Equity Share Franchise Models

Robert Toth is Special Counsel Sanicki Lawyers, with over 35 years’ experience in Franchise, Licensing and Distribution law acting for both local and International franchisors, franchisees and master franchisees and with expertise in dispute resolution. Robert is an Accredited Commercial Law and Franchise Specialist, a member of the Franchise Council of Australia (FCA) and the International Franchise Lawyers Association (IFLA) and regularly writes for franchise and corporate journals online. contact robert@sanickilawyers.com.au or even call him on mobile 0412 67 37 57

Franchising has been operating in one form or another for the past 40 years in Australia and became a regulated sector under the Franchise Regulations which established the Franchising Code of Conduct in 1998.

Moving some years on, the world has changed so have franchisees expectations and the businesses sectors, which are suitable to licensing and franchising.

Franchising is no longer known for the fast food and hospitality sector it is a business model that suits many Business to Business and home service and support sectors and professional sectors.

We still see the same old franchise models being offered by franchisors, consultants, and lawyers despite these significant changes.

The basic premise of franchising for a franchisor is that a successful business owner with systems and branding in place can be replicated by the business owner (franchisor) granting individuals and small business owners a license to operate under their brand and system.

It enables quicker business and market expansion whether it is with more outlets in a state or territory interstate or overseas as opposed to the slow organic growth of a business hiring employees and managers to run their business.

For franchisees it is the opportunity to run your own business with the support, systems and marketing developed by the franchisor. Many franchises came under fire from a number of Parliamentary Inquiries the latest being the “Fairness in Franchising” inquiry in 2019/20 which resulted in more regulation of the franchise sector with a view to protecting franchisees.

The changes included issues such as greater disclosure of rebates, franchisee termination rights, disclosure about online sales and greater penalties for franchisors who fail to comply.

What’s wrong with existing franchise models?

The Government report released in 2020, identified a huge array of issues in the sector such as:

• misuse of marketing fund contributions paid by franchisees to their franchisor;

• a failure to provide any disclosure or proper disclosure required under the Code;

• a failure to disclose rebates and incentives franchisors receive from landlords or suppliers;

• a failure to act in good faith in dealing with disputes;

• misleading and deceptive conduct and false representations or promises as to expected revenues to entice franchises to sign up; and

• disputes about end of term arrangements and non-compete provisions.

In some cases, it was the franchisor or their support people bullying franchisees and engaging in simply bad behavior.

The Most Common Complaints We See From Disgruntled Franchisees

We act for franchisors, master franchisors and franchisees and are regularly involved in dispute resolution and mediations in commercial and franchise disputes acting for both sides.

The franchisee is not always right of course and can often be the cause or contribute to the dispute, by not following the system or by their own conduct however, the main complaints we receive from franchisees of their franchisors are:

• the franchisor and their staff show no respect to the franchisee;

• the franchisor is a ‘no show’ franchisorwe never see them – they appear to have no interest in us unless we do something wrong, and they do not provide any real support;

• the franchisor forces stock on us when we cannot sell what we have; and

• the franchisor in addition to the royalties and marketing levies are also making a margin on products or services leading to a feeling of being “gouged” for fees while the franchisee cannot even draw an average salary for their effort, let alone get a return on their investment.

Responsible Franchising

Responsible franchising is a term we use with our franchisors and new franchisors which includes not only ensuring compliance with the Franchise Code but in addition to this committing to the following:

• Being a force for good and ensuring everyone in the organization has the same objective.

• Ensuring the financial model works for the franchisee.

• Actively supporting and showing interest in the success or otherwise of their franchisee

• Accepting responsibility in part if the franchisee is not performing as expected.

We recommend that franchisors do their financial and cash flow projections not only for themselves but also from the perspective of the franchisee to ensure after all the fees are paid the franchisee can draw a salary and get a return on their investment.

A happy and productive franchise system is one where the franchisee is making money and getting rewarded for their effort!

What do franchisees expect?

Franchisees have greater expectations than in the past and this is more so post Covid.

Franchisees do expect a franchisor to:

• have a proper online CRM system;

• provide proper and meaningful training and support;

• offer products and services at competitive rates using the group purchasing power;

• share in any online sales revenue that may be lost by a retail store including sharing any rebates and incentives received by the franchisor;

• expect their franchisors to show interest in their well-being, personally operationally and financially; and

• be interested in their financial performance and provide support and assistance with marketing.

How can this be done?

Franchisors and their consultants need to “think outside the square”.

As a fan of Edward De Bono’s lateral thinking concepts (vale poor Edward he died in 2020) we need to develop and offer a fairer, more attractive franchise model which provides a greater sharing of risk and a more equitable relationship.

Why do we need to change as a franchise sector?

• To avoid further Government intervention and regulation.

• To assist franchisees and help fund them into a franchise, as banks are tighter on lending criteria.

• To make the entry into a franchise more affordable.

For Franchisors the reality is often the right franchisee is the one that does not have the capital or funds to take up a franchise, while the franchisee who has the funds may be the wrong fit!

The trend is that over the past three years the upfront license or franchise fees has been reduced by many franchisees to make it more attractive and due to funding issues.

Despite this we still see some overseas franchisors setting unrealistic up front franchise fees and wondering why they have no interest from prospective franchisees. The financial model must also be realistic and ensure the franchisee can take a salary for their effort and hopefully get a ROI.

Change is great!

James Baldwin (an African American writer –1924-1987) said “not everything that is faced can be changed, but nothing can be changed until it is faced”.

So, we cannot expect to meet the challenges that confront business today using yesterday’s mindset and models and expect to be at the forefront of business tomorrow. I should copyright that!

“Branchising” an equity share model - a new path

Branchising was a term coined by author David. D. Seltz in a text entitled “Branchising – Proven Techniques for Rapid Company Expansion and Market Dominance” first published in approximately 1960. He was way ahead of his time.

The term describes “business franchising” referring to the conversion of an existing company owned outlet to a franchise or licensed unit.

It has now moved on to describe a model where the franchisor establishes a new outlet in partnership with their franchisee in which they each hold equity, a shared equity model. The franchisor may sell its existing company owned outlet or a part interest in it, to recoup capital for further growth while retaining some degree of control and profit from the franchised unit.

A Branchise, is a franchise under Franchise Code.

What’s the difference between the traditional franchise model and a branchise model

The traditional franchise model is a vertical relationship where the franchisee is under the control and power of the franchisor. Calling your franchisee, a “franchise partner” does not change the fact that the franchisor has that control and power imbalance and that is what creates the disharmony down the track.

The traditional franchise model has:

• onerous obligations on the franchisee;

• little if any real obligations on the franchisor;

• all power and control vests in the franchisor;

• good will, remains vested in the franchisor;

• royalties are generally payable on gross revenue (not profit);

• there is no sharing of risk or profit;

• the default provisions are severe with threat of termination;

• all capital costs are funded by the franchisee;

• additional fees and charges eat into the franchisee’s return;

• restraints on the franchisee at the end of term.

Benefits Of The Branchise Model

The Branchise model is a horizontal relationship representing a more equitable relationship whereby the franchisor and franchisee are in business together working for mutual benefit.

Each party has equity in the enterprise and therefore a vested interest in ensuring its success.

At the end, if the business is sold the franchisee will receive (based on their equity) their share of good will and along the way, their share of profit.

This model addresses many of the negative issues of the traditional franchise model including the funding issues that franchisees face in trying to borrow money to buy into a franchise as banks will no longer lend on a franchisee’s equity in their home to fund entry into a franchise.

In a Branchise, each party contributes their share of the up-front capital cost to establish the business. For example, if the overall startup cost is $500,000 and the franchisor has a 51% equity stake and franchisee 49% equity, the franchisor will contribute $255,000 towards the cost and the franchisee pays $245,000.

The franchisee runs the business with the support of the franchisor who is likely to be more attentive, as they have equity in the business while the franchisor relies on the energy and enthusiasm of the franchisee who has real “skin” in the game.

It is also less likely the franchisor will charge unnecessary or undisclosed fees to the franchisee entity as that will impact on the franchisors profit.

The franchisee also has more direct access to the franchisor’s financial management and support and decisions are made with the knowledge that they both have skin in the game.

Even where it is an existing franchise business bringing in an equity franchisee requires full disclosure under the Franchise Code.

Where it is an existing business of the franchisor being converted to a franchise, the franchisee can buy into the business which allows the franchisor to access capital for the value of the fit-out, stock, equipment and good will (if any) which can be in lieu of the franchise fee.

Risks In A Branchise Model

As with any relationship, there is risk and it’s not all cigars and fine Japanese single malt whisky!

There is an added layer of complexity in that the parties become shareholders as well as in a franchise relationship.

This requires a carefully drafted shareholder or partnership agreement that governs the rights and responsibilities, exit rights, rights of first refusal and drag along and tag along rights that are generally included in any shareholder agreement.

In addition shareholders have minority oppression rights under the Corporations Act which may be used by a franchisee if there is a dispute.

Establishing an equity share model requires expert advice, experience and attention to detail.

It is not the right model for everyone, and it is not a magical solution. But it is becoming more popular and seen to be a more equitable model that addresses a number of the issues that caused dispute with the traditional franchise models.

Whether establishing a branchise model or a franchisee being offered an equity share model it is important to seek specialist legal and financial advice to understand your rights and obligations as there are many tricks and traps that an experienced franchise lawyer will be able to advise on.