Australia: Post-completion issues when buying a franchise

That moment when you finally sign all the paperwork, pay the funds and receive the figurative or physical keys to your new franchise is an exciting time. Although the hard yards are behind you, and the business sale has been completed, you should be aware of several issues that can crop up only after you have taken over control. Whilst these differ between franchises and business models, some of the common post-completion issues include:

1. ineffective communication with customers and/or suppliers about the change in ownership;
2. the previous owner competing with you and taking your clients post-sale;
3. important contracts not being transferred or assigned or outstanding debts not being resolved with suppliers;
4. insufficient training and a poor relationship with the franchisor; and
5. misrepresentations by the vendor that only become apparent post-sale.

This article will outline how you can overcome these post-completion issues when buying a franchise.

Classification of Franchises and Customers

To provide helpful information, we have classified examples of franchises and customers into one of two business models:

1. recurring; or
2. irregular.

Communication With Clients and Suppliers

Many new owners focus on the technical aspects of the sale process, such as:

• making sure all the correct fees and rates are paid; and
• all parties correctly sign the documents.

However, the people-side of the business should not be overlooked.

To get the most value out of your new business, you will want to make sure that the transition of ownership of the franchise is as seamless as possible from the customers' perspective. Although the brand stays consistent, the face or name behind the brand may now be different.

Before completion of the sale, you may consider asking the previous owner to notify regular or high-value clients of the franchise that a new owner is taking over. If those customers are important enough, you may even prefer to have a warm and friendly introduction.

Being proactive about this can provide certainty to customers who may be unsure about you as the new owner. It can also tie in nicely with any promotions or marketing campaigns you may run concurrently. If you are retaining any employees that previously worked in the franchise, then developing a good relationship with them and seeking their input on their regular customers can be an invaluable resource as a new owner.

This issue is most relevant for franchises with a 'recurring' business model.

Suppliers should also be contacted prior to (or just after) completion to inform them of the sale. Here, you need to confirm that there are no outstanding debts owed. If the vendor insists on you not contacting suppliers prior to sale, obtain an assurance under the business sale contract that there are no debts. Even if you are not legally responsible for those debts, those suppliers may refuse to supply until those debts are paid.

Competing With the Previous Owner

When you take over a business, the last thing you want is for the previous owner to start a new business competing with you straight-away. Not only do they have more experience and know-how in that industry, but they may have existing relationships with your customers, which means they may choose the other business over yours.

To prevent this, it is common that a franchise agreement and a business sale agreement will have carefully defined 'restraints of trade' on the vendor/outgoing franchisee, which seek to prevent the previous owner from operating (or working in) a similar business:

1. within a certain proximity to your new franchise (anything from a few kilometres to the same state, territory or nationally); and
2. for a certain time period (from a few months to several years).

While the restraints of trade in those agreements can vary significantly in their function and ultimate enforceability, they can be critical to the success of your new franchise post-completion. If you start noticing substantial departure of seemingly loyal and regular customers in the first few months of owning the business, you might want to have a look online and see if the previous owner has started running a similar business.

A restraint of trade on the previous owner may be a way to stop them from competing for a period (or at least, asking them to do as such). This will depend on the:

• structure of the legal documents;
• value of the franchise you purchased;
• industry; and
• type of products and services.

Consequences of Solicitation

If the previous owner is actively soliciting (contacting) your customers to try and steal their business, you should seek legal advice on how to protect the goodwill in your franchise. Common responses include:

• sending a formal letter to the previous owner; or
• in some severe cases, getting an injunction from the appropriate court.

In any case, it is important to approach this post-completion issue pragmatically, as clients are often free to choose whichever product or service supplier they want, and it can be hard to prove that customers are actually poached. It is important to remember that a list of client contact details is a useful resource for a new business owner, however, is also relatively easy to copy and distribute, so the value in a franchise may be more in the branding, intellectual property and systems rather than the customers.

This issue is relevant for both franchises with a recurring or irregular business model. However, it is often easier to see when a previous owner competes in another irregular business model within the same area of the market as you.

The Transition of Contracts and Earn-Out

Similar to the importance of communicating any transition of franchise ownership to clients, as well as maintaining their business, is the critical step of correctly transferring any legal contracts from the previous owner to you. Some customers may be on:

• monthly;
• quarterly; or
• annual contracts with the previous owner's company.

If you take over the franchise whilst these contracts are still going, it is likely to be a condition of the business sale agreement that they are put in your business' name. This is relevant if you take over the franchise, but not the previous franchisee's company.

The most important thing to know is that there is no automatic transferral of contracts. They have to be properly transferred following the correct process stated in the contract or according to the law. In legal terms, this is known as assigning or novating the property.

Some contracts may expressly allow the obligations (to provide products or service) and rights (to receive remuneration for providing the products or service) under a contract to be transferred with notice, with consent, with third-party approval or freely.

Even still, such transfers are not necessarily as straightforward as changing the name and details on the first and last page. There can be a more complicated legal process to follow. Some contracts, however, may explicitly prohibit a transfer from happening. This means the contract will come to an end. A new one will need to be formed between you and the customer.

Earn-Out

Having a clear method to value the franchise you are purchasing based on any existing and long-term client contracts can be a useful way to ensure you don't overspend without the benefits. An 'Earn-Out' is a condition in the business sale agreement with the vendor that if a certain proportion of the long-term customers or contracts do not transfer across to your new business within a period of time, the purchase price of the business will be (effectively):

• reduced;
• refunded; or
• discounted.

Transfers of contract and earn-out conditions are more relevant in 'recurring' business models. Earn-outs may only be used when there are a number of high-value and important business contracts. Similar conditions can link to the number of key personnel that stay on in the franchise with you as the owner.

Further Training and Relationship with the Franchisor

You may have to undertake training before completion of the purchase of the franchise. This is typically part of the process of gaining the franchisor's approval. Many franchise agreements include provisions for further or additional training to ensure property compliance with the latest systems and procedures in use in the franchise. Some additional training may be available at your request (and also at your cost). This can be invaluable to avoid breaches of the franchise agreement early on.

Some possible post-completion issues can arise out of this further training. This is particularly so if you were not aware of the additional requirements or changes in the franchise system before taking over the business. You may not have known of the changes, but the franchisor expects you to comply with them regardless.

To prevent surprises, you should ask the business vendor or franchisor whether there are any anticipated changes to how the franchise should be run. Here, ensure you are sufficiently up-skilled to tackle this head-on before completion of the sale.

Occasionally, the franchisor may require the previous franchisee to provide ongoing support for you as the new business owner for a period of time. You should familiarise yourself with:

• what they are obligated to do; and
• what you can ask for.

Here, notify the franchisor early on if you are not being given proper support or handover to effectively run the franchise. The last thing you want is for the franchisor to think you are performing badly when in truth, you were not adequately shown how to do it right in the first place.

These issues are common amongst both recurring and irregular franchise business models. It is particularly common in those with a large number of specific processes and operational requirements to follow.

Vendor Misrepresentations

The last of the post-completion issues that may arise is where the previous owner of the franchise misrepresented an aspect of the business operation. Typically, misrepresentations are made about the profitability or turnover of the business. This is because these representations often link to the purchase price.

The business sale agreement may contain promises by the previous owner to be truthful. If they break such promises, you may have some scope for:

• remedies; or
• compensation from the vendor.

The general statutory prohibition on misleading and deceptive conduct can be helpful in obtaining a remedy. However, the best outcome is not being misled in the first place.

Due Diligence

The most obvious way of ensuring the figures are accurate is to ensure they are realistic.

Similarly, it is important to clarify whether sales figures are inclusive or exclusive of GST. In addition, it is important to clarify how the owner's time in the business has been allocated. This may be via either a:

• wage; or
• dividend from the business.

All these issues will clarify how accurate the vendor has been in presenting the financial figures to you regarding the operation of the business.

One possible solution to this risk is to have staggered payments for the purchase price post-sale. This staggering will be dependent on actual sales figures. If the sales figures were not accurate, the seller could pay a lower price.

However, you may need to take more serious legal action, and you should seek legal advice about what options are available to you. Importantly, if the franchisor was not involved in the process of purchasing the business, you may have to deal with the previous owner directly.

However, because you would have signed a new franchise agreement, you also have obligations to the franchisor. This means that unless you can exercise the seven day cooling-off period for a new franchise. Here, you can exit the franchise agreement with minimal repercussions. Your main remedy may be financial or other compensation as it is hard to give back a business when the franchisor may not approve a return of the franchise.

Key Takeaways

Conducting proper and well-advised due diligence will minimise the risk of post-completion issues. You should keep a good record of any statements, representations or documents that relate to the quality of the franchise you are purchasing. Having a well-constructed business sale agreement may better protect you against issues that you only discover post-completion.