Purchasing a franchise

July 1st, 2017

By Jana Doussy and Jaco Grobler

Deciding on and investing in a franchise may be one of the biggest financial decisions a person or company may make. It is, therefore, important to consider all aspects, which will play a role in such a transaction, as well as in the operational activities thereafter. In this article, we have made a summary of things to consider.

What type of franchise is the target entity?

A single unit franchise is a franchise owned and operated by the franchisee. It is the simplest format and the most widely used. If the owner owns more than one franchise, the model becomes that of a multi-unit operator.

An area developer acquires the right to establish one franchise within a specified territory, operate it for his own account and subsequently sell sub-franchises to others within the same territory. The area developer assumes the role of the franchisor in this territory and the fees paid by the sub-franchisees are shares between the area developer and the franchisor on the formula agreed to.

A satellite franchise is where a satellite franchise food entity only has a limited part of the menu of the franchisee.

A fractional franchise is where a franchisee occupies premises within an established business. For example, setting up a hamburger franchise at a petrol station.

Branch conversion is where a company owned store is converted to a franchise by selling it to a prospective franchisee.

A master licence agreement is where a foreign franchisor grants a local individual or company, to be known as the master licensee, franchise rights, usually to the entire country or even a region. The licensee assumes the rights and obligations of the franchisor inside South Africa and shares fee income with the foreign principal.

Product franchise is the forerunner of business format franchising. It is used by companies who need to establish outlets across the country quickly, but have been reluctant to make the required investment into the necessary infrastructure and take on the management problems this would entail. They appoint franchisees instead and in return of exclusivity they offer non-exclusive territorial protection, product training and some branding.

A manufacturing franchise is, in essence, a licence where one manufacturer grants a licence to another manufacturer to produce a certain product. The licensor will provide technical expertise and is likely to control adherence to technical specifications.

Tandem franchising is where the franchise starts out as a joint venture between the franchisor and the franchisee. Usually for employees or Black Economic Empowerment development. At the outset the candidate is given a small stake in the business, which he or she will jointly operate with the mentor provided by the franchisor. Profits generated in the business are usually retained for the purpose of allowing the candidate to purchase the rest of the shares in the business. At a point the franchisor will withdraw from its mentoring position and the arrangement will convert into a standard franchise agreement.

A conversion franchise is where the franchisor, instead of setting up a new outlet from scratch, recruits a franchisee from the ranks of the established independent operators in the same type of business. The outlet receives a corporate image make-over and the franchisee and staff will be trained in the franchisor’s business methods.

The above list is not intended to be a full list of categories of different franchises available, franchises can also consist of various specified characters from different categories.

Information needed in order to obtain financing for the purchase of the franchise

Chances are slim that a prospective franchisee will be in a position to finance the operations of the franchise until it becomes self-sustaining. When franchises make the decision to invest in a franchise they are usually in a blur of overwhelming information, and it is helpful to ask the franchisor to assist with finding the right investors. Financial institutions will want specific information and will ask pertinent questions before financing such a project. They will firstly want specific information from the prospective franchisee. Such questions will be subjective according to the status of the prospective franchisee and are not discussed here. Their questions with regard to the franchisor and the prospective franchisee’s answers thereto in essence forms the basis of a due diligence, firstly, for the banks and secondly, for the prospective franchisee. The prospective franchisee should accordingly accept that there is a clear substantial risk if the information obtained to answer the questions of the financial institution are not satisfactory. The following is a non-exhaustive list of questions that the prospective franchisee and financier should ask:

The franchisor and its market

  • Is the franchisor well-established and does it have a sound track record?
  • Is the brand well respected in its market and in its sector?
  • Is the market reasonably robust, with the realistic chance to grow?
  • Since when has the franchisor expanded through franchising?
  • Does the franchisor display a good understanding of the franchise concept?
  • Is the franchisor prepared to uphold sound franchising principles?
  • When was the franchisor established and for how long?
  • Who are the shareholders of the franchisor?
  • Who are the directors of the franchisor?
  • Has the franchisor or its director’s encountered material debt, criminal or civil proceedings in the past five years?
  • How many of the business units did the franchisor operate before franchising was commenced?

– Where were those business units located (to ensure that the business has been tested in various markets)?

– Did these units produce reasonable profits?

  • Is the franchisor’s intellectual property legally protected?
  • How many franchises are there at present and how many units are operated by the franchisor?
  • Where does the franchisor undertake product testing and assessment?

Franchise documentation

  • Is the franchise agreement sufficiently balanced to adequately protect the franchisee’s rights, yet give the franchisor power to control errant franchisees and protect the brand?
  • Does the franchise agreement contain any clauses that could be harmful to the interest of the prospective franchisee and financier?
  • Does the operational manual appear to be comprehensive and up to date?
  • Does the disclosure document exist and is it sufficiently detailed?
  • Do the financial projections included in the disclosure document stand up to scrutiny?
  • Is the franchisor a member of the Franchise Association of South Africa, an institute whose aim is to develop and safeguard the business environment for ethical franchising?

Franchisee support

  • Has a dedicated franchisee support infrastructure been established?
  • Does the franchisor provide adequate initial and ongoing training?
  • Is the field support team pro-active and supportive of franchises?
  • What is the planned frequency of visits to franchisees?
  • Are regional and national meetings or conventions held?
  • Does the franchisor undertake market research, product development and similar activities that are likely to enhance its long term success?
  • Does the franchisor provide meaningful assistance with local promotional efforts?
  • Is the franchisor’s IT infrastructure up to current standards?
  • Does the franchisor operate a formal assistance for franchisees, which are in distress?
  • What is the relationship between the franchisor and its established franchisees like?
  • Does formal franchisee representation exist?

The product or service

  • Is the product new or does it have an established market?
  • Is the product protected through patents or trade marks and if so, who owns these patents or trade marks?
  • Does the franchisor have a formal process for product development in place?
  • Is the supply of parts or raw materials needed to produce the product secure? How so?
  • Are alternative sources of supply available should problems arise?
  • Is the franchisor the supplier of the product? Or does the franchisor provide the necessary information of the supplier?
  • Under which circumstances will a franchisee be able and allowed to purchase from other sources?

The market

  • What is the total investment required?
  • How much of this can realistically be financed?
  • Does the franchisor assist in obtaining finance? If so, how?
  • What is the upfront fee and what does the franchisee receive?
  • How much will a franchisee have to invest in capital equipment, furniture and fittings?
  • How much working capital should a franchisee provide for?
  • What other expenses can a franchisee expect to incur during the initial period?
  • How soon before a franchisee will have to invest additional capital and for what purpose?
  • Does the franchisor provide the franchisee with a set of financial projections?
  • Is it possible to obtain a set of actual trading results from one of the other franchises already in production?

Ongoing franchise fees and purchases

  • How much is the franchisor’s management services fee?
  • How will this fee be calculated and what is payable?
  • Is the fee subject to a minimum fixed payment? If so, how much?
  • Does the fee percentage decrease once the franchisee exceeds a predetermined level of sales and how does it work?
  • Will the franchisee be required to contribute to a marketing or advertising fund? If so, how much?
  • Will the franchisee be obliged to spend additional money on local advertising?If so, how much and how is it administered?
  • If the franchisee is obliged to purchase goods from the franchisor or a prescribed supplier, is there a minimum amount, be it in product units or Rand terms, that have to be purchased each month?
  • Are there any other periodic or ongoing fees? If so, how are they calculated and administered?

Legal aspects to be discussed with the prospective franchisor

  • Once the franchisee has received the disclosure document and the franchise agreement, does the franchisor observe a cooling off period before the franchisee is permitted to sign the agreement?
  • Is the franchisee permitted to show the disclosure document to his legal advisers?
  • Will the franchisee be required to sign a confidentiality undertaking before he or she receives confidential information and documentation like the disclosure document?
  • Is the franchise agreement negotiable, within reason, or is it unalterable?
  • What is the initial term of the franchise agreement?
  • Does the agreement contain an option to renew, and if so, what are the terms and conditions?
  • If the franchisee has to pay any kind of deposit or option fee, what are the terms and in what circumstances, if any, will he or she receive a refund?
  • Would the area and site the franchisee plans to invest in be subject to territorial constraints of any kind?
  • Does the franchisee have the right to sell his or her franchise, and if so, what restrictions, if any, will apply?
  • Will the new purchaser of the franchise have to be approved by franchisor and pay a franchise fee?
  • Are there restrictions on heirs?
  • May the franchisee entrust day-to-day management to a manager?
  • Does the franchise agreement contain restraints that endure after the term of the agreement?

The aspects mentioned above is not an exhaustive list, but are some of the most important questions to ask. Specific aspects and questions to be raised with the franchisor should be discussed with a professional adviser before a final decision to invest is made.

Jana Doussy LLB Corp Certificate (Unisa) and Jaco Grobler BLC LLB (UP) are attorneys at Stegmanns Inc in Pretoria.

This article was first published in De Rebus in 2017 (July) DR 22.