Due Diligence: The best investment you can make prior to buying a franchise
Purchasing a franchise can be a daunting and unknown process for many prospective franchisees. More often than not, franchisees are given a large bundle of documents to review, are expected to be familiar with the Franchising Code of Conduct and are required to make a large financial investment - often with the dream of creating a better life for themselves and their families.
Too often am I seeing franchisees bypass the vital task of conducting their own due diligence prior to buying a franchise on the basis that it is too expensive, or that it delays the sign-up process. Instead of viewing due diligence as an expense to the business, franchisees should view the process as an investment, as it provides critical knowledge required to make calculated decisions.
What is Due Diligence?
Due diligence is the extensive appraisal of a franchise and the franchisor, undertaken by a prospective franchisee. A due diligence audit will often reveal the following information:
- Current assets and liabilities of the franchisor;
- Current and prospective litigation matters involving the franchisor, a director of the franchisor or an associate of the franchisor;
- Current intangible assets that the franchisor, or an associate of the franchisor may possess (such as goodwill and intellectual property); and
- Current supply arrangements and contracts.
Often, it is not until a dispute arises between the franchisor and the franchisee that a strong case for undertaking a comprehensive due diligence process becomes apparent. Unfortunately, by this time it can be too late.
Conducting a thorough due diligence process at the outset provides the franchisee with the opportunity to consider whether their purchase is good value for money, whether they are properly equipped to combat inherent challenges faced by the franchise, and whether the franchise model meets their expectations. This process also provides potential franchisees with the opportunity to ask any difficult questions that they may have prior to purchasing the franchise.
In recent months, I have received several inquiries from franchisees looking to exit their franchise agreement midterm. Some themes common throughout these inquiries have been that the franchisee did not undertake a thorough due diligence process, that they were quick to sign the franchise agreement, that they did not fully appreciate their obligations under the franchise agreement or that they were not aware that they were entitled to negotiate the terms of their franchise agreement. As a result, their initial dreams and expectations about the franchisor, the franchise network and the operation of their own franchise have not been met.
How Should You Go About Due Diligence?
Here are some tried and tested guidelines to assist you with the due diligence process that Coleman Greig advises prospective franchisees to undertake prior to the purchase of a franchise.
- Check for any upfront and/or continuing fees
In relation to the franchise agreement, it is normal practice for a franchisor to charge a franchisee an array of upfront fees, including an initial franchise fee, training fees for managers and key employees, fit out costs and an intellectual property licence fee, upon execution of the franchise agreement. During the term of the franchise agreement, a franchisee may also be expected to pay monthly royalties (usually a percentage of gross sales), management fees and marketing levies.
During your due diligence process, you should ask the franchisor to confirm what upfront fees you will be expected to pay, as well as what continuing fees you must pay in the future.
- Examine the disclosure document and franchise agreement carefully
Both the franchisor's disclosure document and the franchise agreement are valuable sources of information for prospective franchisees. Franchisees should read both documents carefully, and in the process of doing so, make a list of questions. These could be questions for yourself, the franchisor, your accountant or your lawyer. Where possible, accountants and lawyers who have experience in the franchising sector, and more specifically in advising franchisees should be consulted.
To ensure that you understand the franchise business, further enquiries should also be made - such as visiting existing franchising businesses or speaking with existing franchisees to get a feel for the system and how it operates. A list of the current franchisees should be included in the disclosure document.
- Conduct your own background research
You should use the internet to find out as much background information as you can in relation to the franchise. The internet can often equip you with information that isn't necessarily required to be disclosed in the disclosure document or franchise agreement - so it is generally a good idea to conduct your own research further to the documentation that you are supplied with.
For example, you may discover that the franchisor is planning to expand the franchise network into overseas markets. Keep in mind that the internet can be a highly unreliable source of information, although it may help you to add questions to your list.
- Involve your business advisory team as soon as possible
When buying a franchise, it is important to surround yourself with a team of trusted advisors, including your accountant and lawyer. My experience has been that it is in your interest to involve your accountant as well as your lawyer early in the transaction, so that you begin negotiations with the franchisor having a complete understanding of the full implications of the relevant contractual and taxation obligations imposed on you.
- Get the structure right and have your finances in order
You should consult with an accountant experienced in assessing franchise businesses to discuss both the feasibility of the franchise, and the most appropriate business structure to establish as the franchisee entity. Your accountant will consider your taxation obligations and asset protection strategies, as well as ensuring that you are able to access required finances to help fund the acquisition.
- Don't rely on 'handshake deals' - get everything in writing!
Buying a franchise is a very exciting time. As such, I often see franchisees very keen to get their new franchise up and running - although as an unfortunate result, they tend to rush the process and dive straight in.
With this frantic mindset, franchisees-to-be are less likely to ensure that all promises, obligations, rights or responsibilities are properly documented. This can pose challenges later when you go to rely on the word of the franchisor and they either renege or don't recall the conversation.
- Don't sign a lease until you've been approved as a franchisee and you have received finance
When negotiating the terms of a franchise, you must ensure that you try to arrange for the franchise agreement and the start of the lease to coincide.
Failing to do so may result in having to pay rent for a couple of months prior to the franchise being up and running. It is also important to ensure that once you've ironed out all terms of the leasing and franchise agreement deals, you are approved for finance. Again, you don't want to see yourself out of pocket for an extended period prior to your finance getting sorted.
- Don't underestimate expenses and initial capital required
In the process of furiously organising their finances and budgeting, franchisees often either underestimate or forget to include the additional amounts of money required to cover miscellaneous expenses. These costs may include (but are not limited to) employee expenses such as leave entitlements, uniform and equipment costs, insurances and training expenses, to normal day-to-day operating costs. You should remember to include a "buffer" when it comes to your budget, in order to leave yourself with some room to breathe.
Key Points to Remember
There are three key things to remember about due diligence:
- You're entitled to request it: Commercially, it is sensible to ask as many relevant questions as you can of yourself, the franchisor, your accountant and your lawyer prior to making the purchase;
- Help is available: You won't be expected to understand every piece of information the due diligence process uncovers, nor are you supposed to forecast the potential ramifications arising from this knowledge. Professional advice is available to help you make sense of the information; and
- Due diligence is an investment, not a cost: While due diligence may require your time, the advice of professionals and at least some sort of financial commitment, the overall benefits of the process will far outweigh the short-term costs.
If you are looking for a team of experienced franchising lawyers to whom you can turn throughout each step of your franchising journey, please don't hesitate to get in touch with Coleman Greig's Franchising team.