Legal Brief: Buying a second hand franchise?

What issues should you take into account when considering whether to launch a new franchise in virgin territory or invest in a re-sale as a going concern? Manzoor Ishani, MA, FCILS, FRSA, FInstCPD, FSALS Solicitor reflects on the differences

One of the advantages of buying a franchise in a mature network is that the prospective franchisee may have a choice of whether to open a new business under that franchise or to buy a business from an existing franchisee.

In any given franchise network which has been established for a few years (usually five years or more), there will be some franchisees who are looking to leave the network. The most recent bfa/NatWest UK Franchise Survey reveals that two in five of all franchisees bought their franchise from an existing franchisee. Assuming that the location or territory of such a franchise is acceptable to the prospective franchisee, should he or she seriously consider this alternative?

There are a number of factors which need to be considered before arriving at a decision. The first question to ask is why an existing franchisee wants to leave the network. Franchisees leave for a variety of reasons - some wish to retire, some may feel that the business or the profits it generates are below their expectations, others may find that they have taken their business to a certain level and are not willing to commit the resources required to take it to the next stage, and some may feel that the business is more demanding than they had anticipated.

It is important to try and get to the real reason behind the sale. This is not as simple as it sounds because when asked, a franchisee who is looking for a buyer may not tell his or her prospective buyer the full story and may be inclined to be economical with the truth. There may be hidden reasons. For example, the business may be dependent on two or three large account customers, one or more of which may have already indicated to the franchisee that they are going to withdraw their business. This is not something that a prospective seller will necessarily reveal to a buyer.

In some circumstances, a prospective buyer should ignore the fact that it is a franchise and proceed on the basis that he is buying a business as a going concern, which is what he is actually doing. This means that he must investigate fully the business he intends to buy in the same way as he would if he was buying a non-franchised business. The books will have to be examined closely and searching questions will need to be asked and he will have to press for answers where he thinks that the seller is being evasive. If premises are involved, title to the premises, lease, etc. will have to be fully investigated as will full details of all employees. Remember that in buying a business as a going concern the buyer will take over liability for employing all the staff including their employment history.

The prospective buyer will also need to satisfy himself that customer records are accurate, what the position is with regard to customer contracts and other obligations he will be taking on once he takes over the business. In addition to this, the buyer will also need to protect himself against liabilities of the business and ensure that the seller accounts to him for any money paid on account of contracts yet to be performed, such as part-payments and deposits. Furthermore, he will need to take care to ensure that he takes good title to all the assets free from all borrowings, mortgages, etc.

None of these things feature if the buyer were to take a new franchise because it would effectively be a new business start up. Assuming that the business receives a clean bill of health, the advantage to the buyer would be that he owns a business as a going concern with a customer base and a ready income from day one and he would have determined for himself the potential of that business and how he can grow it in the future.

With a new business start up, there will be nothing in the till on day one and he will have to build up his customer base and business from scratch. In the case of a new franchise he will have to rely on his franchisor's assessment of what his new business will be capable of achieving. Any advice that his franchisor gives him in this respect will be based on the franchisor's experience which more than likely will be in a different area or location. For example, if the franchisor is based in the South East, any projections it offers a prospective franchisee for the new area in the North East is bound to be of less value than a business plan and financial projections based on a business that has already existed and traded there for a few years. When it comes to producing business plans and projections there is no substitute for real experience. Nevertheless, one must remember that past performance is no guarantee to future performance.

On the other hand, a new franchise will cost less than the purchase of an existing franchised business because the buyer will have to pay extra for whatever the existing franchisee's business is worth.

From the franchisor's point of view, whether or not the buyer has its blessing will depend on the circumstances. If the selling franchisee has been running a sub-standard operation, or is failing to grow the business, or has lost interest in it, the franchisor will be keen to see that business change hands. On the other hand, there may be circumstances where the franchisor may have a conflict of interest because by sanctioning the purchase by a prospective new franchisee of an existing franchised business, the franchisor will lose a sale of a new franchise and the addition of a new outlet to the network. Given that franchisors grow their businesses by selling franchises - there is little for them to gain in having a high turnover of businesses for which they have already sold a franchise.

On the other hand, there is an important factor for the franchisor to consider. A successful franchisor needs to demonstrate to a prospective franchisee that his franchised business will be worth something at the end of the day and that he will be able to sell his business and realise a financial gain.

This is best done by a franchisor being able to demonstrate that former franchisees have been able to sell their franchised businesses and for a good price. The questions 'can I sell my business?' and 'when did one of your franchisees last sell his or her business and what profit did they make?' are not uncommonly asked by prospective franchisees.

Whether or not a franchisee has a right to sell his business and if so when, at what price, to whom, and whether or not his franchisor can prevent such a sale will depend on the terms of the franchise agreement. As always, it boils down to the franchise agreement, something which should be thoroughly investigated at the outset. So there you are, you pays your money and you makes your choice!