The Franchising Code of Conduct (Code) requires all franchise systems operating in Australia to maintain a Disclosure Document. Its format and content must strictly comply with the Code.
Franchisors must provide this Disclosure Document to prospective franchisees at least 14 days before the franchisee enters into a Franchise Agreement.
The purpose of a Disclosure Document is to supply key information about the nature of the franchise system and to help the prospective franchisee make an informed business decision about entering the franchise. It’s not meant to contain all the information needed to make this decision, but rather, it acts as a starting point for a franchisee’s due diligence investigations.
Some key things in a Disclosure Document include:
1. Warning Statement
The Warning Statement on the first page cautions prospective franchisees that franchising is a serious undertaking. It recommends they obtain independent legal, accounting and business advice. Franchisors must encourage franchisees to obtain this advice.
The Warning Statement also reminds franchisees that they have a 7 day cooling-off period after entering into a Franchise Agreement or making a non-refundable payment to the franchisor (except on renewals, variations or transfers of existing businesses). This means that franchisees who have a last-minute change of mind or who can’t secure finance can pull out of the deal. It does carry a penalty, with the franchisee being required to compensate the franchisor for a portion of the franchisor’s reasonable costs.
2. Preparation date
The date the Disclosure Document was prepared must be on the first page. This must be accompanied by the signature of an officer of the franchisor. Franchisees can use this date to ensure the information contained within the Disclosure Document is current and up-to-date.
Franchisors must update their Disclosure Document annually within 4 months of the end of the franchisor’s financial year (with some exceptions under the Code). Therefore, most franchisors operating on a standard Australian July-to-June financial year must complete their update by 31 October each year.
3. Franchisor’s details
The business experience of the franchisor’s officers and the duration the franchise system has operated in Australia provides an insight to the experience of the system. Prospective franchisees can judge whether the franchisor has a satisfactory level of knowledge and experience in the industry, which is especially important for new systems.
Franchisors must disclose certain types of litigation they (and their directors) have been involved in, along with any involvement by their officers in previous failed franchise systems.
Litigation can indicate unhappy franchisees, and may act as a warning flag that there are internal issues with the operation of the franchise system.
4. Franchisee details
Contact details for all current franchisees within the franchise system and those who have left during the last 3 years (and the reason for doing so) are an essential element of a prospective franchisee’s due diligence enquiries. Prospective franchisees should contact a selection of these current and ex-franchisees to assess franchisee-satisfaction with the franchisor’s training, support and systems. Large numbers of franchisees who have been terminated or who have left the system may be an indicator of unhappiness with the system. Low numbers of sales may indicate issues with the saleability of a franchised business.
The costs to establish the business and all the expected payments during the course of the franchise must be disclosed. Franchisors will often provide large ranges, so franchisees should undertake a careful analysis. The cost of establishing a store within a shopping centre will be much higher compared to a quiet street corner. The cost of establishing a franchise in a city can also be higher than in a regional area. Items of significant capital expenditure that may arise during the life of the franchise are also important to note. This could be the costs to refurbish a store, or upgrade and replace equipment and signage. If the information disclosed is adequate, prospective franchisees should be able to use the figures to estimate what the total costs will be to set up and run the business, and whether the business model can reach and sustain profitability. A franchisee’s accountant will play a key part in this analysis. The information can then be used to formulate a business plan with the assistance of a business advisor.
6. Goods and services
In most franchise systems, franchisees must obtain goods and services from the franchisor or approved suppliers. There will also be restrictions on the types and brands of goods and services the franchisee can acquire, use and sell in the business. This ensures uniformity across the system. The Disclosure Document must detail how these arrangements will operate, along with the franchisee’s rights (if any) to conduct business online.
Franchisors must also disclose the existence of any rebate arrangements in place with suppliers.
7. Site and territory
Franchisors must disclose whether the franchisee is granted an exclusive territory or if the franchisee’s rights are limited to a particular site. Some franchise systems give franchisees the exclusive right to operate in a set geographical area, while others can only grant the right to operate from a store. Franchisees can use this to determine the risk of competition from within the franchise system itself. A non-exclusive territory can mean that the franchisor can establish multiple franchises in close proximity to each other.
If the franchisor has site selection criteria, then details of this must be disclosed. Regardless of whether the franchisor has nominated the site or negotiated the Lease, it’s crucial that franchisees do their own independent investigations as to whether the demographics of the site or territory can support the business.
Details of previous franchisees who have operated in the particular site or territory within the past 10 years must also be given. A high turnover of franchisees in the one location could indicate a problem with that location.
8. Marketing/advertising funds
If the franchisee is required to contribute to a marketing or advertising fund controlled or administered by the franchisor, then specific details of the payments and the types of expenses for which the fund can be used must be disclosed. A breakdown of the fund’s expenditure for the previous financial year must also be set out.
9. Intellectual property
Franchise Agreements give franchisees the right to use the franchisor’s intellectual property. This can include copyright (over trade secrets), trade marks (over business names and logos) and patents (over inventions), which will be detailed in the Disclosure Document. Prospective franchisees can use this information to undertake searches and determine whether the franchisor has taken steps to register their trade marks. This gives a level of protection against competitors. The ownership structure of the intellectual property must also be disclosed. In many franchise systems, a separate holding company owns the intellectual property and licences its use to the franchisor as part of an asset protection strategy.
10. Financial details
A Disclosure Document must contain a statement confirming the franchisor’s solvency, along with the franchisor’s financial statements for the previous 2 financial years or an independent audit report of those statements. There are alternative obligations if the franchisor is new and hasn’t existed for that length of time. It’s imperative that the financial figures are up to date. If the figures indicate that the franchisor is struggling financially, then this is a red flag for a prospective franchisee.
11. End of term arrangements
Franchisors must clearly disclose whether the franchisee has an option to renew or extend the Franchise Agreement at the end of its term. This includes whether franchisees are entitled to compensation if they don’t renew, and arrangements for unsold stock and equipment. Many Franchise Agreements will give the franchisor the right to purchase the physical assets of the business (such as fitout, equipment and vehicles) for nominal written down market value. The franchisor may also be entitled to take over the Lease of the site. It’s important for franchisees to understand that once the term of the Franchise Agreement ends, and if they walk away from the business, they generally lose the right to receive compensation for goodwill.
While Disclosure Documents can seem a lengthy and burdensome read, they contain a wealth of invaluable information to a prospective franchisee trying to choose the right franchise system. Reading it from cover to cover is essential.
After considering the Disclosure Document, obtaining the right professional advice and conducting the proper enquiries, franchisees should better understand the risks involved in the franchise and how their future relationship with the franchisor will operate.
It’s therefore important for franchisors that their Disclosure Document is comprehensive and legally sound.
The team at Salerno Law are experienced in acting for both franchisors and franchisees in all aspects of franchising law, including:
drafting and updating compliant Disclosure Documents for franchisors;
reviewing Disclosure Documents and giving practical advice to prospective franchisees; and
helping prospective franchisees with their due diligence investigations.
Get in contact if you need our assistance.
DISCLAIMER: This article is only meant to give you general information and should not be relied on as legal advice. Speak to one of our lawyers for more information.
Salerno Law is managed by Emma Salerno, Managing Partner and CEO, who has a wealth of experience from operating her own businesses across Australia as well as a range of in-house and commercial experience both in Australia and overseas.