7 Things to Consider Before Buying a Franchise: A Lawyer's Perspective
By Jonathan Mesiano-Crookston | June 1, 2011
Some of the most recognisable businesses in the marketplace today - Subway, Tim Horton's, and Home Hardware - are franchise systems. This brand-name recognition factor makes franchises very popular with entrepreneurs.
However, buying a franchise doesn't guarantee financial success. In our legal practice, we help businesses evaluate franchise systems before a deal is closed and also deal with the negative repercussions when proper due diligence is not done at the outset.
The following seven tips should help make the buying process a little less stressful, and more successful, for prospective franchisees.
1. Understand what you are buying
First of all, you aren't buying financial success. What you are buying is the right to use someone else's trade-mark and their marketing or sales system, often within a given territory.
For this reason, you should ensure the franchisor has strong trade-marks, a successful business system, and a good advertising program. If the system has many franchisees, this is often a good sign as well. It may mean greater visibility in the marketplace and also that the franchisor can generate more funds for advertising.
2. Do your homework
Check the backgrounds of the operators of the franchisor and affiliated companies. Are they new to the business? Have they been involved in other franchise systems?
Is the franchisor financially healthy? If it is a public company, see if its annual filings are available on SEDAR (for Canadian companies) or EDGAR (for American ones). If it is a private company, prospective franchisees should be given its financial information in a "disclosure document" during the sale process. (If not, see a lawyer.)
Do your own investigation, and do not rely on what the franchisor tells you. The Internet can be a gold mine of news stories and testimonials about the franchise, both positive and negative.
3. Find out what franchisees think
Probably the best way to gauge how you will be treated once you join the franchise is to ask existing franchisees how they are being treated now. Talk to as many franchisees as you can, so you are sure you are getting an accurate picture of things. Ask them how long they owned their franchise, what they paid, what they think of the franchise system, and whether they are looking to sell (and if so, why).
Determine whether the franchisor is engaged in a lot of litigation. While a certain amount of litigation is unavoidable, excessive litigation can be a warning sign. Canadian legal decisions can be accessed for free at www.canlii.org, and American at www.findlaw.com or www.justia.com. Keep in mind that many disputes are settled by private arbitration or mediation, and these decisions are not available on-line.
4. Don't buy the hype
Buying a franchise takes a lot of money and some franchisors profit from each sale. So watch out for sales exaggerations. Take all promises with a healthy dose of skepticism, demand hard data, and ask for all assumptions that underlie any financial projections you are given, in case those projections are not met down the road.
5. Know what you are buying
When you find a franchise you think you want to buy, make sure you understand exactly what you are getting. Remember, you are only buying what is stated in the franchise agreement and the lease, so check those documents carefully.
In the franchise agreement, some things to check are:
- how long is the franchise grant?
- are you granted an exclusive territory? If so, what is it?
- do you have renewal rights? If so, how long, and how are they triggered?
- does the franchisor promise training? Who pays the costs?
Some points to check in the lease are: rent amount, the duration of the lease, whether you can renew (and if so, when and for how long), how to trigger renewals, and how the rent will increase in future.
6. Understand your obligations
Franchise agreements (and associated leases) are typically long-term contracts, so make sure you know what your obligations are. For example:
- what royalties do you have to pay? Are they dependent on sales? Net or gross sales?
- how much are the advertising contributions? Can the franchisor use them only for advertising, and are franchisees entitled to an accounting?
- does the franchisor keep rebates on supplies, or are they passed down to the franchisees?
- do franchisees have a say in how the franchise is run?
7. Be sure you know your rights
Franchise law is complex and differs in each province and territory in Canada. For example Ontario law, which applies to any franchise operated wholly or partly in Ontario, has the following notable points:
- a franchisor must typically provide a disclosure document to prospective franchisees. The franchisee must be given it at least 14 days before he/she pays any money or signs anything;
- a franchisee may have certain legal remedies if the disclosure document contains inaccurate information or if one isn't given at all;
- franchisors may be liable to franchisees for misrepresentations made in the disclosure document;
- franchisors cannot stop franchisees from associating with other franchisees; and,
- both franchisors and franchisees must act with "good faith" and deal fairly with each other.
Currently, three other provinces (Alta, PEI, and NB) have enacted franchise laws, and Manitoba is currently in the process of implementing one. The others rely on contract law to govern relationships between franchisors and franchisees. Do your research and understand your rights before you enter a legal agreement.
Anyone who has questions about these items should see a lawyer immediately.
Finally, be proactive. After you have done your homework and are thinking of buying a particular franchise, consider having a lawyer review the franchise documents before you sign anything. It may avoid troubles down the road and turn out to be the best money you ever spent.