ACQUIRING A FRANCHISE

Date: JUN 17th, 2010

Topic: Industry Experts

1.         Lack of Commitment
To determine whether purchasing a franchise is right for you, you should consider your own personal experience and the time you are willing to invest.  If your goal is to work from 9 to 5, franchises and other independent businesses will likely not work for you.  All small businesses take an enormous commitment of time, effort, and money in order to make them successful.  That being said, there are some opportunities in franchising that may allow you to work around your schedule.  For example, a school teacher may be able to run an ice cream franchise during summer holidays; a fast-food franchise located in a busy office tower will likely close during evening hours for those who need their nights free; and for anyone wanting to work at night, a franchise focusing on telephone solicitation will work best in the evening hours when most people are at home.  Ensuring that the potential business fits your personal lifestyle is an important first step.

2.         Generic Business Concept
Look for unique qualities.  Are there things that a particular franchise does that no one else can do?  It may be unique displays, products, services, pricing, or ambiance.  As a consumer, you should want to purchase the products and services on more than one occasion and develop some sort of loyalty to the business.  If the products are not unique, then check to see if they have been packaged in a unique way. If products are neither unique, nor packaged in an unusual manner, then they should be sold at very competitive prices.  However, if price is the only advantage, you should consider that it will not take long for others to find ways to lower their prices thereby leaving consumers no reason to purchase your product or services.

3.         Lack of Discussions with Existing & Former Franchisees
After visiting one or more locations as a customer, go back as a potential buyer.  Speak to the owner about the profitability of the location and the following items:

  • What is the owner’s overall impression of the franchise system?
  • Does the franchisor provide support when requested?
  • Is there an operating manual which clearly sets out procedures for operation?
  • How much time will you be required to spend at the business?
  • Are you required to buy all products and supplies from a single source or from sources approved by the franchisor? If so, are there any issues regarding pricing or timeliness of delivery?
  • Were there any problems in construction or delays in opening the franchise?
  • Are the revenue and expenses projected in the pro forma cash flow statements realistic?
  • Most importantly, ask if the owner would buy the same franchise again if they could do it over?

You should also speak to the owner about any other issues that you feel may be relevant to your decision whether or not to purchase a franchise – the worst that can happen is that the owner will refuse to answer your questions.

4.         Ignoring the Disclosure Document
If the franchise to be purchased is located in either Alberta, Ontario or Prince Edward Island (or New Brunswick upon enactment of their regulations later this year), the franchisor is obliged by law to provide you with a disclosure document at least 14 days prior to you paying anything to the franchisor or signing any agreements. Even if the franchise is not located in these provinces, it may be prudent for you to nevertheless request a copy of the disclosure document if you know that the franchisor is selling franchises in these provinces.
If the franchisor is a member of the Canadian Franchise Association, it is also required by their Code of Ethics that a franchisor provide a copy of its disclosure document in a similar manner as required under legislation.
The disclosure document contains information that makes the investigation of the franchise much easier.  Information such as the franchisor’s financial statements, business history, litigation history and names and addresses of current and former franchisees, as well as the estimated costs to establish the franchise, are all contained in the disclosure document.  The person signing the disclosure on behalf of the franchisor can be held personally liable for any misrepresentations or omissions in the disclosure document.
The disclosure document will provide you with a package of documents that will include a franchise agreement and may include a sublease, general security agreement and any other agreements to be signed by you pertaining to the franchise.  Make sure you carefully review the contents of the disclosure document and seek the necessary legal and financial advice prior to making the final decision to purchase the franchise.

5.         Ignoring the Competition
Although you may become enamoured by a particular franchise, it may be helpful to also research other related or competitive concepts. Having a comparison, you will be better able to objectively assess the financial and business terms of the proposed franchise. By reviewing all related franchises within a particular industry, you may also obtain information regarding current trends and projections within that industry.  Finally, having this information about your immediate competitors may prove useful as each of you compete for business and customers within the franchise territory.

6.         Lack of Proper Legal Advice
Before signing anything, you should seek professional legal advice.  Just as you would not go to an eye doctor for a toothache, you should not go to a lawyer who does not have franchise experience.  Ask your lawyer when the last time was that he or she looked at a franchise agreement.  If the answer is not earlier the same day or sometime the day before, it is likely that you are not dealing with a franchise lawyer.  Generally speaking, a good franchise lawyer spends more than 50% of his or her time on franchise matters.  In order to be properly advised in this industry, knowledge of how a franchise works is almost as important as the legal advice and it is important to find a lawyer with experience in both areas.  A lawyer inexperienced in franchise matters may be able to tell you what a franchise agreement means, but will not be able to tell you what is missing from it or what should have been included in an agreement.

7.         Stale or Fad Franchises
Every business requires change.  You are going to have the franchise for 5 or 10 years, which is a long time for most businesses to be running on the same format.  Good franchisors invest a great deal of time finding ways to extend the life of their franchise and thereby add value for their existing franchisees.  Ask the owner of a franchise if the franchisor introduces innovative new products or services, or requires renovations during the term of the franchise.  On the other hand, consider whether the franchisor has had any long-term success, or whether the products or services are a “fad” or have limited appeal across different markets or in different market conditions.  The franchise concept must be able to stand the test of time and be adaptable to changing conditions.

8.         Non-Negotiable Franchise Agreement
Franchise agreements, in experienced hands, reveal a lot about the franchisor’s system and commitment to franchisees.  They are typically one-sided allowing the franchisor to strictly control the system.  In most mature systems, franchisors are reluctant to make changes to their franchise agreements.  In most newer systems, particularly where the franchise agreement may have not been previously reviewed by experienced counsel, there may be some room to negotiate.  If a portion of the agreement creates a situation of unfairness or is unreasonable, or is otherwise not applicable to particular circumstances, most franchisors would be willing to make the changes.

9.         Complete Acceptance of Pro Forma Statements
You may also be provided with financial information and projections from the franchisor in order to assist you in obtaining bank financing.  Most pro forma financial statements state on the face of them that they are not to be relied upon.  Therefore, without some research, you should not rely on them.  Take the financial statements back to an existing franchisee and ask if the numbers make sense.  Although the franchisee may not be willing to give you the bottom line numbers, show the franchisee statements provided by the franchisor and see if they are in line with the franchisee’s own experience.  Are labour costs correct?  Are the amounts shown for rent, inventory, supplies, advertising and royalties correct?  Has the owner ever achieved the sales levels shown on the pro forma statement and, if so, how long did it take to get there?  What was the first year like in comparison to following years?

10.       Development Cost Delays & Overruns
Some franchisors do not deliver the franchises in a “turn-key” format, ready for the franchisee to operate.  In some cases, the franchisee will have to develop the premises in accordance with the franchisor’s specifications. If the franchisor requires you to be responsible for construction, it is important to determine whether you are required to use construction companies that are related to the franchisor or whether you can choose anyone you wish.  Even in cases where the franchisor agrees to deliver a “turn-key” operation, the franchisor may be agreeable to allowing you to seek competitive bids if they are not using related construction companies.  You should always ensure that any construction contract has reasonable deadlines and penalties for the construction company if they fail to meet the scheduled deadlines.  Many commercial leases will allow you a fixturing period where you will not be required to pay base rent while construction and leasehold improvements take place; however, this fixturing period is always limited and as soon as it runs out you will be charged rent at the full rates whether or not your construction is completed.

Conclusion
Ensuring that you are properly informed before making a purchase is very important in helping you to avoid pitfalls and bad investments.  Opening a franchise business for the first time is a big step for most people.  As you can see, most of the mistakes committed by franchisees in buying a franchise have to do with incomplete due diligence and/or improper advice. Educating yourself and getting proper advice, although not itself a guarantee of success, can help ensure that you are taking a strong step forward rather than making a leap of faith.

© 2010 Morrison Brown Sosnovitch LLP.

The information provided in this publication is general in nature and relates to the laws of the Province of Ontario, Canada.  While reasonable efforts are made to ensure the accuracy of the information, the information contained herein does not replace the need for legal advice which is specific to your situation

This article has been provided courtesy of Derwin Wong and Dixie Ho. They can be reached at: Derwin Wong dwong@businesslawyers.com or Dixie Ho dho@businesslawyers.com