Jones Partner

Franchising – David versus Goliath! Can the system ever be perfect?

24/04/2018 by Bruce Gleeson

Despite reviews of the Franchising Code in 2007, 2010 and 2013, recent Franchisee disquiet regarding high profile retail franchises and indeed Franchisor failure (i.e. Red Lea Chickens) have many parties asking whether or not there should be further amendments to the Code and other legislation. This article will make three (3) observations regarding possible changes. Indeed in late March 2018 the Federal Government has announced another enquirer whereby the Committee appointed is due to report back to Government in September 2018.

Simply put a franchise is an agreement in which a “brand” owner, the Franchisor, allows a Franchisee to trade under that brand and typically allows or requires the Franchisee to use the Franchisor’s business and marketing systems. With around 1,100 franchise formats and 79,000 business franchise formats, employment of about 460,000 individuals and annual sales of $144 billion, clearly there is lots at stake for both the Franchisors and Franchisees. (1)

The franchise model for many is seen as an opportunity to go into business for the first time with the support of an infrastructure around them. Franchisees have access to use the franchise’s established systems, marketing and reputation. However, there are some limitations to this type of business model for the unaware first time Franchisee. While there is major financial investment from both sides, the Franchisee’s contribution is often disproportionate.

There is no doubt that within franchising there is an imbalance of power between Franchisors and Franchisees. Part of this stems from the Franchisor being better resourced (both financially and also having a much deeper understanding of the particular business system) as compared to the Franchisee. This is particularly the case for first time Franchisees. From the Franchisor’s perspective they want to protect and grow their investment in the franchise. So typically, it is viewed that they have the upper hand in negotiations. However, from the Franchisee’s perspective outside of the family home, it is quite often the next largest investment that they are likely to make. So, from their perspective there is a lot on the line. Indeed, many first time Franchisees have refinanced the family home, sold other hard assets / real estate or used a significant termination payment coming out of a long term employed role.

Quite often when a Franchisee has got some initial advice from me about their options when they are experiencing financial distress, one of the things that is invariably ever present is the complete emotional and financial duress they are under. Typically, they tend to be first time Franchisees and have invested quite often based on representations of the Franchisor or brokers. It is not uncommon for them to have paid between $300,000 to $500,000 (and sometimes more) to invest in the particular franchise. The initial payment by the Franchisee quite frequently is used for the initial store set up and other costs. But does such a significant payment guarantee success or mean that they will get their money back. No it doesn’t, and it never will. Whilst some Franchisees may see a return on their investment, many don’t – particularly in retail food and discretionary spending franchises.

The emotional and financial exhaustion quite often comes at a time where they simply don’t know what to do, who to turn to and they have little in the way of financial resources left even if they wanted to challenge the Franchisor regarding its conduct. And herein lies a significant issue. Where there is a disclosure document that warns the potential Franchisee of the potential risks, I firmly believe that it should carry a warning to say that there is a risk that the potential Franchisee may lose all of their investment. This is my first observation. For example, think about the current Red Lea Chickens external administration which has resulted in the Franchisor ceasing to trade and therefore the losses suffered by those Franchisees. Or it may be that a shopping centre that they are operating within is undergoing major renovations and as a result pedestrian flow is materially impacted which has caused a direct impact on sustainability of the Franchisee. Sure, there may be adjustments, but frequently these come too little, too late.

My second observation is where the proposed Franchisee has effectively made the decision to invest is based on the financial information given to them by the Franchisor. Such reliance is important particularly where it is a new / greenfield site. Should a percentage (%), for example 50% of the annual franchise fee be held as a retention in a trust account for 12 months such that if the franchise at such location does not achieve the projected results, then such fees are refunded to the Franchisee. Whilst such a suggestion may incur the wrath of Franchisors, in new stores or other situations where the Franchisee is making such a significant investment decision, they are entitled to place great reliance on the financial information provided by the Franchisor. Such suggestion is not an easy out for the Franchisee either – some safeguards would need to be considered so that it wasn’t all up to the Franchisor in Year 1 – but in my experience the significant majority of Franchisees give it their all particularly in the first year because they want to see it work.

The third and final observation is that ASIC should re-define the industry categories to give proper effect to measuring Franchisor and Franchisee failure when companies are externally administered. This presently does not happen but should. It is critical to capture this type of statistical information so that it can help us adequately monitor such a huge level of business activity. In addition, it may also provide the industry with clarity as to whether the reasons for Franchisee failures are attributable to Franchisor disputes and whether legislative reform is required / greater powers are provided to the Franchisee to correct the ‘imbalance’ between the parties.

A final point is that with the increasing prevalence of litigation funding and class actions, I think there is going to be a preparedness where the balance of the Franchisor / Franchisee relationship gets way out of kilter that such funders are more than happy to have a look at what redress there may be – particularly for the more significant franchise systems.

In summary, it is doubtful that the franchising system can ever be perfect. But it can be improved and further modifications are required in my view. There is a lot riding on it for various parties, the Franchisor, Franchisee, Landlords, Employees and Customers. One thing I have noticed more of recently in major shopping centres is what appears to be an increasing number of unbranded coffee shops. Does this of itself suggest that the high level of rent and franchise fees can’t be sustained given the price point for a cup of coffee, particularly when the operator can source supplies cheaper than it may have to pay the Franchisor? Do we as consumers care whether we go to a branded versus non-branded coffee shop – as long as the coffee is good? I think there are some changes underway and with consumers having evolving shopping experience expectations it will be interesting to see how this plays out.