The thorny side of franchises

The Dominion Post

Franchising seems the easiest way to break into business. But what are the traps for the unwary? John McCrone joins the throng at the Franchise Expo.

The smiles are bright, the brochures glossy. But what about the business proposition? Will it really fly?

It is a rainy weekend and the Franchise Expo is back in town. The Christchurch Convention Centre is packed with couples, mostly in their late 30s and early 40s.

They browse the stands and the choice is bewildering. Vibrator gyms, Himalayan goji juice, Tupperware, back supporters, business coaching systems, mini diggers, DVD vending machines, monogram embroidery and rented portacabins.

Which of these is going to be a goldmine and which is going to leave you in hock to the bank for the rest of your life?

The experts say it is possible to get burnt by franchise operations after just a sign-up fee. Or ones that are simply such weak ideas that they will never catch on.

However, the good news is that the franchise approach to small business continues to be hugely successful.

And though franchising is still lightly regulated in New Zealand compared with Australia, the industry has become developed enough that it is not hard to sniff out the no-hopers, says David McCulloch of Auckland consultancy The Franchise Coach.

"Twenty years ago when franchising started, we weren't so sophisticated. But now the dodgy or ropy franchisors will find it pretty hard to recruit franchisees.

"There are plenty of lawyers and accountants who are franchise specialists and can give good advice. People are just more streetwise these days."

Mr McCulloch says no one knows better than the franchise teams at the big banks.

They see the profit and loss accounts of thousands of businesses. So if they are keen to lend money on a franchise deal – and in some cases, they will even give preferential rates – then you can be fairly sure about what you are letting yourself in for.

There are other ways to separate the wheat from the chaff, Mr McCulloch says. One safeguard is membership of the Franchise Association of New Zealand. In the absence of specific franchise legislation under commercial law, the association's code of conduct provides such protections as a cooling-off period, dispute-handling service, and rules on disclosure to prospective buyers.

Mr McCulloch says the alarm bells should ring if it seems a little too easy to get a franchise. In the old days, buyers only had to pass the "money and fog" test. Did they have the cash? And did they have enough breath to fog a mirror held to the mouth?

But today, good franchises can afford to be fussy about whom they recruit. They will want to interview 30 wannabes before finding the candidate who is the right fit.

Despite the baffling variety of franchise businesses now on offer – and New Zealand is believed to be to be the most franchised country, with well over 300 "systems" – it should be possible to figure out which opportunities are worth pursuing, Mr McCulloch says

There are still things to consider before signing on the dotted line.

Christchurch lawyer Maurice Walker says the typical franchise contract is hundreds of pages long, making it tempting for buyers to skip over the details.

Mr Walker warns that one danger is taking everything a franchisor says at face value. Or for buyers to think they fully understand complex issues such as territories, training and support. Most contracts have a buried exclusion clause, which states that only what is in the contract counts.

"So when the franchisor makes representations about the number of customers you can expect or the financial returns that may result, try to get those in writing. Because if you do, then you do have some chance of taking action further down the track," he says.

A buyer must also ask about any costs that are not mentioned up front. A franchise will normally have a sign-on fee, a training levy, set-up costs, a monthly royalty, and a branding levy. But other costs have a way of popping up, Mr Walker says.

Some franchise chains insist on attendance at annual sales conferences or continuing training. There may be insurances or special marketing efforts to cover.

The leasing of a shop or office space can be another thorny issue. Many people come unstuck by not making sure the term of any lease matches the term of the franchise.

Franchise terms are a story in themselves. Mr Walker says that 20-year deals used to be common, but five years has become the norm. And though there is usually a right of renewal, it is crucial to consider what can go wrong before you sink your life savings into a venture.

Contracts are likely to have clauses that cancel renewal rights for franchisees in breach of contract conditions. Even if the relationship is happy, the new contract might turn out to have quite different terms from the old one, he says.

Then there is the fine print about getting out of the business. Franchises are generally among the most profitable businesses to sell on, for the very reason that they are well set up with a business model, a brand, and a ready-made support system.

But Mr Walker says a hefty slice of the proceeds may go to the franchise owner. There will be a transfer fee. And buyers should check out how intangibles such as goodwill will be valued and shared. The owner will also have a big say on just when and how the business is sold.

"A number of franchisees have had a rude shock about the amount of money that they thought would be their profit, which actually went to the franchisor in the transfer," Mr Walker says.

Franchise agreements can contain plenty of such fishhooks. Buyers will also find that franchise owners are often reluctant to negotiate any changes to their standard terms.

But Daniel Cloete, national franchising manager at Westpac, says that from a lender's point of view, buying a franchise still seems the nearest thing to a sure bet in business. The combination of motivated local owner/operators and a strong nationwide brand is an unbeatable formula.

Mr Cloete says there are now about 14,000 franchise businesses in New Zealand, employing 41,000 people and turning over more than $10 billion a year.

Franchising is growing at nearly 20 per cent a year, and the failure rates are low compared with other business start-ups.

MR CLOETE says that when a franchise does not work out, the reason is usually the Achilles heel of all small businesses – cashflow. Unlike a house loan, a business loan has to be repaid in three to five years. So purchasers really need to take some care over how they budget for repayments.

They should allow leeway for added costs. He has seen the price of outfitting a shop and other set-up expenses exceeded by 30 per cent to 50 per cent, making a franchise a loser from the day the business started trading.

Then there are the problems of seasonal trading, Mr Cloete says. A retail franchise such as Paper Plus may make most of its annual profits over Christmas, yet the stock will have to be bought in November, when cash is at its lowest ebb.

Finally, fast growth can be the sneakiest killer of the lot. Booming sales may seem good, but it means you will also be buying in new supplies at an accelerating rate.

"More businesses fail because of rapid growth than for any other reason."

So a mastery of cashflow is essential. Some franchises fail simply because the buyers were not prepared for the effort it takes to get a business off the ground, he says. And then there are the franchise systems that were always just a poor proposition.

The hallmarks of a sound franchise are that its business model will be proven, Mr Cloete says. The owners will be able to point to a flagship operation that is already succeeding in the market.

This is important even for an established franchise crossing the Tasman. Australian franchises still need to be tweaked to suit the New Zealand market.

Mr Cloete says buyers should also beware of any franchise that seems to be just a distribution and sales network. What you pay a premium for is a full business system with training, an operator's manual and proper accounting systems.

Especially important is a commitment by the franchisor to keep developing the product. Even famous brands such as McDonald's have got themselves into trouble by standing still for too long, he says. "A franchise has to keep investing in its ongoing development, otherwise after three years you can see the profits drop dramatically."

However, Mr Cloete says there is now plenty of help available to evaluate a franchise and plenty of franchise systems to choose from.

"As long as buyers are prepared to use their head as well as follow their heart, they should do all right."

Franchise Expo 2007 visits Auckland, August 17 to 19, and Wellington, September 22 to 23.