ASK THE EXPERTS

QASK A LEGAL EXPERT What does any potential Quebec franchisee need to know before getting involved in a franchise business venture?

AQUEBEC IS ONE OF THE ONLY Canadian legal jurisdictions without a specific franchise legislation. The core legal body lies with the Civil Code of Quebec and Court precedents. In this context, a potential franchisee may wonder what is the extent of their legal duties, in particular, at the precontractual stage (meaning before formally entering into the franchise business venture): What are the franchisor’s legal disclosure obligations? To what extent do the franchisee’s “due diligence” duties go? What use can they make of the trade and brand names? What are the main pitfalls? We intend to cover these topics in the following article, while also providing practical tips.

Franchisor’s Disclosure Obligations and Potential Franchisee’s Duty to Seek Their Own Information Brand and Trade Names

Every new franchisee needs to understand that, under the terms of the franchise agreement, the brand and trade names which are so reputed (and which, in many cases, are the first and paramount reasons why the potential franchisee joins the network) are “rented” and not “sold.” In other words, the franchisee has no ownership rights over the franchise brand and trade names and can only use them within a very restrictive set of rules. For instance, franchisees cannot use at will the franchise symbols, brand, and trade names in association, such as to their activities on social media without prior approval from the franchisor. Failing to comply can lead to serious damages and substantial Court awards.

Under Quebec law, and contrary to other Canadian jurisdictions, the franchisor is not subject to specific and regulated “franchise disclosure obligations.” Rather, the franchisor is bound to disclose to the potential franchisee everything that is necessary for the future franchisee to provide an “informed consent.”1 This implies the communication of all key information such as, for example, the draft franchise agreement, the franchise history, key information on the network, some general financial information, pending Court litigation (if they are likely to have an effect on the franchise network) and other corporate information. However, the notion of “informed consent” is even broader. If the potential franchisee requires, they may also imply a duty of the franchisor to communicate internal memos pertaining to the potential franchisee’s personal situation, projected business location, and even psychological tests2 .

The potential franchisee, however, is also subject to their own duty of due diligence. They should not only consider information provided by the franchisor, but should also carry out their own research through a due diligence process. The franchisee should, inter alia, request pro forma information (accounting projections and simulations) from the franchisor, and proceed to obtain their own information concerning the franchisor’s reputation, and even solvency. Where possible, the potential franchisee should seek to obtain information and learn about other established franchisees of the network they intend to join. If the potential franchisee is purchasing an existing and operating franchise, their due diligence duties are even more extensive: they should ask for financial statements, expenses (rent, real estate taxes, food costs, insurance, labour costs, inventory, etc.), profit margins, and more.

1 9150-0595 Québec inc. v. Franchises Cora inc., 2013 QCCA 531. 2 Ibid.

Practical Tips

To ensure compliance with the legal obligations, a potential franchisee should be accompanied by a franchise specialist (whether a legal professional or an accounting professional). Very often, at the outset of a business venture, a franchisee seeks to spare and save as much money as possible. Not retaining the services of a franchise specialist (mainly for economic concerns) is, by far, the most typical and costly pitfall awaiting any potential franchisee. For instance, many unsuccessful franchisees realize, after a few months into the franchise operation, that they were not “sold” the concept they were expecting. For example, the franchisor may not truly have a sophisticated network, the technical and operational support may be defective, etc. Most franchisees do not know that after a certain time limit, if they have not made their claims known or decided to ask for annulment of the franchise agreement, the Courts will not allow such annulment because they will consider that, by their actions, the franchisee has “confirmed” the agreement. Being advised by an expert at the very early stages of their business endeavour will allow the future franchisee to access relevant information, truly understand the extent of their legal and business obligations, and sometimes realize that the projected franchise business contemplated is not necessarily suited to their needs.

Frédéric Gilbert

Partner

Fasken Martineau DuMoulin LLP

fgilbert@fasken.com

QASK A FRANCHISE EXPERT How do I find the right franchise for me?

AHAVE YOU EVER TRIED GOOGLING ‘Franchise Oppor- To financially qualify for a franchise, you’ll have to tunities’? If you have, you’ll know that over 302,000,000 meet the franchisor’s minimum liquid capital and net results are populated. So, if you’re someone who is inter- worth requirements. The liquid capital amount typiested in franchise ownership, how do you even know cally includes the franchise fee and some working capwhere to start? ital for the first year of business. Having awareness of

Most people would turn to brands they use on a regu- these numbers will also help you once it’s time to look at lar basis. However, this is typically not the best approach financing options, if you go down that route. and is one of the biggest mistakes people make when The numbers that you should most closely look at searching for a franchise that is best suited for them. when deciding which franchise is right for you are the Instead of just looking at the product or service the franchise fee and the overall investment. One of the comfranchise offers, look at the model the franchise has mon mistakes prospective buyers make is looking solely established. Then, evaluate whether that model is suit- at the franchise fee and assuming that’s the investment able for your skills, experience, lifestyle, strengths, amount they’ll need to start the franchise. weaknesses, likes, dislikes, and financial situation. It’s really important to be aware of what is included A good place to start would be to consider the time in the franchise fee, but more importantly, you need to that you are willing to dedicate to the business. If you are determine what the overall investment level is for the looking for a nine-to-five job, this will automatically elim- franchise. The overall investment includes everything inate some industries, such as food, for example. Are you from equipment, lease, car, marketing, training, technollooking for a business with flexible hours? If so, there are ogy, and all the other fees associated with opening the certain industries and franchises that allow you to build doors to your business. your schedule based on your own availability. When do At the end of the day, make sure you’re choosing a you like to vacation? If you like to go away for a couple brand that suits your lifestyle and your personality. months in the summer, considering a business that Make sure you choose the business that you believe in peaks during the summer months is not a good idea. and that you would be proud to represent. You should also think about the people you want to Once you choose the brand, trust in them and their work with – both customers and employees. If you enjoy system. You chose them for a reason. Follow their advice, working with other business owners and have a large speak to your fellow franchisees, believe in yourself, and network, considering a franchise that is based on a busi- make that entrepreneurship dream a reality. ness-to-business (B2B) model may be a natural fit. Remember, just because you’re in business for yourWhen it comes to employees, you should consider how self, doesn’t mean you’re in business by yourself – that’s many employees you want to have, as well as the type of the value of buying a franchise! employees you want to work with. There are many businesses that you can start as an owner-operator to keep your costs as low as possible, or you may want to build a team and grow the business with them. Are you comfortable working with high school students or do you prefer working with a highly trained workforce? You need to determine who you want to surround yourself with as you grow your business. How do you feel about sales? Regardless of the industry, every single business – franchise or not – has a sales proponent to it. However, there are many different aspects of sales and it doesn’t necessarily mean you’ll be doing cold calling. Some franchises are based on networking, some depend heavily on trade shows, some require a large social media presence, and others are mainly referral-based businesses. Another factor that plays a large role in determining the best franchise for you will be your financial situation. This includes both the numbers that the franchisor will look at and the numbers you should be considering.

Natali Pupovac-Peters

Owner & CEO

Top Franchise Broker

natali@topfranchisebroker.com

TUTORIAL 21: THE FUNDAMENTALS OF FRANCHISING

INTRODUCTION TO REPORTING

MOST FRANCHISE AGREEMENTS REQUIRE the franchisee to report information to the franchisor on a regular basis. This is frequently done on a monthly basis and can be submitted digitally or as written reports. It may simply be financial reports that are generated through point-of-sale systems, online reporting systems, or dashboards. Sales, as well as key operating metrics such as billable hours or average customer spend, are looked at. Profit and Loss statements are typically reported annually. Depending upon the franchise system, reports may be required more frequently.

Franchisee reports are required by the franchisor for several reasons. First, franchisors want to ensure that they’re receiving proper royalties. Royalties are often a percentage of the gross revenues, less collected taxes and refunds. Such royalties cover the costs and expenses associated with providing support to the franchisees and the system, as well as providing a profit to the franchisor and its shareholders. It provides the revenues to continue to build the brand. For the franchisees that are paying their fair share of the royalties, it’s not fair that they do so while others don’t. The non-compliant franchisees, by hurting the franchisor’s financial cash flow, are considered a threat to the system.

Second, the franchisor wishes to ensure that franchisees aren’t running into financial difficulties. Franchisees are in business to make a profit. If profits aren’t realized on a consistent basis, they may not stay in business. Franchised locations closing aren’t good for the brand and for the system as a whole. Good franchisors wish to protect the integrity of the brand and therefore need to be aware of any franchisees in financial difficulty so that they can be proactive in assisting to correct the situation.

Third, franchisors will wish to establish key metrics and benchmarks for the system as a whole. These system benchmarks and averages can be provided back to the franchisee so they can measure their individual performance as it compares to the entire system. It will identify problem areas or items of potential improvement. As an example, you might be experiencing a 35 per cent employee turnover, but other franchisees are averaging 20 per cent employee turnover. This provides the franchisee with an area to focus on to improve the performance of the business.

Fourth, the franchisor wishes to monitor overall business trends. Are certain categories of retail items dwindling in sales and needing to be replaced with another product category? Are the average dollar amounts per transaction shrinking?

This may require adjustments to the offering. Is there an unaccounted disappearance of inventory that may require implementing greater security controls? Without monitoring key business metrics and having a basis for comparison, it’s difficult to make these and other business decisions.

Franchisees aren’t just required to report to the franchisor. Similar to any business owner, the franchisee is also required to submit regular reports and financial submissions to the government. Monthly or quarterly, there may be GST/HST reports, payroll reports and remittance of taxes, workers compensation, and employment insurance. Although it’s the franchisee’s legal responsibility to submit these payments, some franchisors will require copies so that they can ensure that all required payments have been made. Failure to pay government remittance and taxes could result in the government stepping in and closing the business. Again, the franchisor has a strong interest in and commitment to ensuring that the brand continues in the location.

Finally, franchise systems need to be able to monitor their franchisees for system consistency. The product and service offering needs to be consistent no matter the location. It’s through consistency that a brand is created. Thus, there may be required reports regarding the quality of the product or service being provided. A report regarding customer complaints and how they were handled is also regularly provided to the franchisor.

Reporting is a necessary part of being in a franchise system. It may feel sometimes like “big brother” is watching, but ultimately it’s in the franchisees’ best interests, as it protects their investment. It’s in everyone’s interest that no one be allowed to ‘cheat’ the system and all are paying their fair share. All franchisees can benefit from reporting and getting feedback as to how they are doing relative to others. This is one of the biggest benefits of a franchise, when compared to opening as an independent. You, the franchisee, have resources that simply wouldn’t be available if you were on your own. Providing the franchisor with information can assist in improving operations across the system, including early recognition of issues such as internal theft, excessive operational costs, and changing market trends – all of which require corrective action.

TUTORIAL 22: THE FUNDAMENTALS OF FRANCHISING

INTRODUCTION TO AUDITS

WHEN A FRANCHISEE ENTERS into a franchise agreement, they acquire specific rights, but they also commit to certain obligations. The franchisor/franchisee relationship is largely based on good faith. The franchisor trusts the franchisee will comply with the franchise agreement. In most situations, this is the case, but not always. Sometimes mistakes will happen. In more unusual circumstances, a franchisee may intentionally underreport sales or not follow the system in some way. To address this, franchise agreements will usually give the franchisor the right to conduct an audit on the franchisee in question to ensure compliance with obligations.

Most franchise agreements will allow the franchisor to perform a financial audit on its franchisees. The franchisor may sometimes decide to do a financial audit at random; more frequently, it will choose to conduct one in the unusual circumstance where the franchisee fails to submit required financial reports. The franchisor may also do an audit if it suspects that the royalties being paid by franchisees aren’t aligned with the actual amounts that are due. Franchisees who don’t pay their fair share jeopardize the financial stability of the franchisor, and can hinder the franchisor from meeting its obligations to its franchisees, shareholders, and employees.

In doing an audit, the franchisor will look at sales as they’re reported on monthly reports to the franchisor, and compare this to sales as reported in the point-of-sale system, as indicated through sale invoices, government tax filings, inventory turnover, and bank deposits. All of these numbers should be aligned and indicate an equal level of sales. If inconsistencies are found, this could be an indication of accounting errors or intentional underreporting of sales in order to avoid paying royalties.

A financial audit may be the only way to determine what royalties are due and payable if such royalties are a percentage of sales. If no royalties are being paid, or in the event that the audit uncovers that the franchisee underpaid its royalties and other financial obligations, the cost of the audit is typically charged to the franchisee. Allowances are made for error, usually up to three per cent. Where there is an underreporting of sales greater than three per cent, the franchise agreement will generally dictate that the costs for the audit shall then be charged to the franchisee, along with payment of outstanding royalties due, with interest.

If underreporting of sales is an ongoing issue, it may be grounds for termination of the franchise licence. This can be avoided by the franchisee simply fulfilling their financial obligations to the franchisor when due. Franchisors have a variety of ways of uncovering underreporting. Be confident in knowing that at some point the franchisee not paying the appropriate amounts will be caught out.

Obligations of the franchisee go beyond simply financial – franchisees are also required to follow the franchise operating system. The system is designed to create a consistent customer experience, as it’s through consistency that a brand is created. In the interest of preserving the brand, the franchisor will also conduct operational audits. These may be formally announced meetings with the franchisee involved, or they may be done unannounced, sometimes through a mystery shopping program. Things that are looked at in an operational audit may include the following: • Location cleanliness and appearance • Use of logo and advertising materials • Local advertising • Use of approved products and suppliers • Product or service quality and presentation • Speed of service and delivery • State of equipment and proper usage • Confirmation of proper licences and insurance • Compliance with required labour laws and minimum wage • Required hours opened for business

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Good franchisors do operational audits to ensure that the system is being implemented consistently in all locations. Franchise systems need to be able to monitor their franchisees for system compliance to ensure brand protection. Strong franchisees welcome the audits, knowing that it’s protecting their investment. Audits may uncover such things as weak internal controls, higher-thanaverage operating expenses, and possible internal theft. Such feedback from an audit, either financial or operational, can provide valuable information that will assist in improving the business.

Periodic audits are an important part of any franchise system. Often, compliance problems are the consequence of innocent mistakes. Where there are issues, audits can identify them and corrections can often be made to improve profitability. If the compliance issues are ongoing, it may be grounds for termination of the franchisee. It’s important that all franchisees protect their investment in the system by meeting their financial and operational obligations.

STUDY QUESTIONS

TUTORIAL 21

1. Most franchise agreements require franchisees to submit regular reports. These reports are usually:

a) Submitted on a monthly basis b) Submitted in person as part of an elaborate presentation c) A summary of the franchisee’s financial reports, sales metrics, and/or profit and loss statements d) Both a) and c)

2. True or false: Franchisors require regular reporting from their franchisees because it is in everyone’s best interests to be aware of what’s happening throughout the franchise system.

a) True b) False

3. Franchisees are usually also required to submit reports and documentation to the government.

What are some of these submissions?

a) GST/HST reports b) Employment insurance c) Payroll reports d) All of the above

4. There are benefits to regular franchisee reporting. They include:

a) Protecting franchisees’ investments through early recognition of any problems or issues b) Feedback and benchmarking c) Both a) and b)

4) c 3) d 2) a 1) d Answer Key:

TUTORIAL 22

1. An audit is generally performed by a franchisor when a franchisee:

a) Is operating successfully and meeting all obligations as set in the franchise agreement b) Fails to submit required reports c) Is suspected of paying royalties not aligned with the actual amounts due d) Both b) and c)

2. True or false: When a franchisor conducts a financial audit on a franchisee, there is no allowance made for errors in accounting/ reporting.

a) True b) False

3. The franchisor may also carry out operational audits on its location. Things that may be looked at during an operational audit include:

a) Cleanliness and appearance of the location b) Use of approved products and suppliers c) Confirmation of proper licences and insurance d) All of the above

4. True or false: Periodic audits, both financial and operational, play an important role in the success of any franchise system.

a) True b) False

4) a 3) d 2) b 1) d Answer Key: