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“The Right Stuff”: What to look for when buying a franchise in Canada

 

Introduction

The franchise business model has become entrenched as a way of doing business across Canada in recent years and is being applied to new businesses and industries with great success, including hotels, fitness centers, gas stations, cleaning services, coffee shops and a wide variety of retail stores. One of the strengths of the franchise model is that it can be applied to such a wide variety of businesses, so long as their operations can be replicated. The statistics on franchises are impressive (to say the least) and the projections show no sign of this trend slowing. Franchised businesses account for 40% of all retail sales1. There are over 78,000 franchise units across Canada2. Franchising accounts for 10% of Canada’s Gross Domestic Product (GDP)3. Franchising has been reported to account for one out of every five consumer dollars spent in Canada on goods and services4. With an increasing number of homegrown Canadian franchises flourishing ever year, it’s no wonder that so many Canadian entrepreneurs are considering purchasing a franchise. But buying a franchise can be a complicated affair and is usually one of the biggest investment decisions (of both time and money) one can make. While one’s choice of franchise will vary according to one’s personal goals and preferences, this article identifies some of the main issues that any prospective franchisee should consider when selecting and ultimately buying a franchise. What is Franchising? Franchising is essentially a business model which allows an existing business, the franchisor, to license the use of its brand and internal business processes to other entities, the franchisees, which then each operate their businesses semi-autonomously. The franchisor typically receives a franchise fee and continuing royalties from each of its franchisees in return for the licensed rights, access to cost savings from group purchasing and assistance from the franchisor with respect to running the businesses. The allure of the franchise model is that it allows a new business owner to immediately enjoy the benefits of an established business, such as a reputable product, broad customer base and proven systems of supply and distribution. In short, buying the right franchise can reduce the risks associated with starting a new business.

  1. Uniform Law Conference of Canada
  2. Canadian Franchise Association
  3. Manitoba Law Reform Commission, Franchise Law Consultation Paper, May 2007
  4. Manitoba Law Reform Commission, Franchise Law Consultation Paper, May 2007

However, franchises can be costly, both initially and on an ongoing basis, thanks to franchise fees, royalty payments and contributions to common funds for advertising and marketing. Would-be franchisees must also be prepared for the restrictions that can come hand in hand with licensing a franchise system. Perhaps most importantly, franchisees must ensure their expectations are in line with the realities of the business to avoid disappointment and risk to their investment. Selecting the Right Franchise for You The importance of researching and investigating potential franchisors and brands before making your decision to purchase cannot be stressed enough. Franchise systems vary greatly from each other and choosing the right system for you can make all the difference. For example, consider buying a franchise in an industry in which you are already knowledgeable so you can make use of your existing skills and experience. But even more importantly, try to choose a franchise system in which you can envision yourself enjoying the work. Running your own franchise requires a major investment of your time as well as your money, so choose something you will enjoy. The following are some considerations when selecting a franchisor and system. Brand Power & The Franchisor A franchise system’s value is largely based on its reputation and brand recognition, but bigger isn’t necessarily better. Looking at past and projected information regarding potential franchises is every bit as important as considering a franchise’s current performance. Asking the right questions can make the difference between finding the next big thing and finding out that a sure thing has gone wrong. - How well known is the brand and its products? - Does the company have a positive reputation? How is it portrayed in the media? - What is the financial health of company? Is the franchise system growing? - How long has the company been operating and has it been profitable throughout its history? - Is it a long standing company with a history of success or a new company whose future is uncertain? - Who are the directors and officers of the company? What is their background? Do they have particular expertise or industry experience? - Has the company had problems with their creditors? Is the company engaged in any litigation? - Are there franchisor owned stores/outlets as well franchised locations? - Do the franchisors own the rights to the system or do they merely hold the licensing rights for a particular region? The analysis of the franchisor’s current financial position and future growth prospects can be complex and the implications of financial statements may not be clear to unfamiliar readers.

When it comes to analysis of financial information, the assistance of an accountant and other professional advisers is invaluable. Other useful indicators of franchise health and profitability include (i) weighing the number of new franchises being opened versus the number of franchises ceasing operations and (ii) finding out whether existing franchises are being renewed or extended at the end of their initial terms. Geography & Competition Market conditions also play a significant role in the relative success (or failure) of any given franchise. Two new franchise units operating under identical systems can experience opposite results simply by virtue of their location and the timing of their opening. Being in the right place at the right time is essential as even the benefits of a prime location can be negated by an oversaturated market. Think about the following factors when considering whether you have the right franchise for your market: - Is there sufficient consumer demand for the franchise’s products or services in your market? - Is the pricing of your products and services appropriate for your market? - Are the products and services new and novel or well established? Avoid fads without lasting demand. - Is demand for the products and services seasonal or highly elastic? - Is there widespread completion for the products or services in your market or can you take advantage of a first mover advantage? - If there isn’t currently a high degree of competition, what is the likelihood of increasing competition? Avoiding oversaturation and inconsistent consumer demand while identifying opportunities in untapped markets is as much an art as a science, but a reasonable amount of market research and the advice of experienced professionals can go a long way towards improving your odds.

Franchising Legislation Alberta, Ontario, New Brunswick, PEI and most recently Manitoba (effective October 1, 2012) have each enacted franchise specific legislation. Each of these provincial acts impose the obligation on the franchisor to provide the franchisee with disclosure documents containing certain information and they hold both parties to a duty of fair dealing. If considering a franchise located in one of these provinces, some of the information discussed above can be found in the mandated disclosure documents, such as financial statements. However, the acts vary from province to province so be sure to properly understand the rights provided to franchisee in your jurisdiction.

New Franchises vs. Resales Prospective franchisees must also consider whether they wish to purchase a new franchise directly from the franchisor or purchase an existing franchise from another franchisee. In both scenarios you must decide whether to make your purchase and take ownership personally or through another business entity, such as a partnership or corporation. There are a variety of pros and cons for each form of business ownership and partnerships and corporate entities must be properly set-up or incorporated in advance of the purchaser. If buying a franchise through a resale from another franchisee, there are a number of extra matters the purchaser may wish to consider ahead of time. For example, the franchise agreement and other legal documents, such as leases or IP license agreements, often prevent such a sale unless the landlord or franchisor respectively, has given its consent to the sale and the assignment of the franchisee’s rights and obligations. It is also prudent to understand why the franchisee is looking to sell the business. Purchasers might wish to retain an accountant to confirm that the franchisee is not looking to sell because the franchise is struggling financially or bracuase the franchisor is difficult to work with. On the other hand, if the franchisee is relocating or retiring and the numbers look good, purchasers may have less to worry about. As always, there is no substitute for performing thorough due diligence and retaining the assistance of professional advisors. Another significant choice when purchasing an franchise is whether to buy the shares or the assets of the selling franchisee. Each alternative has advantages and disadvantages for the buyer and seller. In an asset purchase, the buyer can select which assets and liabilities of the seller it wishes to purchase and assume while leaving the excess with the selling company. Since the buyer can avoid those assets and liabilities it doesn’t want, the buyer tends to prefer an asset purchase. Conversely, the seller typically prefers to structure the transaction as a share purchase because the buyer purchases the company’s shares and consequently all of its assets and liabilities (as well as a favorable tax treatment for the vendor). The choice of whether to buy the shares or assets of the franchisee are often highly negotiated decisions between the buyer and seller. However, professional advisers can provide assistance with identifying key issues and negotiating and structuring the transaction to optimize the tax implications. The Legal Documents You’ve researched countless franchising opportunities, spoken to other franchisees and vetted financial statements. Now that you have finally chosen your franchising opportunity it’s time to set out the details of the franchisee-franchisor relationship. Failing to spend the time at this stage can negate all your earlier meticulous research as the terms of the franchise agreement and ancillary documents will govern the remainder of your relationship with the franchisor and

more importantly determine your rights and remedies in the case of a dispute. For this reason consult an experienced lawyer familiar with both the legal and business points of establishing the franchise relationship to help negotiate and draft the legal documents. Below are some of the more prominent terms to look for when preparing, negotiating and reviewing the franchise agreement: Term- How long will the franchise relationship last? Does the franchisee have the option to extend or renew the term of the franchise agreement? Does the franchisee have to meet certain conditions or make additional payments in order to exercise its option to extend or renew? Termination- Can the franchisee terminate the agreement before the end of the term? What are the conditions allowing for termination? Does the franchisee have to pay an early termination fee to the franchisor if it chooses to terminate the franchise agreement? What constitutes a breach of the franchise agreement allowing the franchisor to terminate? Does the franchise agreement provide for a “cure period” giving franchisee the opportunity to remedy its breach? Does the franchise agreement contain any provisions regarding arbitration, mediation and dispute resolution? Transfer/Assignment- Can the franchisee transfer, sell or assign the franchise agreement to another party? Is the franchisee required to give advance notice to the franchisor or to obtain the franchisor’s prior written consent? Can the franchisee transfer or assign the franchise agreement to certain approved transferees/assignees, such as corporate affiliates or family members? Costs & Expenses- What is the initial investment cost or franchise fee payable? Is it payable in installments or as a lump sum? Does the franchisor require a deposit from the franchisee? Is the deposit refundable? Does the franchisee require financing? Is financing available from the franchisor and if so on what terms? How are royalty payments to the franchisor calculated? How frequently are royalty payments due? Is the franchisee required to maintain specific insurance coverage? What are the ongoing operating costs for the franchise? Advertising/Marketing- Is the franchisee required to contribute to a regional or national adverting fund? How are contributions calculated and how often are payments due? Is the franchisee subject to any restrictions on advertising and marketing? Is the franchisee free to use the franchisor’s trademarks, logos and other intellectual property? Are the trademarks registered? Location- Does the franchisee or franchisor select the location of the franchise? Does the franchisor provide assistance with location selection? Does the franchisor have to approve the location? Are there any restrictions on location? Does the franchisee have territorial exclusivity? Can the franchise be relocated by the franchisor or franchisee? Is the franchise location to be leased? Is the franchisee or franchisor the tenant under the lease? Is the franchisor sub-letting the premises to the franchisee? Does the franchisor have to approve the

form of the lease? Does the franchisor require the inclusion of particular terms tin the lease? Is the franchisor providing the premises to the franchisee in “turnkey” condition or do the premises require some construction prior to occupancy? Are there specifications, such as floor plans or finishings, which the franchisee must follow? Who is responsible for the costs of construction? Who is responsible for arranging authorizations and permits re development and construction? Support/Training- Does the franchisor provide initial and ongoing training, education and support to the franchisee? What kind of training and support is provided? What are the costs to the franchisee? Where does training take place? Does the franchisor provide an operating manual? Reporting/Monitoring- Is the franchisee obligated to provide periodic reports to the franchisor? How frequently? What information needs to be provided? Does the franchisor have the right to conduct inspections of the franchisee’s premises or records? How frequently and at whose expense?

Products & Supplies- Does the franchisor control the pricing of all products and services? Is the franchisee obligated to purchase all or some of its supplies or inventory directly from the franchisor or only from specified suppliers? Does the franchisee have to make minimum orders from suppliers? Are there any restrictions on distribution or sales by the franchisee? Does the franchisor have to approve new suppliers or products?

Conclusion:

Buying a franchise is without a doubt a lengthy, expensive and complex process, but by taking the time up front to evaluate the options available to you and to properly understand and assess the legal documents governing your relationship with your franchisor, the decision to buy a franchise can be one of the most rewarding decisions you ever make. To maximize the odds of financial success and to minimize the likelihood of costly and stressful disputes with the franchisor, ensure you take advantage of the technical knowledge and experience of trusted advisors throughout the process.

 

By: David Gray and Matthew Zuk, Macdonald Sager Manis LLP

 

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