Harmans Lawyers
08 April 2020

Succession Planning – Thinking About The End Game

All Articles & News, Commercial Property, Franchising

This article was written by Mark Sherry and was first published in the Australia and New Zealand Business Franchise Directory, and has been reviewed and updated in April 2020.

When advising people looking to buy into a franchise system, one of the strangest reactions I get is when I ask the question “So have you thought about how you’ll exit this business in the future?”  I find that most people looking to purchase a franchise don’t understand that what they are buying is the right to run a business for a limited lifespan.  Even if the franchise provides for regular renewals, there is no guarantee that those renewals will be exercisable.  A franchisee is only able to exercise their rights of renewal whilst they are in full compliance with the terms of the franchise system.  At the end of the franchise term (many franchises provide for an initial period of 5 years and a further right of renewal for 5 years) the ability to continue in business rests solely on a decision that the franchisor will make.  Therefore, if a franchisee is looking to maximise the return from their business they need to make good profits along the way and then look to sell the business at a time where they can maximise goodwill and capital gains.  Often this occurs early in the second term of a franchise agreement.

Right at the outset when someone is looking to purchase a franchise they also need to understand the obstacles they will face at the time they come to sell.  Not only do they need their business to be prepared for sale, but other factors will influence it such as market conditions and the sale price they are asking.  Then, even if the sale is successful, there will then be restrictions that they will face such as restraints of trade.  They need to able to live with those restrictions at that time.

In short, even at the early stage of looking to acquire a franchise, a buyer needs an exit strategy and an understanding of the fundamentals involved in selling a business.

When thinking about selling a business the obvious thing for the franchisee to consider is how to best connect with an appropriate purchaser.  Buyers can be found through advertising, particularly if a business broker is marketing the business for sale, but they can also be found closer to home.  It may be that an employee is an ideal purchaser.  Alternatively, the franchisor may have potential interest from someone who has approached them directly looking to run a franchise within the territory.  Often another franchisee with a businesses in or close to the territory may be interested in expanding their operations and becoming a multi-unit franchisee. Therefore, it is not necessarily required to follow a conventional approach by listing a business with a business broker, although this will still often be the case.

One thing to consider first is whether the franchise agreement gives the franchisor a right of first refusal to buy back the franchise when it is being sold.  A franchisee needs to be aware of whether they have an obligation to offer their business for sale to their franchisor so that they do not breach this obligation by entering into a contract with another party without addressing this first.  A franchisee could either offer a business to their franchisor prior to marketing it more widely, or they could enter into a sale agreement with a third party subject to the franchisor waiving their right to buy.

When considering potential buyers there are certain factors that a franchisee should consider.  The first is whether their buyer fits the selection criteria that the franchisor will hold them against.  Ideally, the franchisee will take the time to advise the franchisor that they are looking to put their business on the market and will discuss with them important aspects of the selection criteria that the franchisor will measure a buyer against. That way, they can get an understanding of the ideal profile of a buyer and will not waste their time, or the franchisor’s time, in negotiating with an inappropriate person.

It is particularly important that any potential buyer is solvent and reputable as in many instances a residual liability may sit with a person selling a franchise even after the sale has been completed.  This is often the case if the business being sold occupies leased premises, as the assignment of a lease to a new buyer does not necessarily result in the immediate release of the seller from their obligations to the landlord.  Steps should be taken to complete a basic due diligence on the buyer so as to protect the seller’s interests and minimise the chance of residual guarantees being called upon.

An area that can limit the pool of buyers is when a business is of such value that many potential buyers may struggle to find the whole of the purchase price up front.  In such circumstances it is not uncommon for a seller to leave part of the purchase price in the business to help fund the buyer in their acquisition.  When this occurs it becomes even more important for a seller to complete due diligence on the buyer, as a failure by the buyer could mean that the unpaid balance of the purchase price is less likely to be received in the future.

Experienced business brokers and franchise lawyers hold a wealth of knowledge that can be utilised when preparing a business for sale.  They know what potential buyers are looking for and they can help a seller prepare their business for sale by making sure everything is in order to be able to provide a comprehensive due diligence pack to buyers.  This could involve ensuring they sort out financial accounts, checking all employment agreements are in order, all lease and franchise obligations are up to date, and making sure the business is generally presented in the most positive light.

It is not uncommon for a business owner to include some personal expenses in their business accounts, but this has the effect of reducing profit in the accounts.  Further, the sale price of the business is generally calculated by applying an industry multiplier to the net profit.  An example might be that a business should sell three times the net profit.  Therefore, if the net profit is artificially reduced by including extra expenses, this can have a negative effect on the sale price too.  It can take time to alter habits and make sure that a year or two of accounts that truly reflect the profitability of the business are available to review.  Therefore, the planning for a sale may need to start several years in advance of the actual transaction occurring.

As previously mentioned, many conditions can affect whether a sale occurs. Primary amongst them are the price that a business is offered for, the way it is presented for sale, and general overall market conditions. Some of these factors are manageable but some of them are outside of the control of the seller.  Therefore, a seller needs to be prepared to keep running a business as a going concern for as long as it takes and they should not make commitments to alternative projects until a sale is actually achieved.  To do otherwise can put great pressure on a seller as the deadline for the alternative project looms, meaning the seller may need to compromise on price or other terms to try and obtain a deal.

One of the main things a buyer needs to understand at the time they enter a franchise, is the restraint of trade obligations they will face when they are no longer a member of the franchise system.  Typically restrictions can be placed both on the type of industry the seller can work in and the territory in which they can do it.  This can be particularly difficult if the seller has a specific trade or skill that they need to fall back on.  It is very difficult for someone who has been an electrician or hairdresser their entire life to suddenly have to change try and find new employment in a different industry because they have sold their business and they are no longer entitled to practice within that industry for a period say up to 2 years.  If someone has real concerns about the options for employment that they’ll face at the end of the franchise then they should think very carefully as to whether they should enter into it right at the outset.

A final few matters to consider when looking to sell a business include:

  1. Ensuring that employees needs are considered, and if employees are to continue in the business, that they are advised at the earliest opportunity.  Where a business has key employees that need to be retained then this is even more crucial. There are legislative obligations that need to be complied with too.  It is important to take legal advice prior to selling the business so that an appropriate process is followed.
  2. In a sale contract consideration needs to be given to matters such as:
    1. how future warranty claims are dealt with for sales made by the outgoing franchisee; and
    2. how items such as outstanding gift vouchers are to be dealt with if they are redeemed after the settlement.
  3. In manufacturing businesses, complexities can arise in relation to the way stock is valued if it is part way through a work in progress process at the time of settlement.

Serious consideration should be given to all such issues and a specialist franchise lawyer should be involved before negotiations take place so that an appropriate sales and purchase agreement can be drafted that deals with all complex matters.  A purchaser is more likely to accept a seller’s position if a comprehensive sale and purchase agreement is placed in front of them that deals with all issues in a practical manner, rather than having to deal with issues arising at the eleventh hour just before a settlement because someone has suddenly realised that there are matters that need to be negotiated that had not been previously considered. Proper engagement with an appropriate franchise lawyer that understands the issues is an investment well worth undertaking at an early stage.

In summary, success in business is often about proper planning.  It is quite clear that planning to exit a business should start at an early stage (conceivably it should be part of an initial business plan) so that a business is run profitably and presented in the best possible light at the time of sale to maximise the seller’s outcome.  Taking appropriate advice to achieve that success is essential too.