What to look for in your franchise disclosure document?
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.
If someone is in the market to purchase a franchise business, and they find a system that may be of interest to them, then they will investigate the franchise system further to see if it is the right fit for them.
This involves investing time, effort and money before deciding whether they wish to proceed with a purchase or not.
One of the best sources of information that a prospective franchise buyer can review is the disclosure document for the franchise system that has been prepared by its franchisor. Unfortunately, in New Zealand franchise disclosure documents are not compulsory and therefore a buyer can be tripped up at the first hurdle if the system they are looking at does not have one. In such cases a franchisee may have to spend significantly more time researching and collating the information they need.
However, more and more New Zealand franchise systems are starting to make use of disclosure documents as they recognise the benefit for potential franchisees. Their use has become more prevalent as more systems are introduced from Australia and elsewhere. Further, if a franchise system in New Zealand is (or wants to become) a member of the Franchise Association of New Zealand (FANZ), then it is a requirement of FANZ’s code of practice that franchisors will provide a disclosure document in accordance with their code.
The FANZ code of practice includes minimum requirements for a disclosure document. FANZ requires that a disclosure document be regularly updated and that it be provided to a prospective franchisee with sufficient time to digest its contents before a final franchise agreement is signed or becomes binding. FANZ also require that an updated disclosure document be provided to existing franchisees before their franchise agreements are renewed.
Many systems in New Zealand, even if they are not FANZ members, do have disclosure documents. This is especially true where they have been assisted at some stage in their development by a reputable franchise consultant who has convinced the franchisor of the benefits of a disclosure document.
Ideally a disclosure document should provide the following details:
1. The name and contact details of the franchisor. It is important that at all times a franchisee knows how to contact the franchisor. They should also know the details of directors and executive officers of the franchisor as well as their job descriptions and qualifications.
2. The business experience of the franchisor, how long it has been involved in the type of business being operated in the franchise, how long the franchise itself has been operating, as well as detailing other franchise-related experience that the franchisor may have. This allows a prospective franchise purchaser to gauge the type of person that they are dealing with and whether they are qualified to deliver the assistance that the franchisee expects.
3. Financial projections, so that the franchisee can get an idea of prospective returns on their investment. From a franchisee’s perspective, this is an extremely important item as the detail provided will show just how financially viable the business that they are looking to purchase might be. Disclosure documents do not always provide such written projections however as franchisors do not wish to be seen to be providing guarantees to franchisees around minimum income levels and the profitability of a franchise. Sometimes financial projections may be given, but often this is done as a separate document outside of the disclosure agreement. In nearly every case a franchisor will require the franchisee to seek independent financial advice and to specifically sign an acknowledgement at the time the franchise agreement is signed off that they have received independent financial advice and that they are not relying on any financial data provided by the franchisor. If financial projections are given by a franchisor then they are most often based on the actual historical performance of existing franchisees and they will be published with a waiver that states that there is no guarantee that a prospective franchisee will achieve those results.
4. The key financial information of the franchisor and the people behind it so that a franchisee is able to establish whether the franchise system itself is financially sound and likely to stand the test of time. If there have been bankruptcies, receiverships and the like in the history of the franchisor, or its executive team, these should be disclosed also. The relationship between a franchisee and a franchisor is one that is based on mutual trust. In other words, for each party to succeed the franchisor and all the franchisees in the system must perform for the benefit of each other. A good franchisor will always complete a due diligence investigation of its prospective franchisees to ensure they are fit and proper. An astute franchisee should do the same. If the franchisor has had a troubled financial history then that is certainly something to be wary of.
5. A good summary of the main particulars and features of the franchise system, including things such as its history and how it developed, the intellectual property that is owned by the franchise system and any threats or litigation relating to that intellectual property, details of restrictions that may be imposed on a franchisee such as geographical or territorial restrictions, and details of how the system actually works on a day to day basis. If a franchise is a service-based system, it should provide details on how those services are to be delivered to customers. If it is a system that involves the sale of goods then it should detail how such goods are purchased and supplied and whether there are rebates that are paid to the franchisor by the suppliers. Rebates can be a contentious issue as they are an additional income stream for the franchisor that are generated from the sales of the franchisee. Problems have arisen in systems where their existence has not been disclosed to franchisees.
6. In systems where a franchise is operated from a specific site then there should be a description relating to how sites are selected and approved and the type of site that is suitable for the franchise.
7. How long a franchise agreement runs for along with details as to how, at the end of a term, the franchisee can renew the franchise for a further term or terms. There should also be a good summary of how a franchise agreement might be assigned if the franchisee wishes to sell their business to a third party. If a franchisee is looking to sell their business they are not just looking for a buyer who can pay them the purchase price. The buyer also needs to be a suitable person and that means that they must meet the franchisor’s criteria in terms of background, experience in the sector, financial standing and other relevant factors.
8. The financial information relating to the fee and cost structures of the franchise system. Most franchise systems have a number of fees and levies to be paid to the franchisor. There can be initial purchase fees, training fees, fit-out fees, ongoing royalties, marketing fees and other costs specific to the system. The disclosure document should detail the funds required by the franchisee both to get the franchise started up as well as to fund it on an ongoing basis. These details can then be provided to an accountant to review and to insert into a cash-flow projection. This can be very helpful in assisting a prospective franchisee to decide whether they believe the franchise system to be a viable investment or not.
9. What happens in the event of a franchisee failing to make payments due to the franchisor or otherwise defaulting on some other obligation contained in the franchise agreement. Franchise agreements have rigid provisions detailing what happens in the event of different types of defaults and the sanctions that can occur if they are not remedied. In a worst case scenario a franchisee can have their franchise terminated and they will lose their business and investment.
In summary, a disclosure document, when properly prepared, is an excellent tool for a franchisee to use when deciding whether or not it wishes to buy into the franchise system. However, it should not be used as an excuse for not doing other homework. The veracity of the contents of a disclosure document should always be checked where possible. A prospective franchisee should also talk to a number of existing franchisees and question them on various parts of the system and the matters raised in the franchise disclosure document. It is important to “test-drive” what may look like a glossy franchise system on paper to see if it stands up to its claims in real life.
Purchasers of franchises should also take advice from appropriate franchise professionals such as a suitably qualified franchise lawyers and franchise accountants. The advice that they can add to what is stated in disclosure documents and franchise agreements should not be over-rated and their general knowledge of the franchise world will mean that many hidden traps can be safely avoided.