Franchising – for accountants & their clients
July 2009 By Paul Kirton, Principal & Michele Laks-Belzycki, Senior Associate, MacPherson Kelly www.mk.com.au
This article has been reproduced and amended as to order of content but otherwise reflects the original article prepared by MacPherson Kelly.
A common scenario that accountants encounter is a client coming to see them in one of two situations:
1. The client states, “I need to expand my business”.
The next question is “How?” and often the discussion about increasing sales and wider distribution. A very common solution might be franchising.
2. The client states “I am looking at buying a business”.
The next most logical question is “what type of business?” In more and more cases their reply is likely to be “a franchise business”.
Franchising an existing business or buying a franchise is a serious undertaking which requires careful consideration of the business, its cash flows and future plans. Franchising is merely another model for doing business. Many of the fundamentals are the same for a franchise business as for any other business. However, you and your client should carefully consider, in addition to the usual business fundamentals, a number of additional franchise specific issues.
This article will expand on those additional issues that accountants should examine carefully when advising clients who are looking to enter the realm of franchising.
When acting for a client looking to franchise their business, other distribution alternatives should not be ruled out. Franchising a business will fundamentally change the nature of the business, and some business owners find they cannot accept the different responsibilities, skills or level of scrutiny.
If acting for a potential franchisee, often before seeking advice, potential franchisees will have already made up their minds about a franchise. They are really only seeking your confirmation of their positive opinion. One hurdle that you will need to overcome is that of convincing them that due diligence should still be conducted and is of value.
Finally, one good rule of thumb in considering the value of a franchise is to consider the cost of a franchisee starting a similar business itself. Key questions to ask are:
A business is considered to be a franchise if an agreement has been made:
1. Which is a written, oral or implied agreement;
2. In which a person (the franchisor) grants to another person (the franchisee) the right to carry on the business of offering, supplying or distributing goods or services under a particular system or marketing plan;
3. Associated with a trade mark, advertising or a commercial symbol;
4. Under which the franchisee pays a fee, directly or indirectly.
KEY FEATURES OF A FRANCHISE
A franchise is a business structure where one party (the franchisor) grants another party (the franchisee) the right to operate a business using systems and procedures and associated with a name or brand owned by the franchisor.
One of the key benefits of franchising for a prospective franchisee is that they gain the existing reputation, support and experience of a franchisor rather than having to start a business from scratch. Hopefully this edge will minimise the risk of starting a new business.
To ensure that a prospective franchisor is offering value for money (particularly in the case of a greenfield franchise that has no financial background), it is these features of a franchise that need to be investigated. For example, most franchises have some or all of the following features:
Some of the features will be highlighted when considering the various accounting issues discussed below.
LEGALITIES OF FRANCHISING
In most areas, the terms of a franchise system are not restricted by law. As such, the franchisor is free to set up the franchise system as it sees fit.
However, the Trade Practices Act does provide some controls in relation to competition, pricing, stock supply and unconscionable conduct which applies to the franchise relationship. A good example of that is the issue of third line forcing, whereby it is illegal for a franchisor to force a franchisee to buy stock from a specific supplier, unless that supplier is one of a few suppliers (preferred suppliers) where the franchisee can obtain stock.
The Franchising Code of Conduct (“Code”) is also a mandatory industry code that is underpinned by the Trade Practices Act. The Code operates to regulate the franchise relationship in three main ways:
1. The franchisor is required to provide certain disclosure about itself, its key personnel, the franchise system and likely costs of set up and operation of the franchise.
2. Specific clauses must appear in the Franchise Agreement, specifically clauses in relation to the right of cooling off, assignment, termination and dispute resolution.
3. Certain conduct of franchisors is regulated, in relation to maintenance of a marketing fund, ongoing disclosure obligations, attendance at mediation and the sign up process for franchisees.
The definition of a ‘franchise’ in the Code is very broad. Many business structures that historically were licenses, agencies or distribution arrangements may well fall within the ambit of the Code. Be very careful here.
Usually, the documentation required consist of several substantial documents, including a Franchise Agreement, Disclosure Document and a copy of the Franchising Code of Conduct. Operations Manuals are often present in a system, but seldom provided before a franchisee has signed up, as they contain the true “secrets” of the franchise system.
Timing can also be an issue, as the Disclosure Document and final execution version of the Franchise Agreement must be provided to the franchisee at least 14 days prior to signing or paying any non-refundable money.
The law requires the disclosure document be provided in the form and contain the information prescribed in the Code.
The Franchise Agreement governs the initial and ongoing legal relationship between the franchisor and franchisee.
Also, where a franchisor is selling part of its business, or if an existing franchisee is selling its franchise, there will be a Sale of Business Agreement.
ISSUES IN THE DISCLOSURE DOCUMENT
The disclosure document provides a significant amount of detail which is of interest to accountants. This document also sets out ranges of likely costs to establish and run the franchise. In effect, this document provides the basis from which to determine whether the franchise is potentially profitable.
The following highlights some of the issues that are required to be disclosed and bear consideration:
1. Historical details of the franchisor, it directors and key personnel and lists of any relevant associated companies. This provides a good overview of the business experience on which the franchisee will rely. It also shows whether the franchisor company is merely a ‘$2 company’; with all its assets (including intellectual property) held elsewhere.
2. Details of any relevant litigation against the franchisor or its directors and details of any bankruptcy of the directors. Unfortunately, the Code does not require disclosure of other franchises in which the directors may have been involved through other companies. Details of other failed franchise attempts may not be disclosed.
3. Whether there are any payments made to agents or other third parties as a result of recruitment of the franchisee.
4. Stock supply and sale requirements and restrictions. Details of any minimum inventory requirements, supply channels and ability to seek alternate (possibly better priced) stock are covered. The franchisor may also disclose whether the franchisee is required to purchased from it or its associated entity. Often, a franchisee is required to purchase only from approved suppliers to avoid contravention of the third line forcing provisions of the Trade Practices Act.
Stock supply can become a contentious issue for franchisees which often lead to disputes. This can occur where a franchisee is required to purchase stock it does not need or where a franchisee is only able to purchase stock at uncompetitive prices.
Where stock deals have been negotiated by the franchisor, it is always wise to compare this pricing with readily available and comparable stock.
This information is also important when considering cash flows and the cost of stock. Also, it provides details of additional payments required to be made to the Franchisor. Look out for ‘add ons’ that may make a franchisee uncompetitive. For example, we have come across cases where the franchisees were free to purchase stock and ingredients, however they were required to purchase packaging from the franchisor. The franchisor had imposed a huge mark up and overall the products became uncompetitive.
5. If a franchise system has a marketing fund, extensive details must be provided about the fund.
Of note, there must be a percentage breakdown of the previous year’s expenditure and income in areas of production, advertising, administration and other expenses. The marketing fund must also be audited by the franchisor each year unless 75% or more of the franchisees agree that the fund does not have to be audited.
6. A substantial amount of information must be provided in relation to:
6.1 Prepayments required to be made by franchisee prior to signing a franchise agreement, and whether the payment is refundable;
6.2 Detailed establishment costs of opening a new franchise;
6.3 Detailed costs of an ongoing nature payable to the franchisor or associates during the term of the franchise agreement.
This information should provide a good picture of all costs necessary to start and operate the business. However, the Code allows a range of costs to be provided. While the costs of your particular client’s franchise need to sit within the range, the range may be too broad to be useful in considering establishment and operational costs and cash flow projections.
If only broad information is given it is always advisable to seek an explanation of the determining factors or undertake more detailed analysis yourself.
7. A franchisor may provide earnings information or projections about a franchise. Such projections often cause problems and many franchisors do not provide projections. If such information is provided it should be examined by you very carefully. Generally, it is on this information that a large proportion of franchise litigation is based.
Any assumptions that have been made in calculating the figures must be disclosed. However, from experience, it is usually the unforeseen circumstances that cause these figures to be incorrect. Projections can provide a failed franchisee with ammunition to seek damages from a franchisor. It is always better to avoid the franchise in the first place than to try and recover damages after it has failed to perform.
8. The franchisor must also provide copies of its financial reports, including profit and loss statements and balance sheet for the past two financial years. These are not required to be provided if the franchisor’s auditor verifies a statement of solvency from the franchisor’s director.
If given, these statements allow the franchisee’s accountant to consider if franchisor is adequately funded to provide the services promised. They can also highlight whether a franchisor’s income relies on the grant of new franchises rather than from franchise fees.
Some franchise systems fail because once a market is covered, there is no scope for a franchisor to derive income from the grant of further franchises. If additional franchises are granted, the market becomes flooded and the performance of existing franchises is adversely effected.
ISSUES IN THE FRANCHISE AGREEMENT
The franchise agreement is the legal document that covers the initial and ongoing relationship between the franchisor and franchisee.
While much of the payment and cost amounts will also be covered in the disclosure document, there can often be differences between these documents. This may be due to the particular deal negotiated by the parties.
Also, other hidden costs may become apparent. For example the franchisee may be required to:
The franchise agreement will also describe the franchisor’s payment terms. These may not be compatible with the franchisee’s payment terms, to the detriment of cash flow.
One common example is where a franchisor requires payment on the 7th day of each month for services or goods provided during that month. However, the franchisees may not be paid for 30 days after the end of the month. Another concern can be raised where a franchisee’s franchise fees are based on goods or services invoiced and do not allow for an adjustment for bad debts, promotional offers or dispute discounts.
There are a number of other areas which are appropriate for accounting input. Some of these may be more of a general business nature; however, for new franchisors and franchisees that are new to franchising or business, they can still prove to be valuable in the development or evaluation of a franchise.
1. The rental terms of any lease can impact significantly on the profitability of a franchise. With many shopping centre leases, rental may well comprise of a base rent plus an additional amount based on turnover. The frequency and basis of rental reviews should also be factored into your calculations. Along with the actual rental, you should consider the amount of any bond, stamp duty (if any), landlord’s costs and outgoings.
2. If finance is required, it is likely that you will need to work with your client to prepare a business plan. There are many finance options available and you should work through these with your client to determine which is the most appropriate for the franchise.
3. When considering the franchise fees and finance issues, you should also factor in the term and any renewal term of the franchise. It is important that the franchise is of a sufficient length for both the franchisor and franchisee your client to recover their respective investments and make profit. If your client intends to build the business for a few years and then sell it, the term of the franchise should be long enough for a purchaser to be interested in buying the business.
4. As with any business, the structure of the venture is important for taxation and asset protection reasons. Choosing the structure will usually involve discussions with your client’s legal advisers. With the structure, your role will normally involve preparing annual returns, tax returns and also the various GST reporting requirements. Most franchise systems encourage or require accurate reports and records to be kept by franchisees. These requirements tend to make your role easier.
5. While not strictly an accounting issue, you should consider the exclusive territory (if any) of the franchise. The demographics of this territory should be compared to other successful franchises or similar businesses in the system.
6. If acting for a prospective franchise, an invaluable source of information can be obtained from existing franchisees or their advisers. The code requires a franchisor to list all their existing and past franchisees and you or your client are free to contact them. Speaking with other franchisees provides a good indication of whether a franchisor follows through with its promises.
**Information obtained from the “Franchising Australia 2008” survey conducted by Griffith University, prepared by Lorelle Frazer