from Jordan Druxerman, franchise and licensing lawyer, Garfinkle Biderman LLP.
Purchasing a franchise can be a good option for entrepreneurs who are eager to start their own business but don’t want to incur the risk of developing a business concept from scratch. However, any business venture can be risky, including a franchised business.
The following are some pieces of advice to consider if you are contemplating purchasing a franchise.
The first and most obvious question is “will I make money?” This question, however, is amongst the hardest to answer. To begin the consideration, a potential franchisee should determine the length of term of their franchise agreement. Franchise agreements commonly provide something to the effect of “the term of the franchise agreement will run for ten years, or until the expiry/termination of the lease, whichever is earlier”. The franchise agreement and lease should both be reviewed in detail to determine the length of their terms, including if there are any events which permit the franchisor or landlord to terminate their respective agreements early.
Once the term of the franchise agreement has come to an end, and absent any rights of renewal or extension, the franchisee will no longer have a functioning business or be left with assets of any marketable value. The vast majority of the initial expenses incurred in connection with the establishment of a franchised business are for leasehold improvements, equipment and fixtures, all of which usually become the property of the landlord at the end of the lease term. All a franchisee is generally left with at the end of the term are the franchisee’s movable assets (i.e. the ‘chattels’) in the premises. These, however, will not be new and will be of little value.
Given the above, a franchisee must be as certain as possible that they can earn sufficient operating profits during the term of the franchise agreement to offset the initial construction and development costs.
Most franchisors will be able to provide a detailed outline of the anticipated costs to be incurred in establishing a franchised business. For franchises in Provinces that have franchise laws (e.g. Ontario’s Arthur Wishart Act or Alberta’s Franchises Act), franchisors will be required by law to provide such initial cost estimates. These will be provided through a Franchise Disclosure Document (an “FDD”).
The difficult part of the equation is the estimation of revenues. In Provinces with franchise laws, franchisors may be largely prohibited from providing guidance on what quantum of revenues franchisee can expect to earn, even where the franchisor has expertise that the franchisee may find valuable. In all cases, while a franchisee’s revenues are tied to the franchise system’s goodwill and marketplace reception, to a larger extent, the franchisee’s revenues will be tied to the franchisee’s own ability to comply with the franchisor’s system and properly run their franchised business (e.g. provide a high level of customer service).
Revenues will also be tied to the location of the franchised premises. According to Shawn Saraga, Broker of Record with SRS Canada, “a coffee shop with a drive-thru in Toronto on the southbound side of a street heading towards the downtown core will have sales that are 30% to 50% higher than a comparable location on the northbound side of a street given the time of day that people stop for coffee”. As such, strong consideration should be given to where a franchisee develops its business.
Potential franchisees, to best gauge the location’s likelihood of financial success, should conduct their own due diligence. The franchisor’s existing franchisees should be contacted and asked about their profitability. Additionally, where the location has already been carrying on business and is being purchased as a going concern, a minimum of two years’ financial statements should be required from the vendor franchisee. Two years’ sales history should also be requested from the franchisor. Note that the sales figures provided by the outgoing franchisee and by the franchisor may not match. Lastly, a business or financial advisor should be retained to prepare a detailed business plan.
While the focus of any potential franchisee’s inquiry is to ensure, as best as possible, that the franchisee will generate sufficient profits during the term of the franchise agreement, consideration should, nonetheless, be given to protecting the franchisee in the event that the business is not a financial success.
The franchisee should likely enter into the franchise agreement and lease, and obtain financing, as a corporation, not personally. The corporation should be a ‘sole-purpose’ corporation that does not carry on any other business or own any unrelated assets. Similarly, the franchisee should strongly negotiate out of having to provide personal guarantees to the franchisor and the landlord. Where absolutely required, a time and/or dollar limit can be built into the guarantees. With regards to financing, the franchisee should consider applying for a Small Business Loan (an “SBL”). An SBL is a specific type of loan offered by financial institutions which is backstopped by Industry Canada. The financial institutions, as such, will only require a personal guarantee of 25% of the financing provided.
While franchising generally involves less risk than developing a business concept from scratch, potential franchisees are nonetheless strongly recommended to conduct their own research and diligence into any franchise opportunity. Lawyers, financial advisors, accountants and real estate brokers can also offer invaluable advice and perspectives.