There are many statutory protections for prospective franchisees that assist them gain an understanding of a franchised business they may wish to acquire such as the delivery by the franchisor of a disclosure document, the requirements of the Franchising Code of Conduct that the Franchisor must comply with that at least put the prospective franchisee on notice that it should consider seeking advice from a lawyer, accountant and business adviser and the 7 day cooling off period to terminate the franchise agreement after it is signed. Even with these protections, the adage’ buyer beware’ remains relevant. This warning means the buyer assumes the risk. It is so with the acquisition of a franchised business.
Prospective franchisees need to be as well educated as possible about the franchise they are considering purchasing from a franchisor. Investigations should be as comprehensive as possible, and franchisees should not sign a franchise agreement if they are uncertain about any matters or not satisfied with any responses they have received from the franchisor.
The investigations that the franchisee should undertake before signing a franchise agreement or before purchasing an existing franchise business should include relevant legal, accounting and financial advice. It is difficult to understand why a franchisee who may consider making an investment of a large sum of money in the acquisition of a franchised business would not spend a relatively small sum of money obtaining appropriate professional advice.
Prospective franchisees need to consider a number of risks when considering the purchase of a franchised business. Many of these risks are specifically relevant to a franchise business. Generally, the risk of business failure in a franchisor/franchisee relationship is heavily distributed towards the franchisee. Although there is no benefit to a franchisor in the business failure of a franchisee and, in some circumstances, franchisee business failure may result in financial burdens and inconvenience to the franchisor, the consequences for the franchisee may be extreme.
Prospective franchisees need to consider the following aspects of the franchise relationship in terms of the potential pitfalls of purchasing a franchised business that is not financially successful:
- Franchise agreements are usually for a fixed term. This term is often 5 or 7 years but may be for a longer period. Once the franchise agreement is signed and the cooling off period of 7 days has passed, the franchisee is contractually obliged to continue the franchised business for the full term, even if the business is making losses. If the franchised business makes losses, the franchisee may need to invest further funds into the business which it did not anticipate;
- There are ways to end the relationship with the franchisor such as a sale of the franchised business or termination of the franchise agreement by consent, but it may be difficult to sell the business if it is losing money, and the franchisor may not be prepared to agree to termination by consent without payment of compensation by the franchisee;
- Franchise agreements often provide for the payment of royalties by the franchisees based on gross sales or income. This means that the franchisee is required to pay royalties even if the franchised business is making trading losses. In these circumstances, the franchisor still receives its royalties and the franchisee is obliged to keep trading, potentially making further losses, and not able to exit the franchise;
- Franchisees often purchase a franchise through a company. In these circumstances, most franchise agreements require the persons standing behind the company (the directors, shareholders or the person who runs the franchised business) to provide a personal guarantee of the franchisee’s obligations under the franchise agreement. This puts the personal assets of these individuals who provided guarantees at risk if the franchised business makes losses;
- If the franchisee is forced to close the franchised business due to trading losses to avoid insolvent trading, the individuals standing behind the company may be sued as guarantors for damages by the franchisor in respect of future royalties that the franchisor will no longer receive because of business failure and closure of the franchised business.
Franchisees need to consider these potential pitfalls with great care. All acquisitions of a business, and owning and operating a business, entails risk but the above risks which flow from the franchisor/franchisee relationship need to be weighed against the many benefits of the franchisor/franchisee relationship. This weighing of risks and benefits of franchising should be part of a franchisee’s investigations and due diligence before a decision is made to acquire a franchise or purchase an existing franchised business.
We shall consider other specific risks flowing from the franchisor/franchisee relationship in subsequent parts in this series.
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Bill Morgan is a consultant at Morgan Mac Lawyers and has been involved in complex commercial litigation for over 20 years. Much of his practise involves franchise law and the resolution of franchise disputes. Morgan Mac Lawyers have acted for over 40 franchisor or franchisee clients over the last 2 years.
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