Your ultimate checklist – how to spot a red flag

• Your ultimate checklist.pdf

Your ultimate checklist.pdf

We all know franchising is a low risk way of getting into business, but not every franchisee is successful There have been some franchise chains that have failed to flourish. In a small number of cases the network as a whole has failed.  So in considering which franchise is right for you Rod Young, Managing Director of DC Strategy explains how to spot a red flag.

Is it legit?

Many franchisees and prospective franchisors don’t realise that there are very few barriers to becoming a franchisor.  There are no Government applications to complete, no documents to be filed and no authorities that check on a franchisor before the franchisor can go to market.  The Franchising Code of Conduct as part of the Trade Practices Act describes what a franchise is and the nature of the disclosure that must be provided to prospective franchisees. This law is policed by the Australian Competition and Consumer Commission (ACCC) and legislation backs this with a series of remedies and penalties that will apply if a franchisor is found to be in breach of this black letter law.

Unlike the United State of America where about two thirds of the States require franchisors to register before commencing franchising, Australia has no such restriction. The obligation lies with the franchisor to comply with the legislation and in most cases the ACCC can only react if it is informed about a breach.  This means that while the vast majority of franchisors are bona fide, there is scope for unscrupulous operators to prepare a franchise agreement and draft a disclosure document (or worse, copy someone else’s documents and change the name) and start selling franchises. Even in the US, registration laws do not protect franchisees from franchise fraudsters.

With this in mind it is important to clarify who are the people behind the businesses that offer franchise opportunities and what is their track record.  Just as share prices ebb and flow on the Australian Stock Exchange with the change of management, a franchisee must rely on the competence and previous business experience of the franchisor. New franchisors require careful scrutiny as history has a funny way of repeating itself. Those individuals with a good track record are well worth being associated with in the early stages of the development of a new brand and those with a chequered past avoided.

The disclosure document is the first source of information and is the method the regulators have chosen to ensure prospective franchisees get relevant information about who a prospective franchisee might be doing business with.  For example, the franchise disclosure document requires that the following information be contained within the disclosure document; – Who are the corporate associates of the franchisor? Who are the individual associates of the franchisor? Who are the key executives and what is their business experience? What is the relevant business experience of the franchisor? What is the litigation history of the franchisor? For new franchise systems where often the franchisor is a newly incorporated company, the disclosure document helps get a handle on unproven management by requiring that the franchisor and directors of the franchisor disclose whether in the last ten years they have been convicted of a serious offence or an equivalent offence outside Australia or in the last five years subject to final judgement in civil proceedings or in the last ten years been made bankrupt insolvent or come under administration or involvement in an externally administered body corporate in Australia or elsewhere.  Once the disclosure document has been read and understood, ask further questions of the specific experience of each of the directors, especially of new franchising companies, as their background is crucial to making a judgement on the success of the future franchise venture.

A $1500 probity check of directors and executives can inform the curious about such things as Australian Securities and Investment Commission history, criminal history, media appearances, bankruptcy and insolvency, overdue accounts, current and previous directorships, court judgements, writs and summons’ and land ownership.

This process is especially critical to any prospective franchisee looking to buy a franchise in a franchise chain that has been franchising for less than two years. It may not be quite so critical for a franchise system that has been operating for a minimum of three years and has say ten or fifteen franchises. With two or three years of trading experience under their belt there is an opportunity to look for red flags in the existing network.

The disclosure document is a mine of information.  Not only does the Franchising Code of Conduct require the franchisor to disclose the number of existing franchisees within the network but those businesses owned or operated by the franchisor. The franchisor is required to provide at least the business address and business telephone number for each of the franchisees in the network and to make a statement regarding the history of bankruptcy, insolvency, administration or externally administered body corporate history in the last ten years for each of these franchisees.  Furthermore, the disclosure document must list information during the last three financial years regarding the number of franchises transferred each year, the franchise businesses which ceased to operate, how many franchise agreements were terminated by the franchisor, how many franchise agreements were terminated by the franchisee, how many franchise agreements were not renewed on expiry, how many franchise businesses brought back by the franchisor and the number of franchise agreements terminated where the franchise business was brought back by the franchisor.  This material is enormously relevant for more substantial franchise networks that might have scores or indeed hundreds of franchisees. These facts indicate the historic behaviour of the franchisor and the relative calm or turmoil within a franchise network.  

It is worthwhile checking the information provided is accurate. Meetings with existing franchisees will be very valuable in understanding if the information contained is correct and secondly, if there is further information about events that may provide an understanding of how the franchisor conducts business with his or her franchisees. It will also create an opportunity to discuss some of the circumstances of sales or terminations that may be of concern.

Inability to determine the numbers

How the economics of the business work at the single unit franchise level and the magnitude of income and profit one might expect to make from the conduct of the franchise business will be crucial for future planning

An intending franchisee should not be seeking forecasts from the franchisor, and the franchisor should never provide forecasts to a franchisee.

The franchisor is not compelled to provide any financial information on the future or past performance of individual units and can choose to provide no financial information other than initial capital costs that require disclosure under the Franchise Code of Conduct.

A prospective franchisee should be requesting historical data on the range of sales, variations in gross profit, occupancy costs, labour costs, details of rostering and pay rates and other incidental expenses in the operation of the range of franchised businesses within the network. The franchisee and his or her advisors can then use this information to prepare an estimation of the projected performance of an individual franchise enterprise.

While the franchisor may not be willing to provide these details in the context of identifying each particular location, if the franchisor is unable or unwilling to provide this information on the performance of the network without the need to identify each location this should be of some concern.

Initially, every good franchise system bases its financial expectations on the historic performance of its current company-owned operation and then on an ongoing basis on the combination of the financial performance of both the company owned and franchise network.

Especially in the early years of the franchise, a big red flag is waving if a franchisor is offering a franchise where the franchisor does not operate a company owned business.  This often indicates that the concept is an idea in the franchisor’s mind but is not proven over time. The very foundation of good franchising is a proven and profitable business on which the franchise network is based. This information can be found in the disclosure document.

There are two key elements that one will need to understand in order to make a decision about any particular franchise.  The first is the total amount of capital that will be required to establish the business and the detail of how that total capital requirement is made up.  For example, what is the franchise fee, magnitude of stock, equipment, fixtures and fittings, working capital, opening promotional budgets and the sometimes hidden cost of agreement preparation, legal and accounting advice and expenses during training.  Each of these elements needs to be detailed in every franchise disclosure document.  The second leg of the financial puzzle is what is the projected profit and loss a franchisee might expect from the conduct of the franchise business and this is a challenge for both franchisors and franchisees.

By way of history, since the early 90s a substantial amount of the litigation between franchisees and franchisors was based on the claim by some franchisees that the franchisor had mislead them as to their expectations of what their future earnings might be.  These false and misleading conduct claims have been a treasure trove of litigation income for solicitors acting for franchisees. As a result of the costs associated with litigation many franchisors have chosen not to make any claims or provide any financial history to a prospective franchisee other than the fact that the franchisor is solvent and able to meet its debts as and when they fall due.  This unfortunately is of little value for a prospective franchisee. He or she needs to determine what are the expected revenue, gross profit, operating expenses ( including rent and wages) and ultimately the profit that a franchisee might expect to achieve. Unless a franchisee has the luxury of paying cash, very few, if any, banks would consider advancing funds unless a pro forma profit and loss projection and cash flow can be provided by a franchisee.  Therein lies a conundrum for both franchisors and franchisees.  How can a franchisor in good faith provide financial information that will allow a franchisee to make a considered decision without exposing themselves to litigation if the franchisee is not as successful as both parties might have hoped?  

The answer lies in the actual performance of the company owned and franchised business units within the network and accordingly, the franchisee should be seeking historical sales and profit figures.

If one can’t seem to get the information one needs to determine the numbers at any franchise opportunity after digging and trying hard this is definitely a red flag.  The advice of DC Strategy is to walk away.

Initial and ongoing training programs and support

The very nature of franchising implies that a franchisee buys into a franchise network to get access to know-how and expertise and systems and processes of the franchisor’s proven business system. A franchisee that is at the franchisor’s doorstep because he or she does not possess the experience or knowledge of how to conduct the business will require a franchisor to have a well-structured induction and training program, both prior to, and during the start up phase of the franchise business unit. An on-going mechanism of keeping the franchisee “on the rails” and continuing to follow the franchisors system is also required. Accordingly, a franchisee should be on the lookout for vague promises of training and an inability by a franchisor to outline in detail what will happen in the first days, weeks and months of the franchisee’s relationship with the franchisor. As this knowledge transfer will be the cornerstone of building the franchisee’s business it will be worthwhile taking that training program and discussing it with existing franchisees to determine if they felt it created the knowledge base necessary for them to successfully launch and conduct their business.

Advertising and marketing

An organisations brand and the strategies it is currently conducting and proposes to conduct in the future will be an important discriminator in a competitive environment. Danger signs are franchisors that believe it’s only location that makes sales and have no defined marketing strategy, or who commit a miniscule component of their revenue to advertising. This often mean that a franchisor may have little ability to promote their products and services as the network grows and competition increases. A good franchisor will be able to articulate key elements of their strategy and outline a marketing calendar over the next 12 months.  A red flag will come from franchisors that do not have regular structured advertising and marketing programs. Even a small franchised network can have highly effective local area marketing programs so do not be swayed by the argument that when “we get bigger we’ll be able to start advertising’.

Group purchasing power

Another benefit of a good franchising system is the ability to purchase the stock and consumables of the business at competitive prices and create an opportunity to increase gross profit margins for franchisees as the network grows. These purchasing benefits often help pay for part of the royalties. In some of the bigger networks the purchasing power of the network virtually pays for the total royalty when compared to any independent counterpart. Franchisors should be able to demonstrate the commercial benefit of being part of their group. Examples of pricing of products for stock that the group is able to achieve in comparison with typical prices on the market are a good start.  Check at what price an individual could purchase particular products. This will give an indication of the relationship with the suppliers and the ability to enjoy a competitive advantage. A red flag may be that even thought the group is considerably larger than any independent operators its franchisees still do not enjoy a competitive purchasing advantage. This may be an indicator that either the franchisor is not maximising purchasing opportunities for the group or that rebate systems, which are a valid income stream for a franchisor, are of such magnitude that prices are loaded by the supplier for the benefit of the franchisor but to the detriment of the franchisee.

Franchisor/Franchisee relations

The relationship between a franchisor and their franchises is one of the most important indicators in looking for red flags. Re-read the “As Good as it Gets” article in the May/June 2006 issue of Franchising Magazine (vol 19 no 3). Not all franchise owners will be in a blissful relationship with their franchisor but as due diligence is conducted and one finds more and more franchise owners that are dissatisfied with their relationship with the franchisor then this is a strong warning sign. Ask the franchisor what percentage of franchisees are unhappy in the franchise relationship and go to the trouble of checking the reality against the statement.

Good franchisors understand that the grant of a franchise is the start of the relationship rather than the end of the transaction and will be forthright in these discussions. The red flags tend to be waved by franchisors who claim that everybody is deliriously happy or they don’t really know because they haven’t spoken to many of their franchisees in the last 6 months.

Cultures and values

While some may consider this is a bit too “touchy, touchy ““ feely, feely’, the culture and values of an organisation are often the big differentiator between competitors who are offering similar products. An appreciation of what motivates a franchise organisation will assist in diagnosing the deadly viruses of complacency, lack of enthusiasm and turmoil throughout a franchise organisation. Asking for an opportunity to meet some of the operations people and having a conversation about their degree of satisfaction, what they think of the organisation and the staff turnover of will go a long way to determining whether the business might have an affliction which will compromise ones future financial health.

It will also provide an opportunity to see if ones personal values and attitudes match those of the organisation. Culture clashes have destroyed many relationships both in life and in franchising.

In summary, don’t just give the disclosure document a cursory glance or accept the statement that “this is really a compliance document and won’t tell you much”.  The disclosure document is an important part of prospecting for the fault lines in a franchise system that should be avoided in order to build a future asset base away from a disaster zone.

Many franchisees have only themselves to blame for not doing their homework before purchasing a franchise. It is a credit to the franchise system and the vast majority of franchisors that there has been such a small number of franchise failures and a very low level of franchisee disputation when, in my experience, so little homework has been done by potential franchisees before signing on the dotted line.

Our wonderful economic cycle continues to roll on and since the last recession in 1992-93 Australia has spawned a generation of budding entrepreneurs who have not experienced an economic downturn. In an environment where the franchise marketplace continues to grow it would be prudent to research the franchise to ensure that perhaps the biggest investment of time and money in ones lifetime is based on good information.

In Formula One racing a red flag indicates that the race practice session or qualifying session has been suspended and can be ended prematurely if needed.

Prospective franchisees should heed that same red flag rule and pull out of negotiations before the race of their life commences if the franchise system does not pass scrutineering.

Rod Young 
Executive Director
rod.young@dcstrategy.com
02 8220 8711