Franchise buyer beware

"Many franchisors are still not doing disclosure right," says John Sotos, a franchise lawyer with Sotos Associates LLP in Toronto. "They are not making full and complete disclosure."

The Toronto Star
October 18, 2004

Franchise buyer beware
Doing your research before buying can spare you a lot of heartache, experts say. Talk to current and former franchisees and hire a knowledgeable lawyer.
Donna Green

You've decided you want to be "in business for yourself but not by yourself," but how do you choose from the hundreds of franchise systems in Canada?

The Canadian Franchise Association, a trade association for the franchise industry, estimates there are between 900 and 1,000 franchised brands in this country. Here are some steps to narrow the field and find a system with a good chance of living up to its promises.

Be true to yourself
Surprisingly, the first step is an introspective one. Roger Noble, president of Choice Corporation, a franchise consulting company in Mississauga, says you must first look at your own skills and experience. Once you've got a realistic assessment of your strengths, pick an industry that complements them.

Get your ducks in a row and shoot a few
Next, line up all the franchise systems in your industry of choice. Approach them for informational material. Ned Levitt, a franchise lawyer with Levitt, Hoffman in Toronto, says this should give you a gut feel for the offerings, allowing you to cull some immediately.

You should be especially cautious about chains that are growing very rapidly. "People sell rapid growth as a badge of honour," observes Levitt, "but you've got to be able to service what you sell. If someone comes in and says there are 60 units in the system and they had 40 last year, I say, ‘Run!’ I look for reasonable growth."

The geographic distribution of units is also a factor in how well a franchisor can service its franchisees. It's unlikely the sole franchisee in Ontario is going to be as well serviced as 50 franchisees located in a cluster.

A franchise in a new system will be more risky than a unit in an established system. Noble says a new outlet in nearly any system will be more risky than buying a resale operation, but the opportunity may be greater.

Get down in the trenches
Levitt advises getting a feel for the people and the operation by talking to existing franchisees of those systems still in the running for your investment. This is a crucial exercise.

Don't just talk to one or two franchisees in a system. "Find a cross-section of franchisees," urges John Woodburn, president of C.J. Woodburn & Associates, a franchise consulting firm in Burlington.

Are the franchisees making money and would they buy their franchise again? What is the extent and nature of the franchisor's support? How much operating capital did they require? These are the kinds of questions you should be asking.

If the franchises you are considering have a franchisee association, make a point of talking to the associations as well. You want a system that is financially robust with reasonably content franchisees who are not in serious conflict with the franchisor.

Talk to those in the office
Woodburn says you should also meet the people associated with the franchisor "not just once, but a number of times, to ask questions and to get a flavour." It's important to find out how the franchisor makes a profit.

Some systems make much of their money by selling new franchises or by selling supplies at a mark-up to their franchisees. The best systems make the majority of their profits from the royalty payments of successful franchisees. Although you will be given the franchisor's financial statements, it will not reveal how the franchisors' profits are derived. Woodburn says, "If they won't answer questions, it's a bad sign."

Heavy-duty due diligence
By now you should have narrowed things down to one particularly exciting operation. Now the detailed work begins.

Request a disclosure document from the franchisor. The Arthur Wishart Act (Franchise Disclosure) requires franchisors, with some exceptions, to give prospective Ontario franchisees all material information about the franchise operation before any money changes hands.

Disclosure documents are the major tool in evaluating a franchise, but safeguard yourself by knowing what these documents should, by law, contain.

"Many franchisors are still not doing disclosure right," says John Sotos, a franchise lawyer with Sotos Associates LLP in Toronto. "They are not making full and complete disclosure."

Disclosure has made it relatively easy to contact former franchisees. This is an invaluable source of information about a franchise chain. Talk to as many former franchisees as you can find. Why did they leave the system and would they recommend it to you?

Review the contract
If your prospective investment has passed the previous tests, it is time to invest a little money to get some important protection. You should have an accountant look over the franchisor's financial statements and any financial projections and information the franchisor has provided.

An experienced small business accountant should be able to tell you if the costs and profit margin projections are realistic.

And don't assume being part of a system automatically gives you value, cautions Sotos.
"[Prospective franchisees] should understand what the added value provided by the system is in revenue or in cost savings."

Next comes a detailed review of the franchise agreement. "Get legal review of the contract by a franchise experienced lawyer, not a standard lawyer," says Woodburn.

It would be hard to emphasize this point too strongly.

"People are their own worst enemies," says Sotos.

"They go for cheap advice rather than for good advice. A franchise agreement is a very sophisticated and complex document that requires a degree of knowledge not available to everyone.

"The openness and transparency of the document is an important evaluative tool," continues Sotos.

"Just by looking at the agreement … tells me a great deal. The more rights that are one-sided or discretionary, the greater the likelihood that a franchisee can be hurt, if the will is there."

Of course, all of this does you no good unless you are prepared to follow your lawyer's advice and walk away from a tantalizing opportunity if the contract is too unfavourable to you, or the lawyer's experience or knowledge of that system is less than favourable.

What you can't see …
Then there are the intangibles. Les Stewart says it all comes down to the franchisor's character.
Stewart founded and runs the Canadian Alliance of Franchise Operators. His experience with franchise disputes has led him to conclude that the most important way to evaluate a franchise is by how fair the franchisor is in resolving disputes in the eyes of the current and former franchisees.

As John Woodburn says, "I don't know of anyone that has a perfect relationship in any aspect of life. It's a matter on balance of what is important and what is peripheral."

* * * * *

Contract Pitfalls
Here are some common franchise contract pitfalls, according to John Sotos, a franchise lawyer with Sotos Associates LLP in Toronto.

  • Renewal terms: "The shorter the initial term, the more likely additional fees are to be paid on each renewal. Upon renewal, a new agreement may be required, which may have materially different financial terms unless the terms are fixed."
  • How are supplies priced? "Most franchisors make money out of supplies, which amounts to a hidden royalty." Are mark-ups and supplier rebates disclosed and specified?
  • Territory: "The lack of an exclusive territory represents a significant risk factor." Instead of an exclusive territory, contracts sometimes grant the franchisee the right to purchase a new unit near their initial location. This can result in having two money-losing locations.
  • Advertising fund: "Does this money get held in a segregated trust fund or does it go in the franchisor’s general coffers? Are there restrictions on the franchisor’s use of these funds?" Can they be spent to sell franchises? Does the franchisor make a profit on this fund?
  • Sale to third parties: "Are you permitted to sell your operation to a third party on reasonable terms?" Must you pay for training or pay the franchisor a percentage of the sale?
  • Conditions of termination: "Are there any unreasonable or arbitrary terms that allow the franchisor to terminate your franchise?"
  • * * * *

On the web

Franchise association
Go to www.cfa.ca for contact lists and other information on the industry.

Know the law
The Arthur Wishart Act (Franchise Disclosure) 2000 sets out what information a franchisor is legally required to give.

Go to http://www.e-laws.gov.on.ca/DBLaws/Statutes/English/00a03_e.htm and www.e-laws.gov.on.ca/DBLaws/Regs/English/000581_e.htm

A Helpful Checklist
Tips on buying a franchise can be found at www.royalbank.com/franchise/ Search under "Information and Resources."


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Risks: Canadian Franchise Association, CFA, Roger Noble, Choice Corporation, Arthur Wishart Act (Franchise Disclosure), 2000, Canada, Renewing contract much tougher, Secret kickbacks and rebates, Advertising fund put into general franchisor's coffers, Resale permission unreasonably withheld, Cannibalization of sales, Encroachment (too many outlets put in territory), False earnings claims, Wealth is meant to be re-distributed (not created), Canada, 20041018 Franchise buyer

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