Due Diligence For Small Business – When Buying A Franchise

July 20, 2016/,

What is due diligence?

Doing your “homework”, “doing a bit of research” or “no idea whatsoever” are various descriptors of due diligence by participants in the SME space[1]. This paper adopts a definition of due diligence as set out in a recent Due Diligence Survey.[2]

“Due Diligence means the process of ensuring that investors are getting what they think the are buying and what they are buying is with what they are paying”[3]

The types of due diligence involved in acquiring a SME business (whether with a franchise element or not) should be broadly the same. Matter such as contract review and negotiation, financial analysis, valuation advice, market research, client review, SWOT analysis, site suitability are among the usual items of due diligence.

According to the Due Diligence Survey, accountants are relied upon to undertake most of the due diligence with approximately 55% of all purchasers (whether for an independent or franchise business) consulting their accountant. The choice of accountant is often based on existing contacts rather than seeking a specialist in due diligence.  Interestingly, purchasers of non franchise business are less inclined to seek legal advice with approximately 28% of non franchise business purchaser doing so in comparison to 64% of purchasers of franchise businesses doing so[4].

Franchise Specific Due Diligence

The unique feature of the franchise business is the ongoing relationship and reliance upon the franchisor, its system and brand management. In this regard, any potential purchaser should undertake franchise specific due diligence that would be considered independent and in addition to of the normal due diligence for the purchase of a business.

One of the key advantages of purchasing a franchise business is that a Franchisor must now provide disclosure to a prospective purchaser of a franchise business. Clause 9 requires a Franchisor to provide a “prospective franchisee” a copy of the Code, Disclosure Document and Franchise Agreement (in its final form)[5].  The Disclosure should provide the starting point for any due diligence and enquiry into a franchisor and the franchise system.

It is strongly recommended that an updated Disclosure Document be sought prior to entering into a contract to purchase a business. The vendor franchisee can demand an updated version be provided (should their version be out of date) and the Franchisor must provide such copy within 14 days of such request.[6]

Using the Disclosure and information from other public registers, some examples of franchise business specific due diligence is set out in the following table:

What is being tested Why Being Tested?           How Tested
Is the Franchisor Solvent? To ensure that the Franchisor has the capacity to provide on-going support and administration with respect to the system after the purchase of the business.
  1. Is the Franchisor’s statement of solvency up to date? Disclosed as per Clause 21 (1) Disclosure Document.
  2. Are the Franchisor’s Financial Statement (for the last 2 years or audit statement) satisfactory? Disclosed as per Clause 21 (2) Disclosure Document
  3. Company Search;
  4. PPSR Search
  5. Credit Check
Does the Franchise have a proven concept, product or service with on-going potential? To satisfy the test as to whether the franchise business has a point of difference or competitive advantage which justifies buying into the business
  1. Longevity of the franchise system (Clause 2 & 3 Disclosure Document);
  2. Number of other franchisee’s in the system (Clause 6 Disclosure Document);
  3. Market research (google search at the least) of the market and other competitors (both franchise and non franchise)
  4. Customer enquiry
  5. Other franchisee enquiry (Clause 6 Disclosure Document)
Is there any goodwill attached to the name and/or image of the Franchise system and whether that name and/or image is protected by relevant Trade Marks The right to a franchise is in part the right to use a name, mark or brand associated with the system.
  1. What intellectual property rights does the franchisor (or related entity) hold? Has there been any litigation in respect of the intellectual property? Clause 8 Disclosure Document.
  2. Trademark search via ATMOSS
  3. Business name search via ASIC.
Does the Franchisor have a business format system and if so, does it work? The right to a franchise is in part to be a party to a franchise system which is meant to minimise the risk of making mistakes whilst operating the franchise business.
  1. Longevity of the franchise system (Clause 2 & 3 Disclosure Document);
  2. Sighting Franchisor’s operation manual or enquiring whether the Franchisor has a manual.
  3. Other franchisee enquiry (Clause 6 Disclosure Document) including site visit.
Does the Franchisor provide training, support, advice and marketing assistance? An active franchisor developing their system and franchise network is potentially more valuable
  1. Franchise Agreement
  2. Marketing Fund review
  3. Franchisee enquiry
What is the Franchisor’s relationship with its franchisees? A combative relationship with the Franchisor may destroy business confidence and value
  1. History of litigation with franchisees (Clause 4 Disclosure Document)
  2. Evidence of sales, terminations or non renewals (Clause 6.4 Disclosure Document)
  3. Franchisee enquiry
Is the Franchisor the creator of the concept or a Master Franchisee? If the Franchisor did not create the concept or a master franchisee, what knowledge and skills do they bring the development of the system and brand.

If the franchisor is a master franchisee, what rights do they hold (territory and term of those rights? What happens if the master franchise contract is terminated.
  1. Business experience and Master Franchise disclosure (Clause 3 and 7 of the Disclosure Document)
Is there any litigation history[7]? Has the ACCC shown an interest? If there is a history of litigation or ACCC investigations or orders, this may be indicative of system failure
  1. Litigation disclosure (Clause 4 of DD)
  2. Austlii search

 

If you are buying a franchise business and need expert advice on legal due diligence feel free to contact our lawyers to discuss these issues.

 

[1] The Effectiveness of Undertaking Due Diligence Prior to Starting Up Or Purchasing a Small Business or Franchise Frazer L et al https://www.franchise.edu.au/home/research/due-diligence-research

[2] Ibid p 22 – 23

[3] Ibid p 49

[4] ibid p 26

[5] Clause 9 (1) of the Code.

[6] Clause 16 (1) (b) of the Code.

[7] For example, Pizza Hut Franchise system (as is well publicized in the press) is subject to a class action by ninety percent (90%) of its Franchisees. The claim relates to the imposition of maximum price controls in relation to the sale of pizzas which Franchisees allege have led to a serious deterioration in the profitability of their franchisees.  See http://www.abc.net.au/news/2015-07-27/pizza-hut-franchisees-launch-class-action-over-pizza-price-war/6622748 and also A & A (Sydney) Pty ltd v Yum Restaurants Australia Pty Ltd 92014) FCA 678 (24/6/14) for an earlier interlocutory ruling on an injunction application.

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