Preliminary Business and Legal Considerations
When Buying a Franchise or Independent business.
By: Claus Etzler, EF Consulting; and
David Gray, Macdonald Sager Manis LLP
Disclaimer: This article is for information purposes only and should not be considered as legal advice. It is strongly recommended that any prospective entrepreneur consult a lawyer in order to make informed decisions that could involve legal matters.
Buying a business for the first time is probably the most difficult decision you will ever have to make. While business people like to think they make well informed, rational decisions, in reality most of us fall back on what we already think we know; for better or worse.
The purpose of this article is to provide business owners with a preliminary road map so that they may being to focus their attention on key areas of concern before buying a business.
Preliminary Legal Due Diligence
As a prospective buyer, evaluating a franchised business and a franchisor at a preliminary basis is easier (or more accessible) than a non-franchised business.
There are several sources and methods of evaluating the franchise opportunity, including:
The single best source of information about a franchise or franchisor should be the disclosure document, which is required to be prepared and provided under the Arthur Wishart Act (Franchise Disclosure), 2000. In general, the disclosure document will provide written information about the history of the franchise, financial performance and other information important to a prospective franchisee’s decision whether to buy the franchise.
Franchisees of the Franchisor
Information about the franchisor’s support, commitment, integrity, business acumen, etc. should be readily available from the existing franchisees (as well as past and terminated franchisees) in the system. By speaking to a range of franchisees (from most successful to lease successful), a prospective franchisee should obtain a better perspective of the franchisor and the franchise system or opportunity.
Associations such as the Canadian Franchise Association (“CFA”) are an excellent source of information about franchisors and franchises. For instance, the CFA may have information regarding previous complaints, membership standing with CFA, as well as competitors of the franchisor.
There are a number of franchise magazines that provide ongoing analysis on the franchise industry in general and feature articles on specific franchises in particular. The Canadian Business Franchise Magazine regularly prints current information about franchises as well as provides various franchise overviews over the course of the year. The writer cautions that advertorials and rankings should be used only as an aid in your evaluation and should not be relied upon in your decision making.
Credit Rating Services
Credit rating services should not be overlooked as an evaluation tool, particularly in respect of a non-public company.
Though it is always recommended to request a list of references from the franchisor, a prospective franchisee may also want to contact others not listed with whom the franchisor does business.
In order to analyze a franchisor’s strengths and weaknesses, it may be very helpful to contact the franchisor’s competitors.
Trade Shows and Expos
Franchise and business opportunity trade shows provide a great opportunity to meet a number of franchisors at the same time.
There are numerous franchise consulting companies and independent consultants who can provide a wealth of information on either the franchise industry or a specific franchisor.
There are a great number of franchise specific websites that will assist you in researching the franchise industry.
Basic Legal Considerations regarding Purchase of Franchised Business and Franchise Re-sales
There are two main components to a franchised business: the franchise relationship and the underlying business. The interplay of these components becomes apparent when a person is faced with choosing to purchase a new franchise directly from the franchisor or to purchase an existing franchise from a franchisee. This article will briefly examine the differences of each option by highlighting the basic steps of a typical transaction.
Purchase of a New Franchise Directly from the Franchisor
Step 1. Ontario passed franchise-specific legislation (the “Act”) requiring franchisors to disclose all material facts about the franchise system to prospective franchisees. In Ontario, prospective franchisees have a minimum of fourteen days to review such material.
Step 2. The prospective franchisee typically conducts only general due diligence, such as contacting franchisees. If the location is not identified at the time the franchise agreement is signed, it is difficult to estimate the franchise’s potential. Earning projections should be carefully scrutinized before reaching a decision.
Step 3. The franchisee is frequently required to execute a new franchise agreement; lease or sublease; personal guaranty; and a general security agreement. Mature franchisors are traditionally reluctant to negotiate the terms of such documents.
Step 4. Choosing the location and construction of the premises may be the responsibility of the franchisee.
Purchase of an Existing Franchise from a Franchisee
Step 1. Typically with the assistance of a solicitor or a broker, the prospective franchisee will make an offer for an existing franchise, which may be through an asset or a share purchase agreement.
Step 2. The prospective franchisee will inspect the financial history of the business and the contracts it may be assuming. One needs to focus on the remaining term of the franchise agreement and location lease and whether the length of the term can be extended.
Step 3. Additional considerations includeobtaining the franchisor’s and landlord’s consent to the transfer; reviewing the disclosure document (although the Act provides for an exception to the requirement for the franchisor to provide a disclosure document in re-sales, the majority of franchisors err on the side of caution and provide disclosure documents); transfer fees to franchisor; refurbishing the location; executing a current franchise agreement/lease or assuming the existing contracts; and completing the training program.
Step 4. There are other closing issues with respect to a re-sale, including: (1) termination of existing employees; (2) damage control if previous management was weak; (3) obtaining clearance certificates; (4) non-competition covenants; (5) transfer of licenses; and (6) declarations and indemnities.
In short, there are significant differences between buying a new franchise from the franchisor and an existing franchise from a franchisee (there is a 3rd option not discussed in this Article, which is to buy a corporate store). Each option has its pros and cons and a franchisee should seek legal counsel with experience in franchise matters to review its particular situation.
Start-Up Business Risk
The alternative to buying a business is simply starting a new and independent business. Start-ups may seem attractive since you may be able to save development costs and be able to grow the business to suit your own style. However, the reality is that most new businesses, over 75%, do not survive past 5 years. Why do so many independent business start-ups fail? The major causes are typically:
- Lack of “hands-on” knowledge of the business;
- Poor sales growth partly due to no name recognition;
- Unable to secure good employees;
- High costs of sales due to mismanagement.
Lacking hands-on expertise is a serious problem that can only be rectified with proper training experience or hiring qualified people. Both options will cost you considerable amount of money, for example an experienced manager will expect to be paid over $40,000 even for a small business. Another alternative is buying into a good franchise system which provides you with all the training you’ll need.
The Franchise Advantage
In fact, the better franchises offer several key advantages over independent businesses including:
a) Research & Development - continually improving the business model with product development, service improvements, etc..
b) Access to prime real estate – most major landlords, including the large shopping centres, prefer dealing with national retailers and franchisors. An independent business owner may not have access to the prime real estate.
c) Obtain business expertise quickly through the franchisor’s comprehensive training program. In a matter of several weeks you will learn what will take you a year to learn on your own.
d) mass purchasing power through the franchisor’s negotiated supply channels where you will enjoy volume purchase pricing and faster deliveries.
e) Well known brand name and reputation of the franchisor’s trade name. The benefit is having instant market presence rather than having to build up your market brand.
While franchises are not everyone, the better franchises can reduce your business risk, provided you are matched to the right kind of business.
Buying an Existing Business
Regardless whether you choose a franchise or not, buying an existing business has clear advantages over a start-up business. The biggest advantage is that you by-pass the risky start-up period. With an existing business you can more confidently predict your own future profitability based on what the business is currently doing. However, there are also risks involved in buying an existing business, namely:
a) What are the actual profits of the business? Depending on the type of business, proper financial statements may not be available and means of verifying profits need to be explored.
b) How much goodwill is the business worth? Most sellers over estimate what their businesses are worth and banks normally don’t finance goodwill.
c) Is there potential to grow the business? You need to learn about the business, know your own abilities related to operating the business and research the market to better determine the true potential.
d) Are there any hidden problems in the business?- Contracts such as leases, license agreements and on-going obligations can seriously affect your ability to earn future profits if not understood and dealt with before purchasing.
Before setting out to look for business opportunities, it is highly recommended that you first determine your own needs & abilities when it comes to managing a small business. Some key areas to assess yourself on are:
a) My available cash and net worth. How much can you really afford, considering that you need to add closing costs and working capital on top of your down payment on the business.
b) How much financing will I qualify for? Banks typically are more cautious and lend less money for businesses than they do for home mortgagtes. For example, an average credit score may be good enough for a mortgage but may not qualify you for a business loan.
c) Your ability and willingness to work. It is not recommended that you purchase a restaurant or retail store if you hate working evenings and weekends, as those are the most profitable times of the week for those buisnesses.
d) Your “hard” skills versus “soft” skills. Hard skills refer to more mechanical aspects of a job or task. Operating machinery, preparing budgets, or cooking food are examples of hard skills. Soft skills generally refers to selling, problem solving, organizing, coaching and leadership abilities. Most service type and commercial enterprises will require good selling skills to solicit new customers.
The Importance of Market Research.
Determining the actual profits and growth potential of the business requires investigations and market research. Most people start their market research by reviewing public information, such as doing google searches on the internet, reading magazines, etc. However, to obtain more useful information about the business and its market, one must conduct primary research, also known as “meet and greet”. That is, contacting suppliers, bankers, competitors, nearby franchisees, etc. to find out what is happening in and around the business. If you’re not comfortable doing this, then it’s best to hire someone to do it for you, rather than skip this important research work.
The value in doing all this research is gaining much more knowledge about the business such as what actual profits are, if there are any obstacles to enjoying the business and of course what opportunities are there to grow the business. All of these factors will have an affect on the valuation of the business.
When placing a value (your purchase price) on the business, you should consider the following elements:
1. Separate the Property value (if any) from the business cash flow;
2. Determine real profit from the actual sales and operating costs;
3. Decide on a fair earnings multiple based on the industry and condition of the business;
4. Factor in any limitations that can reduce its value, such as contracts, market potential.
If you know you will require bank financing, establish how much financing you are likely to get for the business before making an offer.
Most small business owners will have three options described below.
● Home mortgage financing – is the least expensive and most accessible form of loan available if you have enough equity in your house and don’t mind tying your house to the business.
● Business Loan – Most small businesses are on a lease and would qualify for a small business loan. The bank requirements for business and commercial loans are much more stringent than home mortgages. Your down-payment will usually range from 25% to 50% of the purchase cost and you will also be expected to have additional collateral on the side.
● Business lines of credits are granted selectively by various banks, some refusing to consider them for start-up small businesses.
Banks will also require you to submit a proper Business Plan detailing how you intend to pay for the purchase, operate the business and repay the bank loan. The best approach is to submit a properly prepared business plan with all supporting documents to one bank (ideally the bank most favourable for your type of business) than “shop around” for banks as a decline from one bank may trigger suspicions from other banks.
First time buyers may be over whelmed with the amount of time, effort and knowledge required to navigate their way through the steps to buying the right business. Retaining business professionals with relevant expertise will provide you with knowledge and confidence to make the right investment decision. These professionals are typically advisors such as lawyers, accountants, business advisors. Experienced commercial real estate agents should be able to give you a selection of suitable opportunities to chose from. Once a potential business is selected, your advisors should step in to impartially assess the risks and income potential.
By using professionals for what they are designed to do, you’ll be able to make an informed decision and avoid common pitfalls and traps on your most important investment.