Some things to consider before buying a franchise

Business structures – franchise

The franchising industry has recently been the subject of media scrutiny with the 7-Eleven wage scandal. Nevertheless, franchising is and will continue to be a major part of the business landscape in Australia. At its best, a franchise can be a great way to start a small business with good systems in place to mitigate the usual risks of starting a business.

 
Historically, one of the earliest examples of franchising as a business activity occurred in mid-nineteenth century Germany. Breweries signed contracts with tavern owners who were to sell the beer exclusively on the tavern premises. In the US, Isaac Singer sold his sewing machines through a franchise. In 1851, Singer started selling rights to travelling salesmen to sell the machines to American households. Today, some of the most recognisable brand and product names are operated or distributed through a franchise (e.g. McDonalds).

Franchise business building

It’s not another legal entity

A franchise is a type of business operation rather than a type of legal entity, which can conduct business. In our previous posts we covered various business structures such as a sole trader, partnership and company. All three of these structures are natural or legal persons which can pursue business objectives.

It’s an agreement

A franchise is an agreement between (usually) two entities, a franchisor and a franchisee. Most of the time these entities are corporations (companies), but they don’t have to be. Two sole traders, or a company and a partnership could also set up a franchise.

For a fee the franchisor grants the franchisee certain rights to use the franchisor’s name, product or system to conduct his or her own business. The franchise agreement stipulates:

  • how the franchisee must run the business
  • the terms and conditions under which the franchisor’s intellectual property or product must be used
  • the exclusive territory where the franchisee is allowed to operate
  • the commercial aspects of the franchise.

Just like a partnership agreement or contract, the franchise agreement can be oral or implied. But having a written agreement is the standard practice.


Example of a franchise:

Andrew approaches Massive Burgers Ltd (MB) to open a fast food restaurant under the same name in Orange, NSW. After some negotiations MB and Andrew sign a franchise agreement where Massive Burgers is the franchisor and Andrew is the franchisee. The agreement stipulates that:
  • The franchisee (Andrew) must pay $400,000 to Massive Burgers for store fit out and equipment
  • The franchisee  must pay 35% of turnover to MB
  • The franchisee  has to follow all operating procedures as specified by MB
  • The franchisor (Massive Burgers) grants Andrew exclusive territory (i.e. MB agrees not to open another MB store within 3.5 kilometre radius of Andrew’s store)
  • The franchisor provides training, support, and pays for all marketing costs.

Regulation

In Australia franchisees have additional legal protection. The Competition and Consumer (Industry Codes—Franchising) Regulation 2014 makes compliance with the Franchising Code of Conduct (the Code) mandatory and all franchise systems must comply.

The Code outlines the rights between franchisors and franchisees. It also requires that franchisors issue a disclosure statement to prospective franchisees and provide transparency in many areas of the business.

The Australian Competition and Consumer Commission enforces the Franchising Code of Conduct. It has the powers to investigate breaches of the code and initiate legal action and initiate proceedings for penalties. For more details read this page on the ACCC website.

Advantages

Business person looking at the map

Running your business through a franchise has a number of advantages:

+Franchisee begins operating a proven business model with established systems
+Access to the established market, exclusive territories and distribution networks
+Franchisors frequently undertake marketing & advertising activities and manage industrial relations
+Franchisees can benefit from centralised procurement and stock management
+Increased bargaining power where the franchisor can negotiate better deals
+Franchisors select future franchisees who are more suited to run the franchise.

 

Disadvantages

Operating a franchise has some disadvantages:

-The franchisee has limited control over multiple aspects of the business
-The franchisee can be dependent on the systems and products
-Sharing income with the franchisor can significantly reduce franchisee profits
-Business restrictions and performance criteria may further erode profits
-There are usually restrictions on the sale of a franchise
-Franchisee may not be able to realise the goodwill of the business upon sale
-Franchisees can fail despite their best efforts due to franchisor’s failure
 

Seek legal advice

We recommend that you seek legal, tax and accounting advice before entering into a franchise agreement.

To ask us about this article or begin to discuss the most suitable business structure for you, simply contact Source Legal Online at always@sourcelegalonline.com.au or 1300 609 450. 

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