A franchise is a licensed contractual right which is not necessarily transferable unless there is a provision in the Agreement to transfer and/or novate those rights. Novation is the substitution of a new contract for an old one whereby the new Agreement extinguishes the rights and obligations that were in effect under the old Agreement.
The Code requires in Clause 17.1(7) that franchisors disclose whether a right to transfer a franchise exists and, if so, the conditions of transfer. Even if there is no express provision for transfer in the Agreement, a franchisee may still request the franchisor to consent to a transfer however there is no contractual obligation on the franchisor to consent.
The Code (regulation 20) provides that a request for franchisors consent to transfer or novation of a franchise must be made in writing. The Code does not expressly require that there be a right to transfer or novation in a Franchise Agreement. It is often just assumed by franchisees that such a right exists.
The Code of Conduct is a mandatory Code and franchisors can not contract out of the Code. Careful attention should be paid to the grounds for refusal to make sure they are reasonable, complies with the Code and that any first right of refusal to the franchisor is on no less favourable terms than a third party is prepared to offer.
Generally most Franchise Agreements provide a procedure which allows for the franchisee to sell the franchise subject to the franchisors approval and a first right of refusal.
What are reasonable grounds for a franchisor to refuse a prospective franchisee;
The Code under Clause 20(3) sets out grounds upon which it is reasonable for a franchisor to withhold consent. Those grounds include;
- The transferee is unlikely to meet the financial obligations under the Franchise Agreement (the franchisee effectively does not have sufficient working capital, assets and reserves).
- The transferee does not meet a reasonable requirement of the Franchise Agreement for transfer. This is open to broad interpretation.
- The transferee has not met the selection criteria. This usually relates to the franchisee being, for example, unable to speak the language or failing training requirements.
- The transfer would have a significant "adverse effect" on the franchise system. This is open to broad and subjective assessment by the franchisor.
- That transferee does not agree in writing to comply with the obligations as a franchisee (a most curious provision!).
- The existing franchisee is in default of its obligations and has not made reasonable provision or can not pay amounts owing to the franchisor, even should it transfer the business.
- The franchisee has breached the Agreement at the time of transfer and not remedied that breach.
Clause 20(4) provides that a franchisor must, within 42 days after a written request for transfer, give the franchisee written notice that consent is withheld and reasons why consent is withheld. If the franchisor does not provide that consent in writing within 42 days of the franchisees request, the franchisor is taken to have given its consent.
The process of transfer and assignment involves a balancing of the rights of the franchisor to protect their interests, brand and reputation, and the right if expressed in the Franchise Agreement, of the franchisee to sell its business and licensed rights.
On a transfer or sale of the franchise business the Code, (Clause 6B) requires the franchisor to give a then current Disclosure Document to the incoming franchisee.
Is there a good time to sell your franchise?
Franchise Agreements are for all sorts of terms. The Code does not require the franchisor to grant any minimum term. Therefore a franchise right can be granted for 12 months, 3 years or 20 years.
There is no obligation in the Code for a franchisor to grant a further term or option to the franchisee.
Selling a franchise within the first 2 or 3 years is not an opportune time to sell and is likely to crystallise a loss to a franchisee.
Most business plans provide for a return on investment (ROI) to a franchisee after 3 or 4 years. The up front capital costs of entering into the franchise are generally amortised over the first 2 to 3 years.
It is unlikely that a franchisee will be able to ask for any good will or obtain a return on their capital costs if they sell in the first 2 to 3 years, although that will depend on the nature of the franchise. Having a trading history and showing financial statements that are up to date and provide for a reasonable wage to the operator and a profit will place a franchisee in the position to have something to offer a prospective purchaser.
What is my business worth?
Franchisees should understand the basic principle of franchising that the good will built over time by the franchisee is really that of the franchisor, as the franchisee is trading on the franchisors brand and system. The franchisee is granted a licence (a contractual right) to operate the business under that brand and system. The good will at the end of the franchise term remains that of the franchisor. Any good will that a franchisee can recover on sale will be dependant on:
- Whether the value of the franchise system as a whole has increased over time;
- Whether the individual business itself is profitable.
- The Vendor may ask for a multiple of its profit which may vary from the previous years net profit, the average of the last 2 or 3 years net profit, or a multiple of 3 to 5 years. There are other valuation models that can also be used.
At the end of the franchise term, if there is no further option, the licence ends. The franchisee is required to de-brand. In that event the only obligation on the franchisor is to pay the franchisee the depreciated or written down value of the franchisees plant and equipment and stock.
There is no obligation on the franchisor to buy back the business from the franchisee or recognise any good will that may have been built by the franchisee over time. Why? Because it is the franchisors good will.
Is a franchisee entitled to renew or a further term?
Franchisees should also not assume that the franchisor will grant the franchisee a new Franchise Agreement for a whole new term at the end of their franchise or in the event they sell the business. There is no such obligation under the Code nor in Franchise Agreements that give that right.
It is therefore best to communicate with the franchisor before placing your franchised business on the market for sale, clarify the franchisors policy and position to your sale. Will they agree to grant a new franchise to the purchaser or will they only agree to transfer the unexpired term of your franchise? This can be a critical question that will impact on the value of your business.
So when should I sell my Franchise Business?
The Code was amended on 1 July 2010 to require franchisors to disclose what is to occur at the end of a franchise term.
The Code, under Clause 20(A) provides that if a Franchise Agreement is for a term of 6 months or longer, the franchisor must notify the franchisee at least 6 months before the end of the term of the franchisor's decisions to renew or not to renew the Franchise Agreement or to enter into a new Franchise Agreement.
Many updated Disclosure Documents now meet that requirement by simply indicating that there is "no right to renew" the Franchise Agreement at the end of the term without any further notice being provided by the franchisor.
The best time to sell your franchise business is shortly after renewing the Franchise Agreement, whilst you may still have a reasonable term left. However if you only have 2 years left of your franchise term without knowing the franchisors position then you have little to offer a buyer.
Don't expect the franchisor to be co-operative if you are in default of your obligations at the time of your sale. Also don't overlook your lease term. If the franchisee holds the lease, how much is left on the lease term as opposed to the term on your franchise. They often are not the same.
The Costs of Selling your Franchise Business
Before commencing the process of selling, ensure you understand the cost and exit fees so that those can be taken into account in your negotiations with a prospective buyer.
The costs of selling can be considerable including:
- business agents fees and advertising;
- landlords costs to approve the incoming franchisee;
- the franchisors costs which can be a fixed fee or a percentage of the sale price;
- Capital Gains Tax on eventual sale.
Plan to sell your business, do your homework, get expert advice from a franchise lawyer and your accountant and identify the issues, costs and process.
Don't accept the first purchaser that comes along. Do your due diligence on them just as the purchaser will undertake their due diligence on you.
Will the franchisor approve the prospective franchisee? Do you think the purchaser will be able to successfully complete training? Does the purchaser have the capital to acquire the business? Do they need to obtain finance? If so, how much?
By asking these questions at the earliest opportunity you may save yourself time, costs and considerable disappointment.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.