from Bianca Stevastos, Partner, Baybridge Lawyers.
There are almost 10,000 franchise brands across the globe and international franchising is growing. With over 73,000 franchise units in Australia, an annual turnover in the order of $131 billion dollars and employing more than 413,500 people there is no doubt that franchising makes up a significant portion of Australia’s economy. While statistics enable us to evaluate franchising from a national business perspective, for franchisees and franchisors the relationship is more personal. The parallel has been drawn before, but in many ways the franchise relationship is much like a marriage. For most franchisees, the decision to join a franchise network is one of the biggest decisions they will make in their lives.
Just like a marriage, once you sign on the dotted line you are committed, there is no easy way out and there is no guarantee the relationship is going to work. A good franchising relationship, just as a good marriage, requires mutual trust, respect and a commitment to perform ongoing obligations.
Is He/She Right For Me?
Many factors need to be considered when deciding which franchise network is right for you. No doubt you will have considered the strength of the brand, the depth of the franchisor’s experience, whether the franchise business will complement your lifestyle, and what you are getting for your investment.
You will have met with the franchisor and its key people to ask many questions in respect to the general operation of the business and to determine whether you can envisage being tethered to that relationship for the next 5 to 10 years, knowing that the average life cycle of a franchise relationship is 7 years. In turn, the franchisor will have assessed your financial standing, business acumen, general suitability and whether you will be a good ambassador for its brand.
You will have met with and spoken to other franchisees in the network to garner their impressions of the franchisor and the network at large. You will have asked many probing questions as to what the franchisor is like to deal with, the efficiency of the systems, and whether individual franchisees are meeting their minimum performance criteria and financial hurdles.
You will have undertaken due diligence on the franchise and the franchisor just as they have vetted you. Such due diligence will include seeking independent business and accounting advice as to the viability of the business, to ensure that the numbers stack up and to provide reasonable assurances that the business will provide you with the financial security you require and a reasonable return on your investment.
You will also have sought specialist independent legal advice in respect to the franchise documentation to ensure that you are fully aware of all of your rights and obligations in respect to the franchise. A franchising specialist lawyer will determine if the documentation provided to you is compliant with the Franchising Code of Conduct (Code) and will guide you through the process while advising you on the pitfalls to look out for.
You have been through the franchisor’s recruitment process and you have been approved by the franchisor for the grant of a franchise. You feel as though you are making an informed decision and you are excited about the prospect of your new venture and being your own boss, but with the comfort of the franchisor’s support and within the framework of the franchise system.
Once the 14 day mandatory disclosure period has expired and you can sign the final documents the courtship is over and it is time to get to know each other better.
The Commitment / Ongoing Obligations
Compliance with the system
If you have an entrepreneurial spirit, a desire to be creative in your business, or if you have owned and operated your own business before, the franchising model as a business may not be right for you. As a franchisee you are bound to comply with the systems implemented, and as directed, by the franchisor. It is likely that the franchisor will have spent considerable time, effort and money developing the systems to create the greatest efficiencies within and throughout the franchise network having drawn upon their experience in running the business. While good franchisors are open to their franchisee’s suggestions as to any accommodations or efficiencies that can be made, it should be remembered that even if you think your way of doing things is better, you must still conform to the systems, policies and training provided by the franchisor.
The franchise agreement and disclosure document should set out all payments required to enter and exit the franchise, as well as any recurring payments required over the life of the franchise. Such payments will likely include a royalty fee and a marketing fee, either expressed as a percentage of the franchisee’s sales or as a flat fee, payable on a weekly or monthly basis. Additionally, there may be a requirement to upgrade the premises at your cost, pay a renewal fee at the beginning of any renewal term of the franchise, and attend any ongoing training and annual conferences. All of these costs add up to your cost of doing business and need to be factored into your business modelling at inception.
Many franchisors do not provide any financial information or data as to the expected turnover of a particular franchise. The exclusion of any such information will mean that you will need to prepare your own cash flow projections and budget based on your own information and research. While, for franchisees, there is a certain element of comfort provided within the framework of the franchise model, it is important to remember that franchising does not provide a silver bullet to success. Just as in any business, there is a risk that the business may not succeed and you will need to ensure you can financially survive in the event the business fails.
Many franchisors operate a marketing fund whereby they collect a prescribed percentage of the franchisee’s sales, or a flat fee amount, to market and promote the franchise network at large. You should be aware that most franchisors are not obligated to spend the marketing fund monies to benefit your particular franchise. The use of the marketing fund monies can be a much contested issue among franchisees and is one of the major reasons for disputes between franchisors and franchisees. Franchisees often feel as though the monies generated through the marketing fund are better spent elsewhere and that it only serves to benefit the franchisor in their efforts to sell franchises. That being said, under the Code there are very strict rules and regulations in respect to the governance of the marketing fund to keep the franchisor accountable. Within 4 months after the end of each financial year, the franchisor must prepare an annual financial statement detailing all of the fund’s receipts and expenses for the past financial year. The financial statement must then be audited by a registered company auditor, unless 75% of the franchisee’s in Australia who contribute to the fund vote otherwise.
In addition to your contribution to the marketing fund, the franchisor may also require its franchisees to conduct their own local marketing to promote the sale of the products and services sold by the franchise business. Some franchise agreements will stipulate that a certain percentage of the franchisee’s sales must be spent on local marketing and while the franchisor does not collect the monies and spend it on behalf of the franchisee, you may need to prove to the franchisor that you have spent the allocated amount on local advertising and complied with the obligation.
Minimum Performance Criteria
Many franchise agreements stipulate that the franchisee must achieve a certain set of minimum performance requirements which will either be articulated in the franchise agreement itself or in the operations manual. Such requirements may be as basic as “the franchisee must complete the store opening training program during the first year of operation” or be financial in nature such as “the franchisee must achieve gross sales of at least 95% of the previous year”. It is important that you carefully consider whether the minimum performance criteria are reasonable and achievable. Failure to meet the minimum performance criteria can result in further training costs and in worst case scenarios termination of the franchise agreement. If the minimum performance criteria are contained in the operations manual and not the franchise agreement, you should request to see the operations manual before you enter into franchise agreement to ensure you are comfortable with its provisions.
Supply of Goods and Services
Most franchisors require their franchisees to purchase the goods and services sold in the business from the franchisor or a nominated supplier to ensure consistency of supply and quality throughout the network. Such arrangement will also provide the franchisor, and the network at large, with greater economies of scale or “buying power” which will result in a lower cost of goods and services to the franchisees and a higher profit margin. In turn, this arrangement may allow the franchisor to clip the ticket on the supply of goods and services down to the franchisee or to receive rebates from nominated suppliers. Under the Code, any rebates received by the franchisor must be disclosed in the disclosure document.
Many of the franchisor’s systems and policies for the day to day running of the franchise will be set out in the operations manual. The manual is developed by the franchisor to set a minimum standard for franchisees and to provide a consistency of operations throughout the network. It is important that you understand that the operations manual is a living document which can be updated at any time by the franchisor and that a breach of the operations manual may also be considered a breach of the franchise agreement.
Records and audits
Most franchisors will require its franchisees to provide them with the records of the business including profit and loss statements and balance sheets on a monthly basis. Such records may also include any reports, sales information, invoices or bank statements as required by the information as a breach of their privacy while the franchisor will want to assess the performance of the business and identify any areas for improvement. If the franchisor suspects that the records are not a true reflection of the sales of the business the franchisor will most likely have the right to inspect the records and have them audited by an independent auditor. You should be aware that if there is a reasonable discrepancy in the records the costs of such audit will be passed on to you as the franchisee.
In essence, a franchise agreement grants the franchisee a licence to use the brand, trade marks, systems and any other intellectual property of the franchisor for the operation of the business for the term of the franchise. Franchisors are very protective of their intellectual property and will require its franchisees and any key personnel of the business to hold any such information in strict confidence which obligation survives the termination of the franchise agreement.
Default and termination
In certain circumstances, the franchisor may terminate the franchise agreement automatically and without notice to you. Such circumstances are prescribed by the Code and apply only where the franchisee:
- No longer holds a licence that the franchisee must hold to carry on the franchised business; or
- Becomes bankrupt, insolvent under administration or an externally-administered body corporate; or
- Voluntarily abandons the franchised business or the franchise relationship;or• Is convicted of a serious offence; or
- Operates the franchised business in a way that endangers public health or safety; or
- Is fraudulent in connection with operation of the franchised business; or
- Agrees to termination of the franchise agreement.
In all other circumstances, if you are in default or breach of your obligations under the franchise agreement the franchisor must provide you with written notice that you are in default, set out the nature of the default and what you must do to rectify the default within a reasonable period of time. If the franchisor provides you with such written notice and you fail to rectify the default within the allotted time, the franchisor may have the right to terminate your franchise agreement.
Sale or transfer of your business
If you wish to sell your franchise during the term, the franchise agreement will set out the procedure that must be followed which will include seeking the franchisor’s consent. It is likely that the franchisor will have the right of first refusal to purchase the business which means that you must first offer to sell the business to the franchisor. Under the Code, the franchisor is taken to have given consent to the transfer if the franchisor does not, within 42 days after the request was made, give to the franchisee written notice that consent is withheld and setting out why consent is withheld.
In accordance with the Code, the franchisor may not unreasonably withhold consent to you transferring or selling your business. Notwithstanding, there are certain circumstances where the franchisor may withhold its consent which includes where the purchaser is unlikely to meet the financial obligations of the franchise agreement, or such transfer will have a significantly adverse effect on the franchise system, or the franchisee is in breach of the franchise agreement among others.
Most franchise agreements contain provisions that will preclude franchisees from setting up, operating or holding any interest in any competing business during the term of the franchise and for a period of time following the end of the franchise relationship. As the franchisee, you will have the benefit of the franchisor’s intellectual property, systems and know-how and the franchisor will want to be sure that you or any of its franchisees do not use such information to set up a business in competition with
the franchise network.
The “non compete” or restraint of trade provisions within a franchise agreement are often confusing to franchisees. Several options may be provided in respect to the period of time (eg, twenty four months – twelve months – six months) and in respect to the geographical area (eg, 5km radius – 3 km radius – 1 km radius) in which you may not operate, or hold an interest in, a competing business following termination of the franchise agreement. Clauses drafted in this manner are called “cascading provisions” or “ladder clauses.” The purpose of such drafting is so that if a court determines that the period of time or geographical area stipulated in the restraint of trade provisions are unreasonable, the provisions can be read down so that the lesser period of time and smaller geographical area can be enforced.
The enforceability of non-compete clauses is a bit of a grey area in the law. On the face of it, they are considered anti-competitive and therefore unenforceable. Notwithstanding, a court will enforce the provisions where it considers protection of a franchisor’s goodwill is necessary. Unfortunately, the only way to determine whether the restraint provisions provided in your franchise agreement are enforceable is to test it in a court of law.
Just as in a marriage, many disputes between franchisors and franchisees occur due to the lack of communication between the parties or differing expectations. Where franchise problems or conflict occurs, it is advisable that the parties first seek to resolve the dispute among themselves and if able have a lawyer or trusted advisor available to guide you through the process. Where disputes cannot be resolved informally between the parties, the Code provides that parties to a franchise agreement are required to first trigger mediation before going to court over the dispute. The dispute resolution provisions of the Code clearly sets out the procedure which must be followed including formal written notice outlining the nature of the dispute, the desired outcome of the dispute, and a timeframe within which it should occur. Should the dispute progress to a point where mediation is required, it is advisable to then engage a specialist franchising solicitor to engage in preparations for mediation or to enter into direct negotiations with the franchisor to settle the dispute.
Figures from the Office of Mediation Adviser indicate that up to 75 percent of mediations result in a settlement, which means that both parties are satisfied with the result and in many cases are prepared to continue the franchise relationship. If the dispute is not resolved through the mediation process, the parties may then need to consider taking further action through the court system.
The End of the Relationship
Unlike a marriage, when you enter into a franchise agreement you know that the relationship with the franchisor has a set expiry date. It is important to have in your mind from the outset what your exit strategy for the business will be. It may be that you intend to build the business up and on-sell it mid-way through the franchise term or during the renewal term. You should remember that when the franchise term comes to an end, in most cases, you will not have the right to sell the business and you will not be entitled to an “exit payment” from the franchisor.
The Moral of the Story
A good relationship between a franchisor and franchisee can result in a profitable, fruitful and rewarding outcome for both parties. Many franchisees have built significant wealth through franchising and as any good franchisor recognises, happy and successful franchisees are imperative to the overall success of the franchise network. As with any marriage, open lines of communication are key to an harmonious franchise relationship together with a strong commitment from both parties to uphold their end of the bargain by performing their respective specific duties and ongoing obligations.