The importance of the disclosure document when buying a franchise

Disclosure Document

The key to making an educated decision when becoming a franchisee is to make sure that the franchise you are investigating has a Disclosure Document as required by the provisions of the Consumer Protection Act as they relate to franchising.

Becoming a franchisee can be somewhat daunting, especially when you don’t know how to make sense of the various franchise opportunities or to evaluate a particular franchisor’s operation. Thankfully, the Consumer Protection Act, 68 of 2008 (“the CPA”) has stepped in, assisting prospective franchisees by compelling franchisors to provide prospective franchisees with a disclosure document.

If you are thinking of becoming a franchisee, the disclosure document is your new best friend. It is packed with valuable information and is designed specifically to educate you about a particular franchisor, its network and its operations so that by the time you have to make the decision whether or not to join a franchise network, it will be a well-informed and educated decision. The CPA’s disclosure requirements aim to protect the eager prospective franchisee from basing their decision to join a franchise brand on propaganda and marketing hype rather than the facts.

The relevant issues found in the disclosure document include:

Background on the concept

This includes details on the franchisor, the company background and brand history, key players within the organisation, their personal details, and the growth and performance of the company.

How it was started? Who started it? Was there a change of ownership? How long has it been in business? How has it performed under its current owners? Who are the directors, the key management persons and something about their backgrounds, the growth and performance over the years? The history of a brand is a good place to start when you are trying to establish if the brand will be a good investment going forward.

The Franchisor’s network

This will give you a very good idea about how big the network is and whether or not the network is a healthy growing network or perhaps it is shrinking or stagnating. To this end, the disclosure documents provide a list of all the current franchisees that are part of the network with their contact details. It also shows which outlets are company-owned i.e. owned by the franchisor. You would be wise to try to establish how many franchisees are joining every year and how many are terminating and not renewing their franchise agreements. Moreover, go and visit the individual outlets to find out from them what you can expect in terms of your relationship with the franchisor and what they think of the brand. The disclosure document also provides an organogram depicting the support system in place for franchisees.

The franchisor’s financial position

Naturally, prior to investing in a franchise brand, you will want to look closely into the financial health and the growth of the franchisor’s turnover, net profit and the number of individual outlets, if any, franchised by the franchisor for the financial year prior to the date.

  • The disclosure document must be accompanied by a certificate on an official letterhead from an accounting officer or the auditor of a company certifying that the business of the franchisor is a going concern;
  • To the best of his or her knowledge the franchisor is able to meet its current and contingent liabilities;
  • The franchisor is capable of meeting all of its financial commitments in the ordinary course of business as they fall due;
  • The franchisor’s audited annual financial statements for the most recently expired financial year have been drawn up in accordance with South African generally accepted accounting standards and fairly reflect the financial position, affairs, operations and results of the franchisor as at that date and for the period to which they relate.

Initial investment, investment capital before borrowings, set up costs, working capital

The disclosure document details the various costs you will have to come up with to become a franchisee, including not just the initial franchise fee, but also the set-up costs, working capital which you may need to get the business off the ground and rental of the premises etc. To make sense of the numbers you need to know that all costs normally vary from outlet to outlet. You must make sure you understand what you are getting yourself into. Always allocate about 10% additional to the cost estimate in order not to find yourself overextended.

Royalty fees and expenses

Ongoing fees and costs are an important consideration. The management services fee is usually paid monthly by the franchisee but may vary from brand to brand. It may be a percentage of the franchisee’s gross turnover or sales or it may be a fixed levy fee. It is a fee paid for the management services rendered by the franchisor for ongoing support and help, for brand building, purchasing power and research and development and for the ongoing use of the intellectual property. Fasa’s recent survey showed the average management services fee was calculated at 6,6% of turnover.

Most franchisors require their franchisees to contribute to national or regional marketing or advertising fund. These funds are pooled to finance the advertising and promotion of the franchise system and to help build brand recognition for the benefit of all the franchisees. In the 2017/2018 FASA survey, the marketing and advertising levies would cost a franchisee, on average, 2,1% of turnover.

Financial projections, potential sales, income, gross and net profits

The Disclosure Document sets out important written projections in respect of levels of potential sales, income, gross or net profits or other financial projections for the franchised business that all play an indispensable part in helping you make the right decisions when buying into a franchise concept.

Trademarks, logo/s

This section gives details on the registration or application for registration by the franchisor of any trademarks. It is important for you to know when you consider joining a franchise brand whether or not they are the owners of the trademarks and if all intellectual property is protected through registration thereof, since it could happen that, in the event that the franchisor does not own the trademarks or intellectual property, the owner thereof can terminate the licensed use thereof which would have a devastating effect on your franchised business.

Territory

Some franchisors offer exclusive territories, others don’t. Check to understand exactly what you’re getting. Fast food franchise agreements typically aren’t exclusive. Look not just at a geographic competition, but also at whether the franchisor is allowed to sell the products in supermarkets or other distribution channels, potentially competing against you.

Renewal, termination and dispute resolution

When you are signing a contract to start a new business, you may not want to think about what can go wrong. The franchise agreement will tell you about the circumstances under which the franchisor can terminate your agreement, as well as the terms for resolving disputes. We recommend contacting existing franchisees and asking them how the franchisor has resolved any concerns or complaints – and whether they have a way to deal with of disagreements before they wind up in court.

Litigation

Franchisors are not specifically required by South African law to disclose any litigation they have been involved in. But it is probably a good idea to ask the franchisor or do your own investigations to see if you can find out if the franchisor has recently been involved in litigation against franchisees. Litigation, these days, is part and parcel of doing business; however, if the franchisor is continuously involved in numerous litigious matters concerning conflict with its franchisees it should be a warning light.

Cooling off period

The Consumer Protection Act (CPA) compels franchisors to make full disclosure of material facts and grant franchisees sufficient time to assess the viability of the franchise opportunity. Franchisors must provide prospective franchisees with a written disclosure document which must be dated and signed by an authorised officer of the franchisor and must be given to you at least two weeks prior to the signing of the franchise agreement
The disclosure document is much more than a mere company profile which contains a brief overview of the franchise opportunity. The disclosure document is given to a prospective franchisee during the negotiation stage and therefore should provide all information necessary to properly asses the franchisor, its network and a particular franchise opportunity. The purpose of the disclosure document is to inform about every aspect of the business relationship that will be established with the franchisor to enable prospective franchisees to make a well-educated decision before concluding the franchise agreement.

Disclaimer
This article was produced for information purposes only and does not constitute formal legal advice. Neither Pieter Swanepoel nor PAS Attorneys Inc. is liable for any losses suffered as a result of reliance upon information contained in this article. Please visit PAS Attorneys website.

 

The views and opinions in this article are those of the writer and do not necessarily reflect those of the Association.

Pieter Swanepoel

Founder / Director at PAS Attorneys
Pieter has extensive experience in Franchising Law, negotiating and drafting commercial agreements, general civil and commercial litigation, including contractual disputes, company and shareholder disputes as well as disputes and claims in damages.
Pieter Swanepoel

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