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The Franchising Tango

Written by : Cheri Bell
"What is the franchising tango?" you rightly ask. The answer is simple, yet establishes its importance. The franchising tango is what I call the reciprocal investigation that is or should be undertaken by both the prospective franchisor and prospective franchisee prior to entering into a franchising relationship together. Essentially, it is the "due diligence" of franchising. In business, prior to entering into any business transaction, the parties to the transaction undertake a "due diligence" or thorough investigation of the other party including the other's financial profile. This should be no different for any franchisee, including a first-time franchisee who dreams of becoming a business owner.

Where Franchisor Leads the Dance:

Once a prospective franchisee conducts his research of the market opportunities and identifies a franchise system that is right for him, the prospective franchisor will ask him to complete a franchise application form complete with prior bankruptcy history, references and snapshot of his financial situation. At this early stage, many franchisors also require completion of a criminal record questionnaire, and psychological testing at the Franchisee's expense. These are all customary requirements that permit the franchisor to determine whether the prospective franchisee is a good "fit" for the franchisor's system and has adequate financial means to sustain himself during the launch phase and until the franchised business is cash-flow positive and generating a positive net income. All of the information provided by the potential franchisee to the franchisor is confidential.

As well, the franchisor will require the prospective franchisee to provide a small deposit (usually ranging between $5,000-$10,000) (in jurisdictions where a disclosure document is legally required to be given to the prospective franchisee, the deposit becomes payable only after a 14-day "cooling off" period from the date the disclosure document was received by the franchisee prospect). The deposit is also a type of qualifier for the franchisor since it is a measure of the franchisee's "earnest" or seriousness about becoming a franchisee. For the franchisee's part, he should ensure that the franchise deposit is fully refundable if either party decides to withdraw prior to executing a franchise agreement.

Finally, if the franchisee candidate passes these earlier stages, he will be invited to one or several face-to-face interviews to permit the franchisor to assess whether he has the necessary profile, skill set and experience to be able to successfully operate the franchised business.

If the franchisor is confident about what he sees and hears at the end of the day, the franchisor's offer will be accepted and the parties move onto the franchise contract stage. If not, the franchisee's deposit should/will be refunded and the parties part ways under no obligation other than the requirement of the franchisee to respect any non-disclosure restrictions he signed before receiving any of the franchisor's documents and information.

Where Franchisee Leads the Dance:

The franchisor is not the only party to undertake a "due diligence." The franchisee is also in the position to do so as he is investing his hard-earned savings in the franchisor's business. Before committing his money and signing on the dotted line, the franchisee has every right to ask the franchisor every question about the franchisor's (and the franchisor's principals') background, experience, vision and plans, and to investigate every aspect of the business he is about to invest in. In many jurisdictions, the franchisor is legally required to issue a disclosure document, which summarizes, in layman's terms, the key aspects and obligations of the franchisor and franchisee under the franchise agreement. The disclosure document also summarizes the corporate history of the franchisor and details the system-wide units as well as the number that have come into and departed the system during the past year. The contact information of the current franchisees and the franchisees that have departed during the course of the last year is also provided. If a franchisor is attempting to discourage a candidate from contacting certain former or current franchisees, a warning bell should go off. A franchisee candidate is well-advised to interview the former franchisees about why they left the system. But understand that not all (former) franchisees were good operators or followed the system as they should have. Some former franchisees may be unjustifiably disgruntled. A franchisee prospect should also interview current franchisees about their degree of satisfaction with the franchisor and the system. Questions like, "Are you making money?", "When did you start to make money?", "Would you renew the franchise at the end of your term?", "What level of support is provided by the franchisor?" are all helpful to the franchisee's investigation of the franchise opportunity.

The disclosure document also provides the franchisor's most recent annual financial statement. It is in the candidate's best interest to review that financial statement (and its notes) with a financial advisor, particularly one that has expertise in the area of small businesses. Candidates should not be afraid to ask the franchisor questions about its financial statement, and the financial and business deal presented by the franchise offer. The entire transaction and business opportunity should be evaluated by an independent financial advisor to the candidate. As stated, the candidate should select a financial advisor who is experienced in small business and who wishes to develop a long-term relationship with that candidate as he grows his franchised business over time. Even in jurisdictions (like Quebec) where a disclosure document is not required, the franchisee candidate is free to ask questions and seek the information he needs to help him make his decision as to whether the particular franchise system is truly right for him and presents a business risk that is acceptable to him.

Assuming that the franchisee is invited to be interviewed by the franchisor, he should ask to meet not only with the executive team, but the operations and marketing staff with whom he would be working on a regular basis. The franchisee prospect should also review the marketing materials that are available for public examination to assess the marketing tools and level of marketing support that will be made available to him when in his launch phase. The interview process is not just a qualifier for the franchisor – it is an excellent opportunity for the franchisee to conduct his own due diligence. The franchisee prospect should be able to include his spouse or significant other, since his spouse or partner may often be involved in running the franchised business. Even if his spouse or partner does not intend to become involved in the business, family funds will be used toward the prospect's investment so the spouse or partner should be comfortable with that investment opportunity as well.

Finally, a franchisee prospect should review all of the legal documents with a franchise lawyer. A lawyer with franchising expertise will be able to zero in on the areas of the transaction and agreement that are not customary or reasonable in accordance with franchise industry practise. Those are the areas, if they will have a material impact on the franchise prospects' current or future business, to negotiate with the franchisor. Lawyers or consultants who are not accustomed to franchising may unwittingly and unreasonably protract the negotiation process for the future franchisee and cost him more in legal fees than would a higher-paid franchising specialist. In some cases, the advice of an inexperienced consultant may even unjustifiably queer the deal.

Understandably, the franchisor cannot guarantee the franchisee's success or profits. At the end of the due diligence process, the franchisee prospect should have confidence in the franchisor and the future of the system. The candidate should feel that all of his questions have been adequately answered. He should understand all of the obligations and expectations placed on a franchisee in the particular system. The prospective franchisee should feel comfortable with the financial risk presented by the franchise offer. A franchisee candidate's gut feeling is the best measure of his comfort level with the franchise opportunity.

By Cheri Bell, EVP
Lori Karpman & Associates Ltd.

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