Due diligence not just for franchisees

By Chris Bradley, Partner

Due diligence in franchising is a two way exercise – it’s at least as important for a franchisor as it is for a franchisee to be satisfied that the relationship will go well.

Failure of a franchisee means a substantial loss for a franchisor. There will be diversion of resources (in particular time, energy and financial) towards dispute resolution and away from growth and business development. This is particularly the case if a franchisee brings proceedings, even if the franchisor ultimately wins. There will also be a loss of reputation and, in an environment where full disclosure is required of franchisee failures and disputes, there will be a loss of goodwill to the franchisor’s business.

The current economic climate may well lead to increased failures and disputes, heightening the need for both sides of the franchise relationship to “be careful out there”.

A Case in Point

The recent Court of Appeal decision of David/UAR v TFAC Ltd/Grisdale involved an Australian home services franchise system seeking to enter the New Zealand market. A Master Franchisee (UAR) had been appointed for New Zealand. They contracted the Grisdales (through their company TFAC Ltd) to take a master sub-franchise in Auckland. The Franchise Agreement was cancelled and the Grisdales sought recovery of their investment as well as damages. The Davids counterclaimed for wrongful termination and damages. Ultimately the Grisdales did not succeed, however, the proceedings (which started in the High Court and then progressed to the Court of Appeal) will have exacted a very substantial toll on both sides.

The Grisdales did get prior accounting and legal advice from advisors experienced in franchising and the franchise documents attested to this. The Court of Appeal recognised the value of this process. Quite possibly Courts in the future may find that a failure to ensure this advice is unsatisfactory. It can certainly be argued, though, that had more attention been given (by both sides) to early warning signs that they were not well suited to each other, disaster may have been averted.

Recruitment Steps

Measures which can enhance the recruiting process include:
Ensure effective financial modelling is undertaken before a franchise system is launched into a market (this includes exporting an existing system to another market). There are several very experienced and highly qualified franchise consultants who are able to undertake this work. Unless both franchisor and franchisee have a viable business model, failure will occur sooner or later.
A planned approach to recruitment. This includes an assessment of the qualities needed for a franchisee to succeed such as personality, technical skills and financial resources. A franchise sale “at any cost” is usually a disaster waiting to happen.
Franchise documentation should clearly set out warnings and requirements for franchisees to undertake effective due diligence. There are a number of ways of achieving this. The solution may, in part, be tailored to suit the circumstances but it is crucial that the documents clearly record the steps taken. Recording these processes may be very valuable if a dispute ends up in Court.
Independent advice is essential. Provide a clear escape route for franchisees who are having second thoughts. Any financial penalties for cancelling following cooling off should be minimised.

In the current climate it is the franchise systems which are well set up and robustly organised which are succeeding. Where the system as a whole is soundly based, and franchisees’ businesses are viable, then the system will be strong. Where a system exhibits a high franchisee failure rate there is structural weakness which ultimately places all participants at risk. And this must have a marked impact on the value of a franchisor’s business.

Effective due diligence carried out by both sides before a new franchise appointment will go a long way towards ensuring that the objectives of the system are matched with candidates who are suited to the task.

Chris Bradley is a specialist in company and commercial law at Duncan Cotterill, with particular expertise in franchising and licensing. C.bradley@DuncanCotterill.com

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