People cite differing reasons for considering the purchase of a franchise. However, one thing all potential franchisees have in common is a desire to make a reasonable profit from the business.

Due diligence is the process of evaluating a business to evaluate its potential. There are different types of due diligence – for example, financial, operational and legal. 

The purpose of gathering financial information for financial due diligence is to assist with the preparation by the potential franchisee of budgeted profit and loss and cash flow statements.

It is these statements that the franchisee should use to determine whether the profit will be reasonable, whether to buy the franchise, and if so, how much to pay for the franchise.

In order for a potential franchisee to obtain the information that is required to prepare budgeted profit and loss and cash flow statements, there is much groundwork to be done.

THIS INCLUDES (in no particular order):

• Talking to speak with existing franchisees (as many as possible) about their financial performance, and obtaining detailed financial information.
• Looking at trends in the financial performance of the particular franchise, the franchise system as a whole, and the industry in which the franchise system operates. Will past performance be representative of future performance or are their local, national or international trends that are likely to affect performance?
• Assessing current and likely competition.
• Analysis of the financial information provided by the franchisor.

It is this last point – analysis of the financial information provided by the franchisor, and making sense of these franchisor figures, that the remainder of this article is concerned with.

A franchisor does not have to provide you with financial information. There is a trend – probably an increasing trend – in Australia for franchisors not to provide financial information. If this is the case, the disclosure document at Section 19 will simply say that the franchisor does not give earnings information.

It is the franchisor’s right to do this – but, if you are unable to obtain sufficient information to enable you to carry out your financial due diligence, you can of course choose not to buy the franchise.

I find it surprising how many franchisors state in the disclosure document that they do not provide any financial information, and then choose to provide “unofficial” information to prospective franchisees. This is a dangerous practice on the part of franchisors, to say the least.

My advice to potential franchisees that face this situation is to discuss it with their solicitors and to consider making sure that all “unofficial” representations are recorded in writing, because otherwise there is the danger that the franchisor could later deny having made these representations.

SO WHAT INFORMATION MIGHT YOU RECEIVE FROM THE FRANCHISOR?

Most franchisors are of course honest and reputable and wish to provide potential franchisees with useful information to help with financial due diligence.

At the same time, franchisors are concerned that the information they provide is not used against them by disgruntled franchisees – and often by franchisees who do not have have good reason to be disgruntled with the franchisor but who use the franchisor as a scapegoat  for their own shortcomings.

The trend of suing franchisors is on the rise in our increasingly litigious society and franchisors have found the need to be wary about the information they disclose.

I always recommend that the information that the franchisor does provide is cross-checked against other sources – information publicly available, information from other franchisors in a similar industry, and most importantly information provided by existing franchisees in the system the potential franchisee is looking to buy into.

SO WHAT INFORMATION MIGHT THE FRANCHISOR PROVIDE?

Information most commonly provided by franchisors in the disclosure document is actual historical results achieved by existing franchisees. The information will rarely be specific details for specific franchisees. The information will usually be an amalgam of the results of existing franchisees.

Not uncommonly, the franchisor will provide information in three categories – the results for franchisees that are classified as having good financial results, average financial results and below average financial results.

Alternatively, franchise performance might be classified by turnover – perhaps three categories, one for franchisees with high turnover, one with franchisees with average turnover and one with franchisees with below average turnover.

In some cases franchisors will provide projections. That is, the financial information will not be based on actual historical results for existing franchisees but on projections made by the franchisor as to what franchisees can achieve.

This is less common than providing historical information because the risk to a franchisor of being sued for misrepresentation is (and this is an accountant’s opinion, not a legal opinion) far greater when projections are being provided than when a summary of a historical performance is being provided.

It is most important to understand that whatever information is provided, your results will be different. The financial information you are given in the disclosure document is only a guide to what you might achieve.

This is why I said earlier in this article that the purpose of gathering financial information for financial due diligence is to gather information to assist with the preparation by the potential franchisee of budgeted profit and loss and cash flow statements – so the potential franchisee can determine what their results will be.

The financial information that is provided by the franchisor – be it historical results or projections – will differ from your actual results for many reasons.

One obvious reason is that the sales for your franchise will depend on factors such as the hours of operation, the area of the franchise where a physical location is involved, demographic factors, etc. Another reason is that your business structure and operating methods may be different to other franchisees.

FOR EXAMPLE:

• Financing costs – some franchisees need to borrow money, others don’t. Some franchisees might lease equipment, others might acquire it on hire purchase. So for different franchises in a particular system, the financing costs might be very different.
• Tax costs – if a franchise is being assessed on an after-tax basis, then the tax costs of different franchises are going to be very different. Franchisees might operate as companies, trusts, sole traders or partnerships. The tax outcomes of each of these business structures may be very different.
• Employment costs – some franchisees will pay themselves fair salaries and others won’t. Some franchisees will take income in the form of trust distributions. Some franchisees will have other family members working in the franchise, some or all of whom may be paid a non-commercial salary.

All of these factors mean that the information that you are provided by the franchisor is only a guide to what you might achieve – and sometimes only a very approximate guide.

It is worth pointing out that a franchise disclosure document must, where the earnings information is a projection, state whether the projection includes depreciation, salary for the franchisee and the cost of servicing loans, and must also provide assumptions about interest and tax. This is not a requirement where the information provided is actual historical results of franchisees.

Finally, a mention of cash flow. The information provided by franchisors is usually profit and loss based – it will be information about sales and costs, whether they are historical results or projections. What the franchisor does not usually provide is cashflow information – what a franchisee’s cash requirement likely to be.

Profit and cash can be and very often are two very different numbers. To illustrate, when a franchise sells an item for $3 that cost $1, it makes a $2 profit. However, if the item is sold on credit, there is no cash in the bank until the item that has been sold has been paid for. So, the day that the item is sold for $3, there is a $2 profit, but there is also a $1 bank overdraft – the cost of the item that was purchased.

When you apply this simple example to many businesses – which may involve purchasing stock, selling items on credit, buying items on credit, buying assets and then depreciating them etc. – the outcome is often that cash at bank at the end of any period will be very different to the profit at the end of the same period.

It follows that both profit and loss and cash flow must be considered when doing due diligence and making sense of the franchisor figures.

Tim is a director of Lanyon Partners Chartered Accountants and heads up their franchising division.