Five Important Questions To Ask Your Franchisor Before You Sign Anything
This article was written by Mark Sherry and was first published in the Business Franchise Australia and New Zealand magazine, and has been reviewed and updated in April 2020.
Do you have a disclosure document?
Reputable franchisors take a lot of time setting up their franchise systems. One of the most important documents that a franchisor can provide is a disclosure document. A disclosure document is a document that explains in layman’s terms the most important aspects of the franchise system. The sorts of questions that a disclosure document might answer include:
- the payments that must be made by a franchisee
- the expectations a franchisor may have of a franchisee
- what ongoing assistance a franchisor will deliver
- the background of the franchise system
- how many franchises are in operation already
- the franchisor’s financial details
- what plant and equipment will be required to run the business along with the approximate costs of such items.
In New Zealand a disclosure document is not compulsory for many franchise systems. However, if a franchisor has voluntarily become a member of the Franchise Association of New Zealand then a disclosure document is mandatory. That is because best practice suggests that a disclosure document should be provided to prospective franchisees.
Can I speak to existing franchisees?
A disclosure document only tells a buyer so much about a franchise system and there are a lot of intangibles within a franchise system that cannot be stated within a disclosure document. One of the best ways to assess the effectiveness of a franchise system is to talk to existing franchisees. From discussions with existing franchisees a person will soon be able to establish whether a franchisor is providing the services that it is obliged to under the franchise agreement and whether the franchise system runs smoothly or has issues.
Every franchisor will potentially have favourite franchisees that they may try to convince a purchaser to contact. It is highly preferable to contact as many franchisees as possible to try and establish just how widely the levels of satisfaction with the franchisor run and to see whether some franchisees are content with the system while others have gripes. One of the indicators of a good franchise system is that a franchisor is responsive to issues when they arise. If a franchisor only allows a buyer to speak with one or two specified franchisees then this should certainly raise an antenna for prospective franchisees.
What are your expectations of me as a franchisee?
Every franchise system has expectations of behaviours that franchisees must adhere to. Ideally, when a franchisor is asked this question the response will be very detailed and the franchisor should be quite animated. The response may even lead the prospective franchisee to question whether they can meet the expectations. This is because one of the main signs of a well run franchise system is that franchisors have high expectations of franchisees and they want to ensure that they comply with the terms of the franchise agreement and the franchise manual. It is a good sign when a franchisor has high expectations as it means that not only will they ensure that you as a franchisee behave properly but that other franchisees within the system also must comply with their obligations so as to ensure a strong brand.
The alternative to a franchisor that cares about their brand and their franchisee’s behaviour is a franchisor who is not that interested in the way that a franchisee behaves once the franchise agreement has been signed and the initial franchise fee has been paid. Where a franchisor relies on the self motivation of franchisees for the growth of a business and will tolerate mediocre behaviour and performances by franchisees without having minimum key performance indicators in place then a buyer should question the system they are looking to buy into. If a buyer is looking to enter a high performing franchise system they need to look for franchisors that keep their fingers on the pulse and have systems in place to foster productivity and service.
What will be my costs under your franchise system?
This question can be difficult for a franchisor to answer. It depends on the way the financial aspects of the franchise system have been set up. Where a new franchise is being purchased then invariably costs will include an initial franchisee fee. There will also normally be plant and equipment purchases and in some cases the cost of premises rental and fitout costs. Where an existing franchise is being purchased then there would not normally be an initial franchise fee but instead there would be the price paid for the existing franchisee’s business. This will no doubt include a goodwill payment for the outgoing franchisee. Generally however the initial payment to get into the franchise is just one payment consideration for a franchisee. In many cases franchisees focus too much on the initial costs and not enough on the ongoing costs of belonging to the franchise system. Most franchise systems have ongoing royalties based on turnover and many have items of stock and/or plant which must be purchased through the franchisor that contain a franchisor’s mark-up. Also, there are often contributions to franchise system advertising which are based on turnover.
It is important to take professional advice when assessing the costs of a system and most specialist franchise accountants will be able to complete projected accounts and cash flow statements for a business that factor in all the payments that need to be made in the course of running the business. At the same time the lawyer involved will advise on contingent liabilities and payments that might have to be made if the franchise business fails. Such payments might include ongoing payments under the franchise agreement, ongoing obligations on the lease arrangements and obligations to repay banks and other lending institutions for money being borrowed. It is very wise to look beyond the initial advertised purchase price as the costs involved go well beyond the scope of those.
How do I exit my business?
This is a question that many people fail to ask themselves at the time of purchasing the franchise as it can be forgotten in the excitement and stress involved in sorting out all the purchase related issues. However, many people enter into start-up businesses with a view to building them up and selling them on for a profit. Others that have a long term perspective may face changes in circumstance due to things such as health or family issues that cause them to have to sell. When selling the franchise it is not simply a matter of engaging a business broker to list the business on the market and selling it to the purchaser that offers the highest price. Most franchise systems require prospective franchisees to be vetted by the franchisor and the fact that a purchaser has the money to pay the asking price does not mean they fit with the vision that a franchisor has of the appropriate franchisee. The franchisor will look at matters such as industry experience, personality types, financial stability and many other factors. Therefore, the prospective purchaser will need to jump through hoops with the franchisor. They may also, where a business occupies premises, have to jump through similar hoops with the landlord.
Once a purchaser has been found, the franchise agreement may still impose significant obligations on the existing franchisee. There may be obligations to train the incoming franchisee. There may be payments to be made by an outgoing franchisee as a transfer fee to the franchisor. Some franchise systems even require the franchisee to pay a proportion of the sale price to the franchisor in recognition of the fact that part of the goodwill of the business is due to the branding and efforts of the franchisor.
In limited life franchise systems (e.g. a system that may run for an initial term of five years with a right of renewal for a further five years) a franchisee needs to confirm what it is that they are selling to a prospective buyer. Some franchise systems effectively allow an outgoing franchisee to sell a whole new franchise by restarting the time frames for an incoming franchisee whereas other systems only allow a franchisee to sell the equivalent of the remaining years in their franchise system. In the latter case, the shorter the time remaining until the franchise expires then the less the sale price will be. Many franchise agreements are silent on how this issue is treated and it is very important to try and get some agreed parameters around it at the outset. It would be fair to say that the more one pays to enter a franchise the more one would be seeking to be able to exit the franchise and recoup initial investments and goodwill. Where small purchase prices are paid to enter franchise systems then ability to be able to sell a full franchise term becomes less of an issue.
It is always important to remember that when you are in doubt about any issue you should take advice from appropriately qualified franchise advisors before signing anything.