WHAT IS A FRANCHISE? BUYING A FRANCHISE? SELLING A FRANCHISE BUSINESS? WHAT YOU NEED TO KNOW.

Kiwis are in love with franchises. And why not? It can work really well. But like any other business, the key is planning and assessment, not chance.   This article summarises some important considerations that can make a real difference when buying or selling a franchise business.

The ‘buyer beware’ principle features strongly when you buy an existing franchised business or take on a new franchise.   You should investigate and assess as much as possible before committing to it.   This article gives guidance on that.

ATTICUS LEGAL, FRANCHISE & BUSINESS LAWYERS HAMILTON

At Atticus Legal we have experience at the coal face in preparing franchise documentation for franchisors – franchise agreements, trade mark user agreements and the whole suite of documents that go with setting up a franchise.   We also have years of experience representing clients in sales and purchases of various franchise businesses.

Unlike some other countries, there is no legislation in New Zealand specifically regulating franchising.   Instead, a collection of general laws apply; contract law, intellectual property, Fair Trading Act and so on.   You need experienced legal advice to navigate through this.

WHAT IS A FRANCHISE? Are all franchises equal?

A franchise is a business arrangement where the owner of a business model or system (the franchisor) permits others (franchisees) to use that model/system (‘the franchise system’) to carry on their own business.   The franchise system usually includes intellectual property owned by the franchisor – eg. trade name, trade mark, copyright.   The franchise will involve an exclusive territory, or sometimes a specific site, where the franchisee may trade.

Depending on the circumstances, you may be purchasing an existing operating franchise business, with the franchisor’s approval, or you may be setting up a new franchise business in a territory.   Many of the same considerations apply.

Sometimes the franchisor may require the franchisee to purchase all its requirements for stock, raw materials or equipment either from the franchisor direct or from a supplier approved by the franchisor.   There may or may not be a rebate system in place (discounts or cash back based on level of purchases).

The franchisor may or may not provide ongoing assistance to the franchisees; for example, a manned 0800 number and nationwide and/or local marketing and advertising (which are all usually at the cost of the franchisees).

Depending on the franchise, the franchisee will be required to pay some or all of the following to the franchisor or its approved supplier:

• a substantial up-front franchise fee.   Beware of unusually high up-front franchise fees relative to the industry/territory as this may not be a good sign – either the franchise brand is very valuable (like ‘McDonalds’) or you are being diddled!,
• a further, usually lesser, franchise fee on renewal of the franchise term (say, 5 yearly),
• initial franchisee training costs, which may or may not be included in the franchise fee,
• purchase costs for equipment, vehicle branding, etc,
• ongoing royalties or ‘commissions’ based on sales (perhaps 2 – 8% of gross sales),
• ongoing marketing and advertising contributions.
• In addition, if a new or additional franchise site is contemplated there will be other costs for the franchisee such as premises fit-out and branding (colour scheme and signage).   Franchisees may also be required to establish their own website, appropriately branded in accordance with the operating manual.

So are all franchises equal? Absolutely not. They vary from industry to industry, the amounts payable by the franchisee, the type and quality of the intellectual property licensed to the franchisee, the term, renewal rights, the obligations imposed on the franchisee (strict v more relaxed), the trading restraints on franchisees, level of ongoing support from franchisors and a host of other factors.

ADVANTAGES OF A FRANCHISE BUSINESS

There are definitely advantages in buying a successful, established franchise business.   They include:

• The franchise system has already proven itself, whether at your intended site or elsewhere;
• Customers and the public are already familiar with the brand and the product/service;
• Depending on the franchise, you get a complete set up ‘package’ ready to go;
• You should get initial training and maybe ongoing training from the franchisor;
• The operating manual gives you specific ongoing guidance and rules to follow;
• You have ‘exclusivity’ within your territory, meaning the franchisor won’t appoint other franchisees within your territory and the franchisor itself won’t operate in your territory;
• You have a fixed term within which to exploit and benefit from those exclusive rights (franchise term plus any renewal rights);
• You may have bulk-buying discounts and rebates from approved suppliers; and
• You may have the benefit of nationwide marketing and advertising by the franchisor and maybe an 0800 number.

DISADVANTAGES OF A FRANCHISE BUSINESS

Some of the above-listed advantages can also be disadvantages.   The disadvantages include:

• The franchise system, while proven elsewhere, may not translate well to your intended site/territory.   What works well on Ponsonby Rd, Auckland may not work well on Ulster St, Hamilton.   ‘Nosh’ is an example of this. And beware of the franchisor who has only one ‘pilot’ business.   Effectively, the system and brand has not yet adequately proven itself;
• The brand may have developed, or may develop, a poor reputation due to other franchisees operating elsewhere going into receivership or liquidation or just not treating their customers well;
• Operating manuals can be quite restrictive; it’s the franchisor’s way, or no way – ie. you give up some control and autonomy;
• You have the benefit of an exclusive territory, but you can’t expand outside that territory. And often you will be prohibited from operating either any other business at all or any other similar business during the franchise term;
• You are usually also prohibited from operating any similar business after the franchise term ends – ie. a restraint of trade defined by restraint period and area.
• You are committed for the length of the franchise term.   If it doesn’t work out for you you’re stuck unless you can find a franchisor-approved purchaser.   And if the business is not doing well it may be difficult to sell;
• You will be required to personally guarantee the franchisee’s obligations (see further below);
• The costs involved (franchise fee, renewal fee, royalties, nationwide advertising, etc) may be disproportionately high relative to the benefit obtained;
• The bulk-buying discounts and rebates may not be generous and/or they may be available from suppliers outside the franchise umbrella;
• Some franchise agreements provide that if you don’t meet minimum sales targets the franchisor may terminate the franchise; and
• Many franchise agreements require that you first offer the franchise business for sale to the franchisor, before offering it for sale to anyone else.

WHEN & WHY YOU SHOULD CONSULT ATTICUS LEGAL, FRANCHISE & BUSINESS LAWYERS HAMILTON

SELLING A FRANCHISE BUSINESS

We recommend that sellers consult Atticus Legal before signing a sale contract.  Why?   Because we can help you with:

• Obtaining your franchisor’s agreement to further rights of renewal of the franchise term (so you have ‘something to sell’);
• Obtaining your landlord’s agreement to additional rights of renewal of the lease term (again, so you have something to sell, in addition to franchise rights);
• We can, in conjunction with your accountant, advise on an accurate turnover warranty that you can hold out to prospective purchasers, and which will be recorded in the sale contract.   Sellers sometimes promise ‘too much’ and can be caught out later if the purchaser has reason to believe that the seller’s turnover warranty or other trading-related warranty was inflated;
• Preparing a sale contract, or reviewing a sale contract prepared by an estate agent, to ensure it includes appropriate terms and conditions (see below), including a contract for franchisor’s approval of the purchaser.   Note the franchisor will require payment of any amounts you owe to it as a condition of such approval; and
• Ensuring your restraint of trade in favour of the purchaser is reasonable compared to your restraint under the franchise agreement.

BUYING A FRANCHISE BUSINESS

For purchasers before contract stage:

Again, we recommend that purchasers consult Atticus Legal before signing a purchase contract or the franchise agreement itself.   Why?   Because we can help you with following.   The below considerations apply when purchasing an existing operating franchised business but may also apply when you are taking on a new franchise.

• Your pre-contract investigation and assessment of the success or otherwise of the existing franchisee and also other franchisees in other territories.   Are you buying a goose that lays golden eggs, or are you buying a lemon?   Ideally this general inquiry stage should be completed before the contract, rather than as part of a due diligence condition after signing the contract.   Maybe you can save yourself some legal fees.   Even just asking to tag along with a franchisee for a day or two will give you some insight into the business.   If it’s a new franchise, ask to do the same with an existing franchisee in another territory.   You can see how they operate, who their customers are and ask what their relationship is like with the franchisor.   Don’t be passive.   This pre-contract inquiry stage is mostly up to you, but we can help guide you.
• You should also investigate any known franchisee failures in your territory and elsewhere.   Why did the business fail?   Could the same circumstances apply to you?   Insufficient customer base?   Poor location?   Was the competition too strong/numerous?, etc.
• Also consider the translation of the franchise system/brand to a new site (see the above ‘Nosh’ example) and the suitability of the existing or new leased premises (eg foot traffic).
• As noted above, the ‘buyer beware’ principle applies.   It’s up to you to investigate and assess as much as you can before you purchase.   Franchisors almost never give promises or ‘warranties’ regarding actual trading, sales forecasts, etc. They’ve been burnt on that before.   And the seller may offer you as little ‘hard information’ as they can get away with.   However, if a franchisor or seller does make a promise (eg. a promise of further franchise renewal rights or turnover information) then you must ensure it is included in the purchase contract or franchise agreement, as appropriate.

For purchasers at contract stage:

So you’ve made your pre-contract inquiries and it all looks good.   When you come to contract stage Atticus Legal can help either prepare the purchase contract or review a contract prepared by an estate agent.   Amongst other things, we recommend that you include the following in your purchase contract:

• A due diligence condition, enabling you to have access to and assess specifics such as the seller’s financial statements, GST returns and bank statements, speak to customers and maybe staff as well, examine employment agreements, lease documents, etc.   This is a crucial investigation and can make or break a deal.   You should take advice from your accountant regarding the financial performance of the business, whether the price is reasonable in light of financial performance and also to advise on your likely working capital requirements;
• A condition for you to obtain franchisor consent to your purchasing the franchised business on terms acceptable to you – eg. as to personal guarantees required by the franchisor (see further below);
• A condition, where appropriate, that you obtain the agreement of the landlord and/or franchisor to additional rights of renewal;
• An appropriate indemnity from the seller as to payment of wages and other employee entitlements (eg. accrued leave) up to settlement date; and
• Other appropriate conditions – eg. your arranging finance.   Note that depending on whether or not the franchisor is a member of the Franchise Association of NZ (FANZ), there may be a 7 day ‘cooling off period’ after you sign the franchise agreement.

Other ways Atticus Legal can help a franchise purchaser:

• Ownership structure: At or before contract stage we can advise on an appropriate ownership structure for the franchised business.  Often a limited liability company is the most appropriate.   But bear in mind that your franchisor and landlord will require personal guarantees from the directors and either all shareholders or at least the majority shareholders.   This may be a good reason for your spouse/partner not being a named as a director or shareholder of the company; and
• Asset protection: Before contract stage you should consider ‘asset planning’ to protect, or limit the exposure of, your main personal assets (eg. your home) from potential business failure, including claims or lawsuits (eg. arising from personal guarantees) brought by the franchisor, the landlord or someone else.   For a number of reasons it’s better to set up any asset protection structure, and transfer assets to it, at or before you enter into a major commitment such as a franchise, lease or bank loan.   This usually involves setting up a family trust and transferring your home, and maybe other substantial personal assets, to it.   A simpler, but less effective, strategy may be to ensure that legal ownership of relationship property assets is equalised and divided between yourself and your spouse/partner (if they are held unequally), so that the ‘non-liable’ spouse/partner effectively protects a significant part of total relationship property assets. This is done through a relationship property contracting out agreement.   It may involve shifting the business assets into the name of the potentially liable spouse/partner and the personal assets (eg. the family home) to the non-liable spouse/partner.   See our estate planning article for the pros and cons of this:  https://atticuslegal.co.nz/estate-planning/

Other sources of franchise information:

There are various helpful sources of franchise information on the internet. We recommend the websites offering independent advice by:

• The Franchise Association of NZ (FANZ).
• The Ministry of Business, Innovation & Employment.

WANT TO KNOW MORE? Just ask Atticus Legal, Franchise & Business Lawyers Hamilton

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CALL ANDREW SMITH, the owner of Atticus Legal, for expert professional advice on any of the matters referred to in this information sheet.

LAWYERS HAMILTON, BUSINESS LAWYERS HAMILTON, SMALL BUSINESS LAWYERS HAMILTON

Ph: (07) 839 4558, Fax: (07) 839 4559, Mob: 021 508 189  

SEE OUR WEBSITE: www.atticuslegal.co.nz

Email: andrew@atticuslegal.co.nz

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Disclaimer: The information contained in this information sheet is, of necessity, of a general nature only. It should not be relied upon without appropriate legal advice specific to your particular circumstances.

This information sheet is copyright © Atticus Legal, March 2016.