier and credit relations (the supplier will often be the franchisor): will they continue on favourable terms? Is supply satisfactory, and if not, will you be able to change sources of supply?
- Trained personnel: will any of the remaining employees of the business be due for long service leave, accrued holiday pay, sick leave and so on?
- What are the liabilities of the existing business? Include unpaid bills, mortgages or security agreements against equipment or other assets, benefits due to employees (including holiday pay, long service leave), pending legal suits and requirements to comply with health, safety or other legislation, particularly local government regulations and ordinances.
A franchise agreement is a legal contract between the franchisee and the franchisor which sets out all of the responsibilities that exist between the parties as well as information and timeframe of the contract, the business location, cost and so on. The franchise agreement is usually drafted by the franchisor. It often tends to be one sided –tying the franchisee down as far as possible, while the franchisor’s responsibility are less clearly spelled out. The contract may be presented in a standard form which the franchisor is not willing to alter.
A franchisor may have sound business reasons for apparently restrictive clauses in the agreement. For example, in the food industry the need for all outlets to maintain high standards may lead to detailed rules on source of supply, preparation, service and so on. It is up to you to decide whether the restrictions in a particular contract are reasonable or disadvantageous to you.
It is important to consult a lawyer who is conversant with the Trade Practises Act and franchising before you sign an agreement. However, you can make a preliminary check for your self on the following matters, carefully considering how they are likely to affect you interests:
- Do you retain your rights at law? For example, is there some restriction on your challenging the validity of the contract or the franchise system in a court of law? When do pay the franchisor’s legal costs?
- What are the termination provisions? Can the franchise be terminated in circumstances which might well be beyond your control; for example if you fail to operate the business for seven days without giving notice in writing to the franchisor?
- Does the franchisor have to give written reasons for termination?
- Will the business premises be taken over by the franchisor if you give up the franchise?
- Does the agreement give the franchisor the right to terminate the franchise for breaches of minor clauses of the agreement; for example, for failure to maintain a certain standard of neatness at all times?
- Are you free to sell or assign the business?
- Are you free to sell before expiry of the franchise term? Can you sell to a third party of your choice? Are you bound to give first refusal to the franchisor, at a fixed price which, in the event may be substantially less than you could obtain on the open market? Will you be compensated for the goodwill you have built up?
- Are you bound to buy all your equipment from the franchisor or can you seek the best price else where? If you locate cheaper supplier, are you obliged to pay to have them tested before the franchisor will approve them?
- Are you obliged to buy insurance through the franchisor? If so, is it adequate and at competitive rates?
- Does the agreement contain a ‘non-competition’ clause, which prohibits you from starting a similar business after the franchise ends?
- Are you allowed, under certain circumstances, to make improvements to the system, or is it prohibited?
- Will you, or the franchisor, own the intellectual property of the improvement?
- Is the resale price of the product fixed in some way or are you free to set the prices you wish to charge?
- Are your rights to make sales at other locations such as fairs, conventions or other gatherings restricted in some way?
- Does the franchisor retain the right to sell the product through other outlets such as supermarkets?
- If you prepare advertising material, does it have to be vetted by the franchisor?
- Are you allowed to have an interest in a similar business while the franchise is in force? Are you able to take on another franchise or does the agreement impose a ‘solo’ franchise? If so you should consider how far competitors, who may be able to take on multiple operations, will be able to undercut you through savings in real estate, rental, staff costs; and through being able to offer a greater variety of goods to the public.
- When and how can franchisor or franchisor’s representatives enter your premises?
- Can the franchisor prohibit production under certain circumstances?
- If a territory is involved in the franchise, are you obliged to sell and distribute within the whole of that territory? If so, will some distribution be unprofitable to you?
- Are you able to sell whatever brands of accessories to the product you choose (for example, replacement parts for cars)?
- If assistance is promised to the franchisee by the franchisor, is this detailed in writing? For example, what precise form will assistance with advertising take? What proportion of your profits will be required for contribution to cooperative advertising efforts? What assistance will be available in an emergency situation?
- Does the agreement provide for arbitration of difficulties and disputes? If it does not, you may find your only option in the event of a disagreement is expensive legal action, against a wealthier firm which can absorb the financial losses entailed much more readily than you.
In discussing any of the above points with the franchisor, you may be told that any ‘tough’ provisions of the agreement will never be used against you, since they exist only to protect all franchisees against occasional careless operator who can give the firm and its franchisees a bad name. This may well be true; however, the fact that some provisions exist mean that they could at a later stage, be used as a lever against you if a dispute arises between yourself and the franchisor. This applies particularly to termination provisions.
It would, of course, be unrealistic to expect the franchisor to give in on all the points mentioned. The best you can expect in any negotiations over the agreement is a compromise. If such a compromise still seems to you to entail too much risk, you might be better off using your money and talents in an independent business.
The product or service
Regardless of whether a business is a franchised outlet or not, the product, and whether it can be profitably sold, is the first consideration. If the product or service cannot be profitably sold then you should look for another opportunity.
- How would you, as a consumer, rate the product or service? If it is of poor quality, if it is unsuited to the particular location, or if it is so specialised that there are not enough potential customers for it, the outlet will most probably fail. The franchisor may have already done a market survey on the product or service, but you should find out for yourself about its marketability in the area concerned.
- Will you be getting a specific franchise territory? If so, it is important to check the statistics on local populations and potential market segments, published by the Australian Bureau of Statistics, as well as surveys by private firms, which can provide the basis for a study of the market area by age group, income, and so on.
- Useful information can be obtained by reading newspapers and trade journals, talking to customers and suppliers, trade associations, chambers of commerce, banks, libraries, small business agencies in each state capital and government departments promoting industrial development and decentralisation.
- Find out through discreet inquiry as much as you can about the competition and decide whether there is room for the outlet to make a profit. Is the market expanding or diminishing? Is the industry you are investigating a progressive one, or is it past its peak and on the decline? If the franchise gives you the right to sell a unique product, or to use a unique process or design, it would be in your interest to search the files of the Patents Office in your capital city to see whether these are protected and, if so, whether the franchisor is the patent holder.
Once you have decided whether the product or service is marketable, you should consider all aspects of the franchise package which are going to affect how you market the goods.
Are you the type of person who is likely to enjoy operating a franchise?
The operation of a franchise is not quite like running your own business. There are many more advantages than being an employee, but it may not suit you. The constraints on your independence may make you feel that you are little more than an employee. You may, over time bitterly resent the continuous payment to the franchisor for royalties, advertising and training. If you are the type of person who is likely to feel unduly hampered by the terms of a lease then it is unlikely that you will be happy with a franchise agreement. Similarly, if you want a risk-free operation, someone else to make most of the decisions and if you see the franchise as offering an easier lifestyle than if you were an independent small business, you should forget about buying a franchise.
A franchisee is probably half-way between employee and an independent small business owner. The degree of ongoing dependence which exists between franchisors and franchisees means that both parties should carefully assess each other before signing any agreement.
Personal factors that you should consider
- Are you physically capable of performing the work?
- Are you prepared to work hard and take financial risks?
- Can you accept guidance and direction?
- Is your personal experience relevant to the type of franchise you are considering?
- Do you have an educational background that lends itself to this field?
- Do you have learning capacity and temperament to succeed?
- Do you have the ability to mix with people?
- Is your financial position strong enough to get you through the first year?
- Will you earn an adequate income, does the franchise suit your intended lifestyle, and is the concept something you will enjoy doing?
- What do you think about the franchisor’s existing public image and financial standing?
- Most importantly, do you have your family’s full support?
Honest answers to the above questions will help you determine your suitability and potential success as a franchisee.
Trade Practises considerations
It is important to consider the legislative requirements of the Trade Practises Act 1974.
Section 52 states that a corporation ‘shall not, in trade or commerce, engage in conduct that is misleading or deceptive or is likely to mislead or deceive’.
Predictions made by franchisors to prospective franchisees regarding the profitability of future franchises must well be researched and the figures provided must be realistic estimates. Also, silence or omission of material facts may constitute misleading or deceptive conduct.
Exclusive dealing and third line forcing
Section 47 prohibits suppliers from limiting their reseller’s ability to acquire goods or services directly or indirectly from a competitor of a supplier. It may also be considered ‘exclusive dealing’ if:
- A franchisor refuses to supply goods or services unless the franchisee complies with conditions imposed by the franchisor; or
- A franchisee refuses to buy unless the franchisor complies with conditions imposed by the franchisee;
And the purpose or effect is to lessen substantially the competition in any market in which the supplier and reseller compete.
Section 51AA provides that a corporation ‘must not, in trade or commerce, engage in conduct that is unconscionable with the meaning, from time to time, of the unwritten law of the States and Territories’.
Franchisors must take particular care to explain fully the franchise, including any negative aspects, to prospective franchisees to enable them to make a worthwhile judgement as to what is in their best interest. The unequal bargaining power that a franchisor may have could be construed as an unfair advantage, thus allowing franchisees to remedy the situation through expensive court action.
Franchising Code of Practise
A self-regulatory Franchising Code of Practise was introduced in Australia on 1 February 1993. it is currently in its fifth edition.
The purpose of the code is to ensure a framework is in place to help monitor and control the growth in the franchise industry.
The main code obligations on franchisors are as follows:
- Franchisors who register as members will be required to provide disclosure by way of a disclosure document which is to be updated at least annually and be provided to all prospective franchisees at least seven days prior to signing the agreement, and to existing franchisees on renewal.
- Prior to signing the franchise agreement registered franchisors will be required to provide franchisees with a copy of the Code of Practise and a published guide for franchisees approved by the Franchising Code Council LTD. In addition, franchisors will require each franchisee to produce a certificate from a solicitor certifying that the solicitor has explained the franchise agreement to the franchisee. Alternatively, the franchisee should sign a statement that the franchise agreement has been explained by a solicitor.
- Franchise agreements for new franchisees subject to the code will contain a minimum seven-day cooling-off period from the date of the franchise agreement.
- Franchisors and franchisees will not participate in unconscionable conduct, which is unlawful, in relation to franchise agreements and should at least observe the commercial standards and/or ethical conduct as set out in provision 12.2 of the code.
- Franchisors and franchisees will comply with the code’s dispute resolution procedures.
- Franchisors will require each franchisee to identify clearly, both within business premises and on business stationery, that the franchisee’s business is being operated under a franchise from the franchisor.
- Franchisees are required to provide financial disclosure to an approved purchaser of the franchisee’s business.
- Advisers, including accountants and solicitors who advise in the franchising area, will be able to provide information of their franchise experience, respect the confidentiality of all information received concerning a client’s business and will not disclose any such information without the client’s prior written permission.
- Financial institutions registered with the council will comply with the code by agreeing to provide customised franchisee finance/service packages only for franchise systems where the franchisors have agreed to comply with the code and are able to provide a current Code Registration Number.
- Service providers which are publishers and advertising media providers registered with the council will comply with the code by agreeing not to take or place advertisements from persons purporting to sell or provide franchise opportunities unless those persons are able to provide a current Code Registration Number.
What to do when things go wrong
The code’s dispute settling provisions require that:
- You give your franchisor details in writing of your problem, what you want done and the best way to fix the problem.
- You and your franchisor agree on how to fix the problem.
- If you cannot agree how to fix the problem within three weeks, either of you may refer the matter to mediation or ask the Franchising Code Mediation Advisor to appoint a mediator. Both parties are required to attend mediation, and each must include a person authorised to settle the dispute. You must pay your own costs. If mediation is unsuccessful the mediator will issue a certificate showing this.
If you have any queries or concerns about your business operations and the Trade Practises Act contact the ACCC.
ACCC Info centre 1300 302 502
Small business officers can be contacted at the ACCC office in your State or e-mail us.
Botany Bay BEC
21A Dalley Avenue, Pagewood 2035, Telephone: 61 2 9316 5877, Facsimile: 61 2 9666 5141 email