Royal Commission a warning to questionable franchises

December 12, 2018

Franchise businesses should see the Banking Royal Commission as a warning of the kind of increased regulation and scrutiny that could come if they fail to improve support for franchisees.

From pizza to pastries, chocolate to chicken, it has been a devastating year for food franchises in particular, and the number of mum-and-dad investors and small business owners burned will only draw more attention from government and regulators.

A wave of legislation has flowed on from the Royal Commission in the financial system, with measures designed to stop some businesses taking advantage of everyday Australians or individuals.

Eighty percent of franchisees are the same individuals that also get wrapped up in superannuation issues with their financial planners or in fraudulent investment schemes. These individuals may not be aware of new requirements to protect and disclose information on certain matters, brought about by legislation changes.

Australia has seen a flurry of high-profile food franchises collapse in the past year, including Jamie’s Restaurants, New York Pizza, Hombre Mexican Cantina and Oliver Brown chocolatier. In May, a group of Red Rooster and Oporto franchisees complained they were being “pushed to bankruptcy” while a deal to rescue chocolate franchise Max Brenner from collapse last month appears to have fallen over.

Long-standing concerns about franchise models, including whether the Franchising Code of Conduct remains effective, are the subject of a Senate Inquiry due to report next month. The Code is intended to assist franchisees to make an informed decision before entering a franchise agreement, including requiring investors to provide evidence they have received independent, legal and accounting advice. However the requirements are not enough to protect many people, including those swayed by enthusiastic marketing and optimistic forecasts. The Code is not detailed enough and has too easily become a tick and flick process for potential investors.

In recent years there has been a lot of encouragement from business coaches for businesses to franchise as a means of generating high levels of wealth for minimal output. Franchising essentially allows businesses to sell a methodology and let the franchisee take on the risk of building the business. People investing in franchises are often not experienced investors; they're certainly not wholesale professional investors. They are often mums and dads who have worked hard for the savings they are now investing into the goodwill of someone else's business model.

More than 1000 complaints have been reported to the Mediation Adviser for the Code in the past two years, with more than half relating to 10 per cent of franchisors. Some franchises have up to 50 separate complaints lodged. Exacerbating the challenge is the rise of new franchises, often without a tried-and-tested business model, or franchised by start-ups with the main goal of raising capital. A 2016 report into franchise found 42 per cent of brands began franchising immediately, or within the first year of operation.

To minimise risk, people interested in investing in franchises should look towards brands that have a strong history of success with outlets across a variety of locations – this is evidence that the business model can work across a large scale. Key red flags for potential investors include high franchise fees, expensive locked-in agreements around supplies and compulsory marketing and administration costs that might not benefit the franchise owner. Other red flags include an unwillingness from the franchisor to be transparent about its earnings, about the turnover of new and old franchisees, and whether the franchisor offers assistance in reselling.

While a Royal Commission into Australian franchises is not yet necessary, the process set up to protect those investing in franchises needed to be rethought to include a best-practice mechanism and an audit and quality assessment process. The quantum of money invested in franchises is possibly the biggest investment individuals in Australia will make, second only to their superannuation. With the sales turnover for the Australian sector estimated at $146 billion, there is a pressing need for a framework to protect the interests of Australians who invest in the model.

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