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Francorp - The Franchising Leader in the Philippines

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Franchising Tip: Read your franchise agreement

By  Noel Siggaoat, Managing Director, Francorp Philippines

Buying a franchise, especially for the first time, is a major life decision for most people. It requires a huge commitment of time and money and often results to a major change in lifestyle. Although it requires a leap of faith in order to execute, it also requires a lot of careful thought and deliberation.

Surprisingly, many would be franchisees do not exercise the necessary diligence in studying their franchise agreement before signing. Yes, they read the major provisions like royalties, franchise fees, contract terms, and others but they never really go beyond those or at least scrutinize the relevant provisions as deeply as they should.  Sometimes, they are intimidated by the sheer volume of legalese found in a franchise agreement. Some just put their blind trust in the franchisor. The naivete comes back to haunt them later on when they realize they have agreed to something that becomes difficult for them to comply with.

These are some of the provisions in franchise agreements that franchisees take lightly or tend to underestimate the significance of:

Supply arrangements. Franchisors usually require franchisees to buy products from them or from approved vendors only. This is to ensure the quality and consistency of the products or services being sold in the stores. Franchisees should look more closely into these provisions because their margins and, therefore, their profitability could be compromised if these are not priced fairly. While it is normal for a franchisor to require certain items to be purchased from them, the prices at which franchisees buy these items should be competitive with sources outside the system.  The transfer price at which these items are purchased should give the franchisee adequate margins. Since the franchisee is legally bound by the franchise agreement to buy these items from the franchisor, he will not be able to buy from other cheaper sources; otherwise, he will then be in violation of the franchise agreement.

Renewal and related fees. In considering a franchise investment, would-be franchisees look very closely at how much money they would have to raise in the beginning for the initial investment. They scrutinize this figure and compute when they will get a return on their investment. What they fail to take into account is that later on, they may have to spend additionally to renew the franchise after so many years. A renewal fee might be required to continue the business past the initial term of the agreement. The franchisor may also mandate that the store be renovated as a condition for renewal.

While it is normal for businesses to renovate their stores to keep it looking fresh after so many years, would-be franchisees should try to get an idea to what extent the future renovations will be. Would this entail merely repainting and replacing worn-out fixtures, or does this entail a complete redesign of the store and installing major equipment?

Will the Franchisor charge a renewal fee? At Francorp, we usually recommend to our franchisor-clients not to charge renewal fees since there are very little costs associated with renewing an ongoing franchise unlike in the beginning where a franchisor incurs substantial costs in evaluating, training, and marketing to a new franchisee. A would-be franchisee should find out whether or not a renewal fee will be charged.

Territory provisions. Is the franchisor giving exclusivity to a location, or is he giving rights of first refusal? Exclusivity means no other store – franchisee or franchisor-owned – will be allowed to open in the franchisee’s territory. Rights of first refusal to the territory mean that the existing franchisee will be given the option to invest in an expansion store in the territory. If he foregoes that option, the expansion store may be offered to another franchisee or may be owned by the franchisor. This new store may cannibalize some of the first store’s sales and even some of its customers. A would-be franchisee should look closely as to what his rights and privileges are with respect to the territory he is operating in.

Return of Investment. While the Return of Investment figure is not indicated in the franchise agreement per se, it is a figure that would-be franchisees tend to misunderstand.  When marketing their franchise, companies usually quote an estimate of when the investment in the franchise will be recovered by the franchisee. Many franchisees believe that these figures will happen with certainty. However, these are based on certain assumptions happening.  Ideally, these figures are a historical average of what other stores in their system have experienced. Sometimes though, these could be projections based on ideal situations, or in worst cases, they are merely numbers based on wishful thinking. Would-be franchisees should find out what the basis of these numbers are and make their expectations accordingly. In Francorp, we use historical sales data in projecting future sales and consequently, return of investment figures. This way, clients’ franchisees will have realistic expectations regarding the viability of their investment.

In general, franchisees should do their due diligence before entering into a franchise agreement. They should look into all aspects of the franchise. They should not be afraid to ask questions. The only stupid questions are those that are not asked. If they are not comfortable with reviewing legal or business plans, they should get legal or business advice from those able to guide them. If there are any provisions or policies that they are uncomfortable with, they should discuss these with the franchisor or try to negotiate before signing the franchise agreement. Once the franchise agreement has been signed – or any agreement for that matter – the franchisee will not have a lot of leverage to negotiate with. They should not accept as gospel truths the numbers quoted them but use their judgment in assessing the soundness of those figures.

Would-be franchisees should also try to talk to current franchisees of the company. Find out if they are happy with their investment. Knowing what they know now, will they invest in the same franchise all over again?

Reviewing the franchise agreement with due diligence does not always guarantee a happy ever after in franchising. But instead of a leap of faith, going into a franchise becomes a careful, calculated step.

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