Many believe buying a franchise presents an easier path to a successful and profitable business instead of starting your own company because you are purchasing an established brand with “turnkey” operations.
It sounds enticing, but in reality, investing in a franchise involves a myriad of legal risks and obligations that you may not have considered before.Below are 7 legal factors to consider and address before you rush to sign that franchise agreement.
1. Perform Your Due Diligence
Depending on the industry category, the average initial franchise fee is $25,000 and the average total initial investment required by a franchisee is between $150,000 and $200,000.
That is a big financial commitment.
Before you put pen to paper, it is crucial that you thoroughly research and evaluate the franchisor, the franchise system, and the hard numbers to determine whether or not it’s the right investment opportunity for you.
2. Have a Lawyer Review the Franchisor’s Franchise Disclosure Document
An important part of the due diligence process involves reviewing and evaluating the Franchise Disclosure Agreement (FDD), which is provided by the franchisor to prospective franchise owners.
What is a Franchise Disclosure Document?
A franchise disclosure document is a written report that summarizes vital business and legal information about the franchisor. It is a useful resource that provides prospective franchisees with material facts and allows them to make an informed decision prior to investing in a franchise.
The typical FDD may include topics such as:
- Franchisor’s background - company history; how long it has been operating in that industry; key figures involved in the management of the business (directors, general partners or officers, executives, etc.)
- Existing franchisees - List of existing and closed franchisees and their contact details
- Investment requirements - a summary of estimated initial start-up costs as well as continuing fees to operate the business such as royalties, advertising, leasehold improvements, etc.
- Intellectual property - licensed usage of registered trademarks and other intellectual property assets.
- Litigation - includes any pending or prior actions against the franchisor and/or its directors and officers
- Financials - financial statements such as balance sheets, statements of operations, owner’s equity, and cash flows.
- Training and support - franchisor to provide an outline of ongoing training, support, and development
Under section 5(1) of the BC Franchises Act, a franchisor must provide a prospective franchisee with a disclosure document as set out in this section, and the prospective franchisee must have received the disclosure document at least 14 days before the earlier of
- the prospective franchisee signing the franchise agreement or any other agreement relating to the franchise, and
- the payment, by or on behalf of the prospective franchisee to the franchisor or the franchisor's associate, or any consideration relating to the franchise.
It is highly recommended that you review all documents with a qualified franchise lawyer. They have the experience and knowledge to pinpoint any areas of concern before you formally execute the contracts.
Skip the reading and book a free consultation with a franchise lawyer to review your documents.
3. Interview Existing Franchisees
As indicated in the previous section, the FDD contains a list of existing franchise owners in the system. They have already been through the process of purchasing and operating the same business model that you may potentially be a part of.
Setting up a meeting with one or two existing franchise owners can be incredibly useful. This is a chance to gain awareness of the kinds of concerns and issues you’d have to address later.
Questions you may want to ask may include:
- What made you choose this franchise?
- What is the most rewarding aspect of being an owner of this franchise?
- What unexpected challenges did you have to deal with?
- Were you provided proper training by the franchisor? Can improvements be made?
- Does the franchisor provide enough assistance in marketing and promotions?
- Have the financial returns met your expectations?
- Are the initial start-up costs what you expected to pay?
- How many hours do you put into the business per week?
- Do you have any advice for me as I continue exploring this as an investment opportunity?
4. Franchise Agreement Terms are Negotiable
Keep in mind that franchisors pay substantial legal fees to draft their standard form franchise agreements and are generally reluctant to make any major changes. However, franchisors are legally obligated to allow modifications in the franchise agreement, as requested by the franchisee, to enhance their franchise rights.
There are several important legal provisions that should be brought to the negotiating table. This may include, but are not limited to:
- Territorial boundaries and exclusivity rights;
- Franchise renewal rights;
- Franchise transfer rights;
- Potential grace periods for royalty obligations;
- Limitation of liability if franchise agreement is terminated due to poor performance;
- Personal guarantees
- Potential rights of first refusal when it comes to location expansion
5. Avoid Signing Unnecessary Personal Guarantee Documents
In the event that the franchisee breaches the obligations and liabilities under the franchise agreement, the franchisee should be cautious about who to include as a personal guarantor. For example, individuals who are not directly involved with the business should not be personal guarantors.
If the franchisee has a sole director, that individual will be providing the guarantee. However, if there are multiple individuals involved with the franchise, the franchisor may require all of them to be guarantors. It is best to obtain legal advice to determine the best approach to prevent any unnecessary financial exposure.
The franchisee may also want to consider negotiating with the franchisor to set a limit on the duration and the maximum amount the franchisor can pursue under the personal guarantee.
6. Incorporate Before Buying Into a Franchise
Incorporating early offers a number of valuable benefits to prospective franchisees:
- Limit liability - The corporation acts as a separate legal entity that will protect your personal assets from liability to creditors and/or lawsuits
- Lower corporate tax rates - Corporate entities are taxed separately from their owners (compared to a sole proprietorship which is taxed at a higher personal income tax rate)
- Transfer ownership - Enables owners to transfer ownership of the company more easily to others
- Lowers the barrier to entry - Incorporation reassures the prospective franchisor that you’re serious about the business opportunity
- Increase credibility - Operating as an established corporation helps increase the overall credibility of the franchise company
Incorporating can be a valuable tool for a new franchise owner. However, you should consult with a business lawyer to ensure your company is set up correctly.
7. Know When to Walk Away From the Deal
The prospect of running a franchise can be an exciting endeavour and it is easy to look at the whole situation through rose-coloured glasses. During the investigative process, you may uncover some red flags about the franchise company that may ultimately affect your ability to operate a successful business.
You may need to take a step back and evaluate whether the information you gathered about the investment opportunity is aligned with your personal goals, and matches your financial expectations.
If you are planning to operate a franchise, speak to one of our franchise lawyers to help you explore your options. Please call us directly at (778) 565-4700 or simply fill out our contact form to schedule a free consultation.
The preceding content is for informational purposes only and does not constitute legal or professional advice. To obtain such advice, please contact our offices directly.