Franchise Article

 

 

 

Undoubtedly, franchisors will be keen to obtain a return on their substantial investment in launching their franchise and will wish to recruit prospective franchisees as quickly as possible.  As already indicated, great care needs to be taken to ensure that any prospective franchisees are up to the standards required by the franchisor.  As in all things, the 80-20 rule applies -  80% of franchisees perform well and 20%  don’t and franchisors spend 80% of their time dealing with the 20% that don’t.  Equally a franchisor needs to ensure that its approach and actions  in recruiting franchisees do not put off prospective franchisees or their advisors.

 

Further franchisors need to ensure that they do not produce business plans which are over ambitious in the early years of their franchise.  For those franchisors that are taking a master franchise from a foreign franchisor, great care needs to be taken in setting a development schedule at the right level.  Research that has recently been undertaken suggests that only a small percentage of development schedules (minimum numbers of franchises operating at each anniversary of the agreement in order to maintain either exclusivity or to keep the agreement in place) are ever achieved.   Some franchisors from overseas jurisdictions which have a greater entrepreneurial spirit than the UK , and/or where franchisee failure is not, within reason, considered to be detrimental to the franchisor, tend to set over optimistic targets for franchisee recruitment.  There are a considerable number of franchisors who have been extremely successful but which after two or three years of operation with only one or two franchisees in existence considered withdrawal from franchising.  Certainly franchisors should think hard about preparing any business plans which demonstrate franchise recruitment levels of more than one or two franchisees in the first year.

 

2.         Danger Signs 

 

This section deals with some of the common mistakes made by over “keen” franchisors, as follows:-

 

-          “Hard sell” – franchisees are often invited to invest their life savings in a franchise, to give up a job and devote substantial time and effort to making their franchise business successful.  In such circumstances it is inappropriate for franchisors to put any pressure on franchisees to “sign up”.  Certainly, franchisees should not be signed up at a franchise exhibition which would, in any event, amount to a breach of the exhibition organiser’s requirements.  Franchisees must have sufficient time to consider the franchise opportunities, to talk to other franchisees and to obtain legal advice. 

 

-          Time constraints – whilst, inevitably, franchisors have training sessions at fixed times in a year, and prospective franchisees need to be notified of them, they should not be used as an excuse to put pressure on franchisees to enter into the franchise agreement.  Prospective franchisees should be fully aware of the training timetable and make their own assessment.  Equally, if there are a number of prospective franchisees interested in the same territory, there is no harm in the prospective franchisees being informed of this, but a franchisor should be aware that it is relatively easy for this to be interpreted as pressure on a franchisee.  Hardly worth saying, but franchisors should not under any circumstances “manufacture” competing interest in a franchisee territory and should not turn entering into the franchise agreement into a race between prospective franchisees. 

 

-          New franchisor - inevitably franchisees who enter into a franchise agreement with a new franchisor that does not have a significant number of existing franchisees who are trading successfully will be taking a greater risk than taking a franchise from one who does.  This is simply a fact of franchising life but, of course, every successful franchisor has to start somewhere!   

 

-          Non contractual statements – franchisors should resist the temptation to indicate to franchisees “don’t worry about what’s in the franchise agreement we’ll agree something different”.  These non contractual statements amount to either a representation or possibly a collateral contract.  The franchisor may believe that it is being helpful but unless these statements are written down and form part of the franchise agreement itself or a side letter to the agreement, then almost certainly contractual provisions in the franchise agreement will have the effect of ensuring that these statements are not legally binding on the franchisor which will be harmful to the franchisor – franchisee relationship.

 

-          No pilot testing – it has already been stressed that franchisors must pilot test because otherwise they are selling a concept whereas franchising is about selling a proven business format.  Some franchisors do launch their franchise without pilot testing.  Any attempt to do so will make it even harder to recruit franchisees in the early days.  The requirement for pilot testing is also imposed on foreign franchisors who are entering the UK market.  The BFA simply does not believe that a system that is successful outside the UK will inevitably be successful in the UK and, therefore foreign franchisors or their master franchisees must establish pilot operations.  The BFA is able to impose a pilot testing requirement by virtue of its membership criteria and also because of the contractual provisions in the agreement between itself and exhibition organisers in the UK which requires all those who exhibit at BFA shows to have pilot tested their system.  

 

-          Advisors – as already indicated the franchise units of the banks pay particular attention to who the advisors to a new franchisor are in order to establish whether this is a franchisor that is worth backing.  Equally, franchisees and, more particularly, their legal advisors will be likely to take a more positive view of a franchise which has used established franchise consultants and lawyers. 

 

-          Failures – a franchisor must be “transparent” about the number of franchisee failures that it has had.  A significant number of failures will inevitably have a negative effect on recruitment.  Failure rates of more than 10-15% would begin to give rise to concern.  Franchisors must be honest as to the reasons for franchise withdrawals.  In practice, relatively few franchisees simply terminate their franchise if they are trading profitably because they would want to receive the capital value (however small that might be) of their franchise business through a sale.  In 95% of cases if a franchisee simply terminates, even if that franchisee wants to withdraw because of ill health or he wishes to emigrate, the reason is his franchise business has not been trading profitably.

 

-          Franchisee list – franchisors should always provide prospective franchisees with a full list and contact details of all their franchisees and not simply the five or ten top performers.  A failure to provide this list to a prospective franchisee is likely to give rise to considerable concern. 

 

-          BFA Membership – whilst there are a number of long established, successful and ethical franchisors who are not members of the BFA most ethical franchisors do wish to be members.  Prospective franchisees will inevitably want to know why a franchisor has not applied for membership of the BFA. 

 

-          Poor agreement – not all franchisees will obtain legal advice on their proposed franchise agreement, although probably more than 85% do, and for those that do, if the agreement has been badly drafted, this will certainly be commented on by their legal advisors.  It will also, inevitably, make it harder for franchisors to obtain membership of the BFA because one of the accreditation tasks performed by the BFA is to have a franchisor’s agreement reviewed by the Legal Advisor to the BFA. 

 

-          Change agreement – franchisors should not negotiate or amend their franchise agreement with a prospective franchisee.  A willingness by a franchisor to do this will sound warning bells. 

 

-          No need for legal advice – there are substantial benefits for a franchisor in ensuring that franchisees obtain independent legal advice on the franchise agreement.  Some franchisors discourage this.  This would be worrying for a prospective franchisee. 

 

3.         Finding Franchisees

 

Franchisees are recruited in a number of ways.  The difficulty in recruiting franchisees should not be under estimated.  Franchisors currently cite the lack of suitable franchisee candidates as the main reason for limiting their growth.  It is important, as a starting point, to understand how franchisees research and select a franchise.  Over three quarters look at a franchisor’s web site.  This figure is likely to increase and, therefore, franchisors need to ensure that their web site is easy to find, easy to navigate and encourages franchisees.  Over half will have investigated other brands and, therefore, franchisors must ensure that their franchise offering, in terms of the initial fee, continuing fees, turnover and profitability are not less attractive than those of their main competitors. 

 

In addition, prospective franchisees will have undertaken research through general franchise web sites, such as the BFA’s web site as well as attending a franchise exhibition and acquiring the BFA’s franchisee pack.  They may well also have attended seminars on franchising which have been put on either by the BFA, Business Link or groupings of franchisors.  Franchisees are therefore likely to be well informed about franchising and the systems that are available. 

 

The NatWest/BFA Survey summarises the checks undertaken and advice sought by prospective franchisees as follows:-

 

Assess whether the franchise fees are fair and value for money	86%
Ask existing franchisees whether their business are profitable	85%
Ask existing franchisees for their opinion of the franchisor	80%
Seek advice from an accountant	79%
Check the financial stability of the proposed franchisor	74%
Seek advice from the franchisee’s bankers	70%
Assess the impact of running the business on the franchisee’s family	68%
Seek advice on the franchise agreement from a non-bfa affiliated franchise solicitor	63%
Check whether the franchisor is a BFA member	61%
Ask whether the franchisor has operated a pilot before launching the franchise	39%
Seek advice on the franchise agreement from a BFA affiliated solicitor	25%
Seek advice from another bank	25%

 

Magazine advertising has historically been the most frequently used method of “attracting” franchisees.  The Franchise Magazine, Business Franchise Magazine and Franchise World have recently been joined by other magazines such as Making Money, all of which are aimed at promoting franchising and franchise systems.  However, franchise magazine advertising has been overtaken by a franchisor’s own web site as the best way of attracting franchisees and there has been a rapid rise in the importance of the BFA web site and other franchise web sites in terms of recruiting franchisees with a relative decrease in the importance of magazine and newspaper advertising. 

 

Section 3.1 of the Code of Ethics requires all recruitment advertising for franchisees to “be free of ambiguity and misleading statements”.  Section 3.1 probably applies only to advertisements but Section 3.2 applies also to publicity material which will include material on web sites as well as either “advertorials” or articles appearing in franchise magazines to which the Franchisor has contributed.  If in such material there is a direct or indirect reference to “future possible results, figures or earnings” which a franchisee might expect then such figures must be “objective” and “not be misleading”.  The BFA in its “Extension and Interpretation” to the Code of Ethics seeks to make it clear that section 3.2 applies only to “publicly available material” and that in discussing individual business projections with franchisees, franchisors “are invariably involved in making assumptions which can only be tested by the passage of time”.  That may well be the BFA’s view but in practice franchisors should not make any assumptions.  It is for a prospective franchisee to make assumptions on the basis of the objective information provided by the franchisor. 

 

All franchisors (whether members of the BFA or not) should ensure that they comply with sections 3.1 and 3.2 of the Code of Ethics.  Failure to do so will substantially increase the likelihood of a misrepresentation action claim being brought against a franchisor.  

 

 

 

The UK is unusual in having no franchise disclosure laws.  Increasingly, legislators are introducing such laws.  Within Europe, France , Spain , Italy , Belgium and Sweden all have disclosure laws.  Greece has announced its intention to introduce disclosure laws and other countries such as Germany and Austria rely on general obligations in their civil code to oblige franchisors to make disclosure to prospective franchisees.

 

Although the UK contains no specific legal requirement obliging disclosure to franchisees the Code of Ethics imposes obligations. 

 

Section 3.3 of the Code of Ethics imposes two specific obligations on a franchisor deriving from the general obligation to enable prospective franchisees to enter into a binding document with “full knowledge”.  First, franchisors are required to give a copy of the Code of Ethics to their prospective franchisees.  In practice, very few franchisors operating in the UK do this, not because they object to it, but because they are simply unaware of the requirement.  The second specific obligation is that franchisors are required to provide “full and accurate written disclosure of all information, material to the franchise relationship, within a reasonable time prior to executing the agreement.” 

 

What amounts to full and accurate written disclosure has been set out by the BFA in its publication “Disclosure of Information to Prospective Franchisees – A Guide for Franchisors”.  Essentially, disclosure is required in the following areas:-

 

-          Information regarding the business and the financial position of the franchisor.

 

           The franchisor must ensure that their promotional material or prospectus must:

 

-        explain his business, its development, the development period providing sufficient information to enable assessment of the franchisor’s  business experience and background; and

 

-        provide a copy of the latest set of accounts – comprising a complete set of accounts, including a certified balance sheet and profit and loss account (dated and certified by its auditors not more than 12 months prior to the date provided to the franchisee);

 

-        a confirmatory statement that it has never had any action taken against it in consequence of debt, save for any genuine dispute or if this cannot be provided then a full explanation of the circumstances.

 

-          The people involved in the franchise company.

 

           The franchisor should disclose information on the directors and senior executive staff (being staff with authority to make decisions directly and substantially affecting franchisees).  The following information should be provided:

 

-        names

 

-        qualification(s)

 

-        responsibilities

 

-        previous relevant business experience

 

-        confirmation that they have never been:

 

-        bankrupt

 

-        insolvent

 

-        had action taken against them in consequence of debt

 

-        convicted of a criminal offence

 

         If this cannot be given then a full explanation should be given.

 

-          The franchise proposition including details of the pilot operation where appropriate.

 

           The franchisor should provide the following:

 

-        description of the proposition

 

-        state what is offered

 

-        a realistic description of the business format (to include details of the range of services and continuing services available to the franchisee)

 

-        details of the development of the franchise system to include:

 

-        the amount of pilot testing

 

-        the financial performance of the pilot operations

 

-        franchisor’s suppliers and alternatives if the source fails

 

-        site approval:

 

-      basis of approval

 

-      whether franchisee is to rely on franchisor’s choice

 

 

 

           The franchisor should provide the following details:-

 

-        the number of franchisees

 

-        their details (names, addresses and telephone numbers)

 

-        where they trade

 

-        dates opened

 

-        number of terminations and reasons

 

-        number terminated by franchisor that year and grounds

 

-        details of any litigation (if any)

 

-        trading history over 5 years (if territory previously traded)

 

-          The financial projections :-

 

           The franchisor must:

 

-        clearly state the basis of the presentation of the financial projections

 

-        clearly warn franchisees that they should understand that no franchisor can warrant with accuracy any financial performance in any particular case

 

-        warn franchisees to take independent accountancy advice

 

The best the franchisor can do is:

 

-        show illustrations of what has been achieved in practice

 

-        show what sort of gross and net profit might be achieved if certain turnover levels are reached

 

-        gross margin and revenue expenses shown should be the same as or no better than those actually achieved in practice by the franchisor in his own operation or on average by his franchisees

 

-        the franchisor should clearly state which of the alternatives he has chosen for his illustration

 

-        franchisor should put a statement on each page of the projections setting out the origins of those projections and confirming that there is no guarantee that an individual franchisee will achieve the same results and that there is no intention that the individual franchisee should rely on them as a warranty or guarantee

 

-          The contract

 

           The franchisor should (preferably in writing) advise the franchisee to take independent legal advice.

 

 

 

 

 

 

 

 

 

Franchisors should use the above list of disclosures as a useful starting point in the preparation of a disclosure document.  The BFA does not require franchisors to undertake disclosure by way of a standard format disclosure document but believe there is considerable merit in franchisors, at the end of the recruitment and disclosure procedure, bringing together all relevant and material information provided by the franchisor to the franchisee in one document.  Both parties should sign the document and acknowledge that the information contained in it is a complete and accurate record of the disclosure given and received.  This is useful to both parties and may prevent misunderstandings or disputes at a later stage.

 

Franchisors should not view the requirements of the BFA concerning disclosure as burdensome, but as simply setting out a common sense approach.  Franchisors have no interest in recruiting franchisees who are not fully aware of all relevant aspects of their franchise business and franchisors should not provide any misleading or false information to prospective franchisees because, increasingly, franchisees who fail will seek to recover their lost investment by bringing proceedings against the franchisor for misrepresentation. 

 

Franchisors who are not members of the BFA do not have to comply with the Code of Ethics or the BFA’s disclosure requirements but if they do not intend to, they need to have an eye on the decision of the High Court in re Driver Time Recruitment Limited; re DST Limited which was a case involving public interest winding up petitions presented by the DTI.  The DTI sought to have two companies involved in franchising wound up. In that case it was clear that the Judge placed considerable emphasis on the requirements of the BFA.  The Judge indicated:-

 

               “At this point I should mention the British Franchise Association (“BFA”) the umbrella organisation for franchise businesses in general.  It has a Code of Ethics to which its members must adhere.  The BFA is not a regulator, indeed the franchise industry is unregulated.  Membership is not compulsory for a franchisor to be able to trade.  Nonetheless, its Code of Ethics provides a good indication of what is to be regarded as fair practice in the industry.  The Code requires franchisors to make various disclosures when selling franchises to investors.”

 

Any franchisor  (even those who have no intention of applying for membership of the BFA) failing to comply with the BFA’s disclosure requirements will substantially increase its exposure to legal action.

 

5.         Taking a Master Franchise

 

A significant number of new franchisors in the UK have entered into a master franchise agreement with a foreign franchisor.  This is potentially attractive because the system will have been tried and tested (albeit in another country) and the foreign franchisor will provide assistance.  The obvious disadvantage is that payment has to be made to the franchisor for receiving the master franchise rights and the master franchisee has to remit a percentage (often approximately 20%) of  sums received from sub franchisees.

 

Care needs to be taken when entering into a master franchise agreement and you should not assume that a system which was successful overseas will necessarily be successful in the United Kingdom .  Indeed, the BFA has been concerned at the assumption that foreign franchise systems do not need to be adapted for the UK market.  It has published a technical bulletin addressing this issue which sets out:-

 

 

 

In other words an imported system must be successfully pilot tested in the target country before being generally offered for sale to potential franchisees, although this would not apply to countries that are neighbours and have similar markets, such as the UK and Ireland .

 

The BFA is able to enforce its requirements not only through its membership application process but also because franchise exhibitions in the UK require  franchisees who wish to exhibit to be approved by the BFA.  Broadly, the BFA will require master franchisees to have pilot tested the system in the same way as any other new franchisor entrant to the UK market.  Undoubtedly, these new rules will make it harder for master franchisees to recruit new franchisees in the early days, although in this they will be no different to other franchisors.  This does mean that great care needs to be taken in agreeing a development schedule with a foreign franchisor – provisions which oblige master franchisees to appoint a minimum number of franchisees as at each anniversary of the master franchise agreement.  A failure to achieve the development schedule usually entitles the foreign franchisor to terminate or to withdraw exclusive rights in favour of the master franchisee which highlights the importance of agreeing a realistic development schedule.

 

Master franchise agreement, unlike sub franchise agreements, are negotiated agreements and you would certainly expect substantial negotiations on the initial fees and continuing fees payable to the foreign franchisor and what the master franchisee receives for them.  The trend is away from high initial fees containing a substantial profit element for franchisors to fees which represent the cost of granting the master franchise rights (which will include legal costs in preparing and negotiating the agreement, travelling, training and assistance) and a small profit percentage.  In addition you would expect the initial term to be long enough to allow to franchise terms to be granted to sub franchisees so that fifteen to twenty five year terms are common with, of course, the right to renew and unlike sub franchise agreements it is unusual for franchisors to have complete discretion on the renewal terms.  Master franchise agreements are, of course, complex legal agreements which will require to be reviewed in detail along with the franchisor’s track record.  Prospective master franchisees should as a very minimum establish :-

 

-        the franchisor’s “track record” (openings, terminations and franchise disputes) in its home country;

 

-        what is the franchisor’s current rate of growth and reputation in the home country;

 

-        if the franchisor is required to  disclose information in its home country obtain a copy of the disclosure document;

 

-        when the franchisor started to expand overseas with  master franchising, how many master franchises have been granted and are they successful;

 

-        whether the franchisor has the management in place to provide the necessary back up, training and assistance.

 

In addition, a prospective master franchisee needs to satisfy itself that the products or services which are the subject of the franchise have a market in the UK and there are no legal reasons why these products or services cannot be sold.