I have written many articles on the importance for potential franchisee entrepreneurs to undertake a thorough due diligence of any particular business or franchise system before entering into a franchise agreement.
We find that most potential purchasers come armed with a number of standard and sensible questions which include; what are the ingoing fees, what are the ongoing royalties or costs and how much money they will make?
Due diligence will involve looking at the financial model of the system, the performance of existing franchises and in many cases the resale of established franchisees and any associated capital gains. For new or greenfield franchises these are of course largely hypothetical exercises and for established, you are looking backwards versus looking forwards.
There are however three areas that potential franchisees often fail to fully understand or take into consideration. Hiding in plain site, these relatively straight forward clauses or terms of any franchisee agreement can have significant impact on the value created by the franchisee entrepreneur, or what they are able to retain over time, on selling their franchise business.
My advice is simple, ensure that you understand what each is and include this in your evaluation and due diligence.
Understanding the franchise territory
Most franchise agreements and or most franchise systems have a territory or trading area associated with a franchise agreement. First step is to understand is this territory exclusive or non-exclusive, i.e. can another franchise agreement or franchisee be granted in the area and or can they trade in that territory.
Or is it a first right of refusal, i.e. that you will be offered any additional trading opportunities before they are offered to anyone else? If it’s the latter, what are the conditions associated with that first right of refusal?
Every franchise system and their associated business model is different, so there is no one-size-fits all in terms of what is best or most appropriate, but it is a key commercial element to understand.
Assignment clauses and exit fees
When a franchisee sells their business to a new franchisee or business owner what are the costs? Who pays, i.e. the exiting or incoming party? Are these a flat fee or a percentage of the sale price. Do these fees change over time depending on what period of time is left on the franchise agreement?
Are there any restraints on when or costs associated with when a franchise business is sold, i.e. that it cannot be sold in the first terms or payment of potential fees?
From our experience, this is probably the most often overlooked of all clauses in franchise agreement and the one that can have not only the biggest impact on the resale value created and retained by a franchisee entrepreneur, but also their ability to sell.
Termination and restraints of trade
My personal and very strong view is that restraint of trade clauses in franchise agreements are completely valid and reasonable. For an incoming franchisee you want the protection and comfort to know that you will not be competing with an outgoing or former franchisee in the market you are planning to operate in.
For franchisor it’s completely valid for them to want to be able to protect the value created by their intellectual property, market development and support of their franchisees both current and in the future.
The consideration for potential franchisee needs to be how will their future plans be affected by restraint of trade clauses, i.e if they have a particular skill or occupation, will purchasing or entering into a franchise prevent them from operating in this area when they exit the franchise?
Again, it’s something to take into consideration both in terms of the value created by the clauses whilst you are in the system and the potential restrictions when you leave.