A. INTRODUCTION
This article is addressed to accountants, attorneys and notaries who provide advice to business people that wish to purchase a franchise or to join another type of group.
In this context, the mandate is to properly advise a client before his final decision to purchase a franchise or to join a group. This article proposes 10 important tips to discuss with your clients who find themselves in this situation. The tips are part of what we call a "due diligence" of a franchisor or a group, as the case may be.
As regards this article, any reference to a franchisor is also a reference to a group.
B. WHY A DUE DILIGENCE OF A FRANCHISOR?
There are several reasons for potential franchisees to undertake a due diligence of a franchisor.
Before accepting (or even applying for) a new job, a person will inquire from several sources to obtain information about the employer. Before buying a house, a buyer always asks for an inspection of the house as a pre-condition of the purchase.
When purchasing a franchise, the same principle applies. The objectives of this exercise are to learn about a franchisor and the operation of its franchise network as well as to minimize the risks of an investment of this nature. For a potential franchisee, the financial investment is very often an important amount. This reason in itself should be sufficient for a potential franchisee to undertake the due diligence of a franchisor.
In addition, the philosophy of a franchisor is another reason to undertake the due diligence of a franchisor. Indeed, franchisors like people have a philosophy with respect to the conduct of their business, on the role of a franchisee in a franchise network, on the responsibilities of a franchisee (employee, manager, business person), etc. This philosophy should conform to the philosophy and to the aspirations and expectations of a potential franchisee. It is a question of determining if both parties are compatible.
In this respect, the franchise agreement and the operations manual often give us information about the philosophy and the management style of a franchisor.
The franchise agreement and the operations often provide information on the philosophy and the management style of a franchisor.
On another matter, it is important to differentiate a "new franchisor" from an "existing franchisor". By "new franchisor", we refer to the starting-up of a new franchise network and also to any franchisor from another province or another country that wishes to export its franchise concept to Quebec.
An "existing franchisor" refers to a known franchise network that is well established in Quebec or in Canada (St-Hubert, Tim Hortons, McDonalds, Sport Experts, etc).
We make this distinction to bring to your attention that in general the risks of joining an existing franchisor are less than those associated with joining a new franchisor. On the other hand, it should be mentioned that there are advantages and disadvantages in purchasing any franchise. What it is important to remember is that a due diligence of a franchisor can decrease the risks associated with the purchase of any franchise.
Having said that, all new franchisors are not necessarily a bad investment and the opposite is true for existing franchisors. It is normal to proceed with an analysis of a business opportunity to determine the risk associated with the purchase of a franchise and to evaluate if this risk is compatible with the rate of aversion to risk of a client.
In summary, we submit that there are several reasons why a potential franchisee who wishes to purchase a franchise or to join a group to make a due diligence of a franchisor or a group, as the case may be: the financial investment it makes, the expectations of a franchisee, the risk associated with an investment, the management style of the franchisor, the experience of the management team of the franchisor, the distribution of the responsibilities in a franchise network, etc.
We do not pretend that this list is exhaustive, but it includes some of the most important reasons in support of the due diligence of a franchisor.
C. THE DUE DILIGENCE
Firstly, we bring to your attention the fact that the business model in franchising is different from the traditional business model.
Indeed, within the framework of the traditional business model, a company uses its own human, technical and financial resources to proceed with its development. It is the owner of the company (the shareholders and its Board of Directors) who makes all the decisions with regards to the operation of the company.
In franchising, a person, the franchisor, uses the human, technical and financial resources of a third party, the franchisee, to proceed with its development. Contrary to the traditional business model, even if a franchisee is qualified as an "independent entrepreneur", the franchisee must operate its business according to the standards, procedures and directives of a franchisor. Consequently, the franchisee is generally limited with respect to the decisions that it can make as concerns the operation of its business. On the other hand, it purchases a concept that has proven itself over time, thereby increasing the chances of success of its business.
It follows that the differences between the two (2) business models justify a more exhaustive research by a potential franchisee of the franchise business model as a step prior to the due diligence.
In addition, even though this article proposes to potential franchisees important tips of things to verify concerning a franchisor before the purchase of a franchise, we also recommend them to undertake a self-examination of their own financial, human and technical resources beforehand.
In principle, the experience, personality, training, expectations and the financial resources of a potential franchisee should guide it in the choice of an industry and, eventually, to a franchise in that industry. The objective behind this exercise is for the potential franchisee to find a franchise that is compatible with its personality, resources and experience.
Having said this, there are franchise networks that require a minimum of training to become a franchisee.
In summary, we recommend potential franchisees learn about the functioning of the franchise business model and undertake an examination of their own resources and expectations with respect to the purchase of a franchise beforehand. Further to this examination, a potential franchisee can more easily find the right franchise to purchase.
D. 10 TIPS
My 20 years of experience working with franchisors, franchisees and other groups lead me to suggest a list of 10 important tips to verify with your clients with respect to the purchase of a franchise.
It should be mentioned that this list is not exhaustive. Furthermore, it should be pointed out that the tips that are the most important when evaluating one franchisor are not necessarily the same for every franchisor. Each file must be evaluated on its own merits. By working with your respective clients when researching information on a franchisor, you will discover which tips are the most important to verify.
1. The Franchisor
A franchisor is potentially the next business partner of your client. To properly advise your client who wishes to purchase a franchise, research on the franchisor is imperative. This article provides tips on where to find information on the financial situation of a franchisor, its experience (that of its management team), its corporate culture, its communication structure, its management style, its products andor services, etc.
To this end, the 10 tips address different aspects of the operation by a franchisor of a franchise network. The tips include information sources on franchisors, the evaluation of the services that they offer, the financial terms of the purchase of a franchise, the financing of a franchise and comments on certain clauses contained in a franchise agreement.
1.1 Information sources
Information sources on a franchisor are numerous. Here are a few:
- The franchisor’s web site;
- The franchisor’s employees;
- If the franchisor is a public company, you can do searches at www.tmx.com and www.sedar.com;
- The franchisor’s franchisees. In this respect, I recommend you meet and speak with the most recent franchisees of the franchise network. They have just lived what you are about to experience with the franchisor. Usually, these franchisees are very satisfied or very dissatisfied. So in this way, you will hear the two (2) sides of the story;
- Search on the Web using the Google search engine - you can find articles on a franchisor published in newspapers or magazines as well as communiqués prepared by a franchisor;
- Court Houses in Quebec have a computer system which the public can consult. It allows you to search and find legal procedures taken by a franchisor as well as those taken against a franchisor;
- The Register of Personal and Moveable Real Rights (R.D.P.R.M) allows you to verify certain legal recourses taken by a franchisor and will also give you general information on the financing and the financial situation of a franchisor (www.rdprm.gouv.qc.ca);
- The Enterprise Register (www.registreentreprises.gouv.qc.ca) gives you information on the management team and a shareholders of a franchisor, as well as on the number and location of franchisees in a franchise network; and
- You can also ask a credit agency (www.equifax.ca) to conduct a credit investigation on the franchisor to determine its general financial situation.
1.2 The Disclosure Document
More often than not, when I speak about a Disclosure Document to a potential franchisee, he asks me "What is a Disclosure Document?"
Certain provinces in Canada, specifically Ontario, Alberta and Prince Edward Island (and soon New Brunswick), have adopted specific laws on franchising. These laws provide that a franchisor must submit to a potential franchisee a document which is called a "Disclosure Document" and this, at least fourteen (14) days before the signature by the franchisee of a contract with regard to the franchise or to the payment by the franchisee to the franchisor of an amount of money.
It should be mentioned that there is currently a movement in the province of Quebec to adopt franchise legislation.
The Disclosure Document contains a great deal of information about the franchisor:
- Its activities;
- Its history;
- The management team which operates the franchise network on a daily basis;
- A list of existing franchisees as well as a list of those who have left a network (with phone numbers);
- Certain important clauses of the franchise agreement;
- Some contain detailed information about the financial operation of a franchise;
- The financial statements of a franchisor;
- Legal procedures taken against a franchisor during the last 5 years; and
- General information on the functioning of the franchise network of a franchisor.
There is a tremendous amount of information in this document which allows a potential franchisee to evaluate a franchisor.
Therefore, if you are considering purchasing a franchise from a franchisor which offers franchises in one of these provinces, you know that it has a Disclosure Document. We recommend you ask the franchisor for a copy.
Certain franchisors have a policy to submit the Disclosure Document to every potential franchisee, other franchisors will only provide one if a potential franchisee asks for it, while other franchisors have a policy not to submit a copy. It is up to you to evaluate the position of the franchisor.
If a franchisor offers franchises for sale in the United States, it is bound to submit to every potential franchisee a Uniform Franchise Offering Circular (U.F.O.C.), a document even more complete than a Disclosure Document. You can consult them free of charge at
www.freefranchisedocs.com.
From a legal perspective, what is important to know is that there are no laws in the province of Quebec which oblige a franchisor who has a Disclosure Document or a U.F.O.C. to provide it to a potential franchisee … but nothing prevents a potential franchisee from insisting on obtaining it.
1.3 The services offered by a franchisor
The services offered by a franchisor to franchisees vary from one franchise network to another. They are important to verify to determine the responsibilities of the franchisor and the franchisee, that is to say the decisions that rest with the franchisor and those that will fall upon the potential franchisee. Furthermore, ask the franchisor about the costs associated with the services it offers within the framework of the purchase and the operation of a franchise.
The services offered by a franchisor to franchisees are commonly called "initial" services and "continuous" services. Here are some examples of these services:
1.3.1 Initial Services
The initial services are the services offered by a franchisor to franchisees of the franchise network until the opening of the retail outlet to the public. Some of these services can be supplied by third parties:
- Assistance with respect to the choice of a site;
- Assistance with location layout (general plans);
- Assistance with the choice of inventory;
- Assistance with the supply of products and services;
- A computer system and software; and
- Initial store opening advertising.
Certain franchisors offer franchisees turnkey operations. In this case, the franchisor takes charge of all the aspects of the franchise … from the construction of the retail outlet to the initial store opening advertising. Once the retail outlet is constructed and fitted, the franchisor hands over the keys of the retail outlet to the franchisee for the opening to the public.
At the other extreme, certain franchisors only give a franchisee an Operations Manual and general plans and the latter has the responsibility to construct, fit and publicize the retail outlet … according to the standards, procedures and directives of the franchisor.
1.3.2 Continuous Services
Continuous services are the services offered by a franchisor (or by third parties) to franchisees of a franchise network for the duration of the franchise agreement. Here are some examples of these services:
- General business advice;
- Accounting services;
- Preservation of the uniformity of the concept (operations, advertising, trade mark, store layout, etc.);
- Circulation of bulletins, information, internal magazines, etc.
- Advertising management (regional andor national);
- Franchisee meetings; and
- Supply of products and services (suppliers).
I repeat, verify the costs associated with the services.
1.4 Training
Like for the other services offered by a franchisor, a potential franchisee should also verify the initial training and the continuous training offered by a franchisor. An important part of the success of the operation of a franchise depends on it.
Generally, the training is different from one franchisor to another and from one industry to another. As a general rule, the more complex the franchise concept andor the technology used by a franchisor, the longer the initial training should be and the more frequent the continuous training should be.
1.4.1 Initial Training
- Nature?
- Duration?
- Who has to take it?
- Cost?
1.4.2 Continuous training
- Frequency?
- Continued?
- Cost?
1.5 Duration of the Franchise Agreement and Lease
A franchisee often has to pay the franchisor an important amount to purchase a franchise and construct a retail outlet, perhaps $100,000, $500,000 or a few million dollars. In this context, the franchisee should verify how long it is going to benefit from the franchise, one (1) year, five (5) years, ten (10) years?
Indeed, this information will allow a franchisee to calculate how long it will be necessary for it to recuperate its initial investment and make a profit (its return on investment). To do this, the franchisee has to verify the duration of the franchise agreement and the lease, or, the sublease if the franchisor is on the lease.
Generally, the franchisor ensures that the duration of the franchise agreement is the same duration as the lease or the sublease agreement if the franchisor is on the head lease … but this is not always the case. It is up to you to evaluate the position of the franchisor and the possible repercussions for your client.
On the other hand, in certain industries like the automotive industry, certain franchisors limit the duration of the franchise agreement to one (1) year to allow them to implement important annual changes to the operation of franchises and this, despite initial investments in the millions of dollars by franchisees. It seems inconceivable to us, except under exceptional circumstances, that a franchisor could end a franchise agreement after a one (1) year period, notwithstanding the duration provided in the franchise agreement. As such, in this situation, the franchisee (a car dealership) does not have the opportunity to benefit from the franchise which it bought.
Another matter to be verified concerning the duration of these agreements is the extension option, if one exists. An extension option allows the franchisee to prolong the duration of these agreements and to continue to benefit from the franchise.
If these agreements contain an extension option, ask yourself:
- How many options are there?
- What is the duration of the extension option(s)? Is the duration of the extension period in the franchise agreement the same as that contained in the lease?
- Are there conditions attached to the exercise of these options? What are those conditions?
- Is the rent specified for the extension period(s)?
- Do you have to send a notice to the franchisor or to the landlord to benefit from the option
- Are the extension options in favour of the franchisee, the franchisor or the landlord?
- If they are in favour of the franchisee, it can simply send a notice to the franchisor/landlord and the duration of the franchise agreement or the lease, as the case may be, will automatically be extended;
- If they are in favour of the franchisor or the landlord, verify the conditions of exercise of the extension option.
- Finally, verify if there are fees to be paid to benefit from the extension option (franchise fees, administrative fees or legal fees).
1.6 Territorial Protection
Territorial protection is a commitment by the franchisor in favour of the franchisee that provides for the granting of certain protection rights within the defined territory in which the retail outlet of a franchisee is located. There are various types of territorial protection clauses:
- Complete Exclusivity - is a commitment by a franchisor in favour of a franchisee not to open other retail outlets in a defined territory (in which the retail outlet of a franchisee is located) and this, for the duration of the franchise agreement. It is also possible to obtain it from the landlord, that is, in the lease;
- Right of First Refusal - is a commitment by a franchisor in favour of a franchisee to offer first to the franchisee in a defined territory (in which the retail outlet of a franchisee is located) the possibility of opening any new retail outlet in that territory. However, despite this protection, if the franchisee refuses to open the new retail outlet, the franchisor has the right to grant the new franchise to someone else;
- Hybrid Right - is a commitment by the franchisor not to open another retail outlet in a smaller territory combined with a commitment by the franchisor to offer first to a franchisee, in a wider territory, the option to open any new retail outlet and this, for the duration of the franchise agreement.
Certain franchisors grant franchisees territorial protection in the franchise agreement. For other franchisors, any type of protection is something that a franchisee has to ask for and negotiate. Other franchisors have as policy not to grant territorial protection. It is up to you to evaluate the position of the franchisor and the possible repercussions for your client.
1.7 Financial Conditions
The financial conditions connected with the purchase of a franchise vary from one franchise to another, from one industry to another and even inside the same industry.
We recommend that every potential franchisee analyze these conditions. This analysis allows the calculation of the investment necessary to purchase a franchise and to compare the costs of different franchises within the same industry. It also allows the franchisee to verify the financial projections of the franchisor or, if the franchisor does not provide financial projections, to allow the franchisee (and its accountant) to prepare financial projections. We address financial projections later in this article.
For purposes of analysis, you should divide the financial conditions connected to the purchase of a franchise into two categories, being the franchise fee and the other continuous fees (royalty, advertising, accounting, computer system, etc.) and the expenses of opening a retail outlet, that is, the cost of construction of a retail outlet, including the rental improvements, the inventory, the equipment and the other goods and services necessary to open and operate a retail outlet. In this second category of conditions, the contribution of the landlord (T.I. or tenant inducements) should be included, if applicable.
In this way, a potential franchisee can more accurately and easily calculate the costs connected with the purchase of a franchise and establish two (2) points of comparison between various franchises.
1.8 Financing
One of the advantages to joining certain franchise networks is the financing which franchisors offer franchisees and which is necessary for the franchisee to purchase a franchise. Consequently, we recommend verifying with the franchisor if it offers financing.
Franchisors offer different types of financing. The most common are the following:
- Direct financing by the franchisor, usually a medium-term loan (3-5 years);
- Pre-approved financing program by one or several financial institutions, including a credit margin and a medium-term loan. In this case, there are conditions that the franchisee has to meet, but as long as the franchisee meets these conditions, the process of obtaining the financing is faster and generally less expensive for a franchisee than if it had to obtain financing on its own;
- Equipment rental;
- Consignment of products.
Even if certain franchisors offer financing, we recommend you also verify with your own financial institution to determine if you are eligible for a S.B.L., a small business loan. This type of loan is part of a federal financing program. It is offered by most financial institutions and has very interesting conditions, including a personal guarantee limited to twenty-five percent (25%) of the amount of the original loan. The balance of the loan is guaranteed by the federal government. The maximum amount of the loan is $300,000. When writing these lines, the government is meeting with various members of the business community, including franchise associations, to obtain their ideas on how to improve this program. The results are to be published in March 2010.
1.9 Financial Projections
It is a common practice for certain franchisors to submit financial projections to potential franchisees, also called PRO FORMAS.
Pro formas are income, expenses and profits estimations of the operation of a franchise over a period of time usually varying between one (1) and three (3) years. They are prepared using network statistics, market study (revenues) and known data (royalties, rent, advertising expenses, construction costs, etc.).
We advise potential franchisees ask franchisors questions on the origins of this information and the information and documents which served in preparing them.
Why? To allow a franchisee to evaluate over time the profitability of the purchase of a franchise, its return on investment (R.O.I.).
It should be noted that certain franchisors have as policy not to provide financial projections to franchisees. In that case, we strongly recommend to every potential franchisee to prepare them (with their accountant). They can obtain the information from the franchisor, the franchise agreement (the financial conditions), the operations manual, the loan agreement (financing), other franchisees, the lease (the rent) and the market study, if applicable.
The exercise of preparing financial projections is not a science. Several factors outside the control of a franchisee and a franchisor can affect this information (competition, an Act of God, a recession, the bankruptcy of a supplier, etc.), but for lack of other empirical methods to try to foresee the results of the operation of a business, it remains an exercise which we consider compulsory by all potential franchisees before the purchase of a franchise.
1.10 Trade Marks
By definition, a Trade Mark is a word, a group of words, or a distinguishing feature allowing a franchisor to become known, or to have recognized its franchise concept andor the products andor services which it offers.
Examples: Who does not recognize the big "M" of MacDonald’s, "M&M" of M&M Foods, the names Tim Hortons, Valentine and Subway.
When a franchisee buys a franchise, it also buys the right to use the Trade Mark of the franchisor … and the reputation and goodwill that comes with it. Consequently, it is important for a franchisee to verify 1) if the Trade Mark belongs to the franchisor; and 2) if the Trade Mark is properly protected, that is registered as a Trade Mark with the government.
To do this, the government has a Website which the public can consult via the Internet. The site is called "STRATEGIS" (
www.ic.gc.ca). The results of a search on this site provides to whom the Trade Mark belongs, if it is registered and for how long, and, more importantly, if it is disputed, that is if someone else claims the Trade Mark.
Do not forget, the Trade Mark identifies the business of a franchisee and distinguishes it from the competition.
E. CONCLUSION
Unfortunately, too many potential franchisees literally fall in love with a franchise concept and skip important steps prior to purchasing a franchise. As advisors, it is our role to ensure that our clients make good decisions and with all the information that is available to them … to minimize the risks associated with the purchase of a franchise (and there are some), the whole while protecting the assets of our clients.
It is important for every potential franchisee to consult professionals specialized in franchising within the process of the purchase of a franchise, whether it is an accountant, a lawyer, a consultant, a financial advisor, etc.
As mentioned above, the business model in franchising is different from the traditional business model, differences that should be known to a potential franchisee before the purchase of a franchise. Given this fact, it is strongly recommended to any person who is interested in purchasing a franchise to ensure the services of specialized advisors in franchising.
According to government statistics, on average 80% of companies starting up fail during the first two years of operation. The average failure of new franchisees is 1/7. Despite these statistics, the operation of a franchise requires an important investment of funds, time and energy.
By following the 10 tips in this article, a potential franchisee should be able to form a rather complete portrait of a franchise network and the advantages and disadvantages associated with the purchase of a franchise from that network. As well, it can minimize its financial risk, find a compatible business partner and maximize the chances of success of the franchise it purchases.
Enjoy your franchising files.
Claude J. Pellan, Attorney
Franchise and Business Law
