If you are considering buying a franchise, the disclosure document is a key part of the process that aims to ensure prospective franchisees can make an informed business decision.
Under the Franchising Code of Conduct, all franchise systems in Australia must maintain a disclosure document, which must be provided to prospective franchisees at least 14 days before entering into a franchise agreement.
The purpose of a disclosure document is to supply key information about the nature of the franchise system and to help the franchisee make an informed business decision about entering the franchise.
Despite being tailored to each franchise system, disclosure documents must comply with the Code’s prescribed format. Key elements in a disclosure include:
The warning statement on the first page cautions prospective franchisees that franchising is a serious undertaking. It recommends they obtain independent legal, accounting and business advice, but also highlights their cooling-off rights.
Disclosure documents must specify their preparation date and be signed by an officer of the franchisor. Franchisees can reference this date to ensure currency.
Franchisors must update their disclosure document annually within four months of the end of their financial year (with some exceptions). Therefore, franchisors working on a standard July-to-June financial year must complete their update by the end of each October.
The business experience of the franchisor’s officers and the duration the franchise system has been active in Australia provides an insight to the stature of the system. Prospective franchisees can judge whether the franchisor has a satisfactory level of knowledge and experience in the industry, which is especially important for the new systems.
Contact details for all current franchisees within the system and those who have left during the previous three years (and the reason for doing so) are an essential element of a prospective franchisee’s due diligence. Current and former franchisees should be contacted to assess satisfaction with the franchisor’s training, support and systems.
If large numbers of franchisees have had their agreements terminated or have left the system, it may indicate unhappiness with the system.
Franchise agreements give franchisees the right to use the franchisor’s intellectual property. This can include copyright (trade secrets), trademarks (business names and logos) and patents (inventions), which will be detailed in the disclosure document.
The ownership structure of the intellectual property must also be disclosed. In many systems, a separate holding company owns the intellectual property and licences as part of an asset-protection strategy.
SITE AND TERRITORY
Franchisors must disclose whether a franchisee is granted an exclusive territory or if their rights are limited to a particular location. Some systems give franchisees the exclusive right to work in a set geographical area, while others can grant the right to work only from a specified store. Franchisees can use this to determine the risk of competition from within the franchise system itself.
If the franchisor has site-selection criteria, then details must be disclosed. Regardless of whether the franchisor nominated the site, it is crucial that franchisees do their own independent investigations as to whether the demographics of the site or territory can support the business.
Details of previous franchisees who have worked in the site or territory within the past 10 years must also be provided. A high turnover of franchisees in the one location could indicate a problem.
GOODS AND SERVICES
In most franchise systems, franchisees must obtain good and services from the franchisor or an approved supplier to ensure uniformity across the system. The disclosure document should detail how these arrangements will work, along with the franchisee’s right (if any) to do business online.
Franchisors must also provide details of any rebate arrangements in place with suppliers.
The franchisee’s establishment costs and all the expected payments during the course of the franchise must be disclosed. Franchisors will often provide large ranges, so the franchisees should undertake a careful analysis. The cost of establishing a store within a shopping centre will be much higher compared to a quiet street corner.
Unforeseen capital expenditure is also important to note. This could be the franchisee’s costs to refurbish their store, or upgrade and replace equipment and signs.
Franchisees should be able to use these figures to estimate what the total costs will be to set up and run the business, and whether the business model can reach and sustain profitability. A franchisee’s accountant will play a key part in this analysis.
If the franchisee has to contribute to a marketing fund controlled or administered by the franchisor, then details of the payments and how the fund will be used must be disclosed.
Franchisors must clearly disclose whether the franchisee has an option to renew or extend the franchise agreement at the end of its term. This includes whether franchisees are entitled to compensation if they do not renew, and arrangements for unsold stock and equipment.
It is important for franchisees to understand that once the term of the franchise agreement ends, and if they walk away from the business, they generally lose the right to receive compensation for goodwill.
Finally, a disclosure document must contain a statement confirming the franchisor’s solvency, along with their financial statements for the previous two financial years or an independent audit report.
It is imperative the financial figures are up to date. If the figures indicate the franchisor is struggling financially, then this is a red flag.
While disclosure documents can seem a lengthy and burdensome read, they contain a wealth of information invaluable to a prospective franchisee trying to choose the right franchise system. Reading the document from cover to cover is essential.
After considering the disclosure document and making proper inquiries, franchisees will better understand the risks involved in the franchise and how their future relationship with the franchisor will work.
Luke McKavanagh is a commercial lawyer specialising in franchising and business law.
Read the official release of the article HERE from the Franchise Business Magazine website!