Think twice before joining a franchise
Running your own shop in a well-established chain may sound like a great idea, but many Australians have regretted getting involved in a franchise system. Franchise operators can make your investment sound like a sure thing – even a new and exciting adventure – but the experience of franchisees often turns out to be quite different from what they were led to believe.
Promised support from the franchisor is not always forthcoming, and franchisees still have to pay the franchisor regardless of how well the business holds up. But the downside of franchising hasn't dampened enthusiasm – the number of franchise systems in Australia has nearly doubled in the past 15 years alone.
In 2012 franchising generated around $131 billion in revenue with about 1137 different types of franchises employing upwards of 400,000 people. It's a big part of the economy, but the biggest problem for franchisors is finding franchisees, so they spend big bucks on advertising to get more people on board.
It's hasn't been an easy ride or a fair go for the many franchisees and former franchisees we interviewed for this report though. The franchisee might run the shop, but the franchisor can:
- impose unforseen costs,
- force the franchisee to buy overpriced supplies, and
- fail to provide crucial support.
In 2010, the Australian Competition and Consumer Commission (ACCC) received more than 600 franchise-related complaints, many of which had to do with misleading claims about franchisees' potential earnings.
The problem is...
The longstanding issue is that franchisors write up agreements that are weighted heavily in their favour. Some go as far as requiring the franchisee to cover the costs of the franchisor in the case of legal action, or prohibit joint legal action by franchisees. The agreements may also promise that the franchisor will help the franchisee get the shop up and running, but be vague on the details.
With little or no business experience, many franchisees often sign up on blind trust. But when the costs of meeting the franchisor's demands are more than the franchisee bargained for – and the promised support doesn't come through – franchise outlets can fall over. The franchisee can then lose their $300,000-500,000 investment, and the franchisor is free to flip the business to a new franchisee.
Even if the franchisee can present an open-and-shut case that the franchisor has breached the industry's code of conduct, they can rarely afford the legal costs of bringing the case to court.
Is there any regulation?
Following three government investigations, a voluntary Franchising Code of Conduct (FCC) was enacted for the franchise industry in 1990. And after another government investigation in 1997, adherence to the code became mandatory.
But enforcement of the code is another matter. ACCC Chairperson Rod Sims has acknowledged that much of what goes on in the franchising industry is "outside our jurisdiction", even though it's the ACCC that's tasked with regulating the industry.
In April 2014, changes to the franchising code of conduct aimed at better protecting franchisees were announced. They include:
- Better disclosure from franchisors of the realities of running a franchise outlet, including the challenges posed by online competitors.
- A requirement that franchisors and franchisees must act in "good faith" toward one another.
- Empowering the ACCC to better enforce code compliance.
Western Australia on the case
West Australian MP Peter Abetz introduced a state bill in 2010 to better protect WA franchisees, which was narrowly defeated. He has also drawn attention to the ACCC's unwillingness to become involved. Abetz referred in his February 2013 submission to the FCC review to numerous "stories of woe" from WA franchisees about franchisors who violated the code with impunity.
Some franchisees had been restricted to buying goods and services exclusively from the franchisor at inflated prices, a cost that contributed to the demise of their businesses. "Under these circumstances, the franchisor then terminates the franchise, resells it to a new franchisee and collects another substantial franchise fee," Abetz wrote. "The process is then repeated, resulting in a churn-out of franchise agreements, which only benefit the franchisor."
And because franchisors are under no obligation to renew agreements, regardless of how well the franchise has been performing, they can leverage the franchisee's effort and investment to their own ends, Abetz concluded. "There is nothing in the franchising code of conduct that prevents a franchisor not renewing an agreement, and simply taking over the thriving business that the franchisee has established through his [sic] own hard work and investment."
Franchisees can be left out in the cold by franchisors, but it can also go the other way. One of the biggest problems for franchisors is finding franchisees who can be relied on to maintain quality and stick to brand standards. In 2012, 18% of franchisors were engaged in a dispute with a franchisee, and about half of those disputes were about system compliance (with fees the next most contentious issue).
Here are some examples:
- In 2012 two Bakers Delight outlets (in the NSW suburbs of Tuggerah and Artarmon) were fined by the NSW Food Authority for failing to maintain clean equipment and not doing enough to get rid of cockroaches, respectively.
- A number of Domino's Pizza outlets in NSW (in the suburbs of Cambridge Park, Campbelltown, Forster, St Marys and Willoughby) were also fined for failure to maintain clean conditions.
- Franchisees running Donut King, Eagle Boys Pizza, Gloria Jean's, Hungry Jack's, McDonald's, Nando's, Pizza Hut, and Subway outlets also made the NSW Food Authority name-and-shame list for various infractions.
- Some systems work better than others when it comes to consistently living up to the brand's promise and standards. For instance, Michel's Patisserie was named the Australian 'Coffee Shop of the Year' for the second year in a row based on a Roy Morgan customer satisfaction survey, beating out McCafé, Muffin Break, The Coffee Club, Gloria Jean's, Hudsons Coffee, Donut King and Starbucks.
The Franchise Council of Australia also keeps tabs on what it views as Australia's best franchisors and franchisees. Franchisor of the Year awards for 2012 went to 7-Eleven and Luxottica (whose franchises include OPSM and Sunglass Hut), while individual franchisees running PoolWerx, Sign-a-Rama and Mister Minit outlets were also named.
What about franchisors?
Franchisors also have to worry about unauthorised activity by franchisees, such as:
- sneaking in products not offered by the company,
- cutting overhead costs at the expense of the customer, or
- brand piracy, in which franchisees adopt the franchise's approach and a similar look and name once their agreement expires.
A number of franchisees we interviewed expressed frustration at not being able to customise their offerings to meet the needs of a customer base they understand best.
We heard from more than a few aggrieved franchisees and ex-franchisees along with a few satisfied ones in the course of our investigation.
Graeme Brown, former North Perth Bakers Delight franchisee
"We needed to make $10,500 a week to break even. In four-and-a-half years we only did that twice. The shelves had to be full, so we were tossing out about half of what we baked every day or giving it away to charities. And, the shop was in a terrible location."
Peter Berryman, former Ranger Outdoors franchisee
"Our marketing payments just went into general funds and weren't used for marketing, but there was no regulatory body to keep an eye on the franchisor to prevent this from happening. Franchisees don't have the funds to prove a legal case. We went to ASIC, we went to everybody, but no-one would help."
Isaac Chalik, former franchisee and NSW/QLD rep for the National Franchisee Coalition
"Due diligence isn't possible because the franchisee has to rely on information provided by the franchisor. People get spread sheets about the performance of other stores that turn out to be unsupported by tax documents. With as much as eight per cent or 12% of your annual revenue going to the franchisor in royalty payments, plus another 10% for marketing costs, any profit margin is raked off by the franchisor. But the bulk of their profit comes from churning franchisees."
Catherine Lezer, Smartline franchisee
"I've been with Smartline since 1999 and have stuck around for a number of very good reasons. They provide fantastic data management and IT support and also look after the relationships with the banks, all of which gives me a competitive advantage I wouldn't have on my own. The franchisor takes 30% of my commission in exchange for a great support system, which I consider a very fair deal."
Gerry Gerrard, general manager, Bakers Delight
"There's a whole series of support systems that people can draw on. We have 550 franchisees, and if a handful have grievances that's a very low number. We want them to succeed – it's better for both parties."
Stephen Giles, deputy chairman, Franchising Council of Australia
"There's been a huge amount of scrutiny on the sector, and when wrongdoing has been investigated, it always turns out there's nothing there. We recommend that potential franchisees speak to as many existing and former franchisees as they can and get good legal advice. Almost 100% of franchisees don't seek legal advice before going into an agreement."
Professor Lorelle Frazer, director of the Asia-Pacific Centre for Franchising Excellence, Griffith University Business School
"Franchisees are often wooed by the franchisor during the recruitment process and then dropped once they're in the contract, but the main issue is that they haven't done the due diligence before signing the agreement. Franchisees need to understand they're only getting a right to operate. Many of the problems in the industry stem from [franchisees] not realising it's not their business."
If you're considering becoming a franchisee, it's important to do your homework. We consulted with franchise lawyer David Newhouse of Newhouse & Arnold Solicitors to put together a checklist.
He says, "By the time the franchisees come and see us, they're about to lose everything – their house, franchise business, life savings and, in some cases, their marriage. It is critical that once the relationship with the franchisor turns – usually when sales are down or a breach notice has been issued – you urgently seek legal advice and try to salvage the relationship before it's too late."
- Ask questions of the person selling the franchise. Why is the franchise business being sold? What training will I get? How much money will I need to run the franchise in the first six to 12 months?
- Search the internet for stories and comments about the franchise system and its directors.
- Spend time observing the franchise system.
- Fact-check all statements made by the franchisor.
- Understand who your competitors are in the marketplace.
- Employ an accountant and business adviser to carry out due diligence and make sure they understand franchise systems and the industry you'll be working in. They should also review your business plan to confirm that the financial models supplied by the person selling the franchise are accurate and that the business is viable.
- Use a specialist franchise lawyer and make sure they also do franchise dispute work so they know what to look for in the agreements. Never use a lawyer recommended by the franchisor.
- Make sure all financial statements or financial models provided to you form part of your contract and relate specifically to the franchise outlet you're buying.
- Contact current and former franchisees and ask key questions like: How much support does the franchisor provide? How much profit do you make? What are some of the challenges that the business faces? How many hours per week do you need to work, including administration? Can the business run without you? Are there any seasonal impacts on the business? If a franchisee has left the system, why did they leave?
- Never pay a deposit or sign documents until you've received legal advice from a specialist franchise lawyer, and set up the right legal and tax structures from the beginning.