The following is part of a series of short articles to assist individuals and companies who are contemplating buying a franchise.
Buying a newly constructed franchise brings with it the greatest potential for a purchaser to penetrate into uncharted territory. However, the greatest potential for reward is often also associated with the greatest risks. A purchaser must therefore be mindful to assess these risks and consider the following points unique to this type of situation.
When purchasing a new franchise, a specific location may not be determined in the franchise agreement. Either the franchisor or franchisee will, in accordance with the terms of the franchise agreement, be responsible for finding the location. The franchisee will be required to pay an initial franchise fee, which becomes non-refundable upon execution of the franchise agreement and, quite often, a deposit for the costs of construction. It would be prudent to have the franchisor agree to return a portion of the initial fee in the event that a location is not found within a reasonable period of time.
When the location is not available, the only real information a franchisee has at its disposal is what is disclosed by the franchisor in the disclosure document. The franchisor is obligated to disclose all material information, but there will obviously be no information on the specific location.
Market surveys or traffic flow studies that have been completed by the franchisor should be included in the disclosure document as material information if certain sites are being suggested to the franchisee. In choosing a location or reviewing a proposed site, the potential franchisee can easily do their own count if no survey exists by going to an existing good location in the franchise system, parking outside and doing a physical count of persons or vehicles passing by. Counting the traffic required in order to get a certain number of vehicles into the franchise location and comparing this to the traffic at a new location may be an unscientific way to test the site viability, however, the franchisee can roughly determine, assuming the demographics are similar, whether or not the proposed location should be raising any red flags.
If there is a defined location and an offer to lease, the franchisee should be provided with a copy of the offer to lease for review of the terms. Rents should be matched against those in the pro-forma statement provided by the franchisor to see if they are reasonable. The offer to lease for a location in a new development should have an estimate of additional rents, failing which an estimate should be obtained.
The offer to lease is generally entered into by the franchisor with the intention of subletting to a franchisee and without the input of the franchisee. As a result, a franchisee may not necessarily have an opportunity to negotiate better terms. The document is offered to the purchaser on an “as is” basis. The issue of zoning can be crucial, particularly where franchise locations are being built in newly developed areas. If possible, a representation should be obtained from the landlord in the offer to lease that the proposed use of the business is not in violation of the existing zoning. That being said, it would generally be prudent for a franchisee to verify the zoning compliance by making inquiries at the relevant municipal authority before he or she proceeds.
Landlords often grant exclusive rights to other tenants and the offer to lease should have a representation that no such covenants were given to other tenants that would prohibit the operation of all or part of the franchise business.
With new construction, the landlord will often grant some leasehold allowances to assist the tenant in building the new location. The franchisee should negotiate with the franchisor to ensure that these leasehold allowances are going to be passed on to it. Obviously, when a landlord grants these leasehold allowances, they expect to recover the money in the rent over the term of the lease. Franchisors that retain leasehold allowances for their own benefit are often doing so to the detriment of their franchisees in respect of rents that are paid over the course of the term. That being said, there are many franchise systems that do so and which take the position that it is part of the cost of obtaining the franchise.
For more information on franchising, contact Derwin Wong or Hailey Kersey by phone at (416) 368-0600 or by email at dwong@businesslawyers.com or hkersey@businesslayers.com.
Revised October 2015
© Morrison Brown Sosnovitch LLP, 2015 All rights reserved.
