Investing in an International Franchise Concept

What you need to know about investing in an international franchise concept.


Investing in an International Franchise Concept

The franchising sector in South Africa continues to grow by between 15% and 20% every year, making it one of the most attractive markets for international franchisors.

Entrepreneur spoke to Eugene Honey, head of Trade Mark Prosecution and Commercial IP at Bowman Gilfillan and a member of the Franchise Association of Southern Africa’s executive council, to find out more about what local entrepreneurs need to know when researching and buying into an international franchise system.

Exchange Controls

When you decide on the home you want to buy, you have to await bond approval. The process of buying an international franchise is similar. Until exchange control approval has been obtained from the South African Reserve Bank (SARB), the franchise agreement is suspended. Exchange control authorizes payments – such as royalty fees – going out of the country.

The exchange control department of the SARB will examine the franchise agreement and determine whether the royalties fall within certain parameters and are not unreasonably high. It is unlikely that approval will be granted for minimum royalties – set fees which are payable regardless of financial performance.

Upfront fees must also be deemed reasonable for payment approval to be granted. Application to the exchange control authorities is made via brokers at any of the leading banks.

Financial Muscle

The financial strength of the franchisor is crucial to your survival. Determining the financial viability and stability of a franchise system, however, is never an easy task. “A complete due diligence must be done, including a detailed analysis and appraisal of the business so that you can ensure that there is nothing which contradicts your understanding of the current state and potential of the business,” says Honey.

The franchisor should be able to prove that the product or service has yielded at least three successive years of profitable trading, preferable five. Failing that, the investment may be risky. The franchisor’s financial statements and profit projections must stand up to expert independent scrutiny.

Collect all the financial data pertaining to franchise and present it to your accountant for financial analysis. If there is a flaw in the financial picture presented by the franchisor, your accountant should be able to spot it.

It’s advisable to obtain an up-to-date credit rating on the franchisor and its principals, as well as a credit rating from a credit-checking organization. Be aware that the franchisor is bound to inform you of any on-going or pending litigation against the business.

“To establish the financial stability of the master franchisee in South Africa, your best source of information is existing franchisees,” notes Honey. “Contact them, find out if they are profitable and ask them what level of support they receive from the master franchisee. If advertising support has suddenly dried up, for example, is it because finances are tight? The franchisees are at the coalface; they know better than anyone else what is going on at the heart of the business.”

It’s always advisable to bring in a consultant or a business broker to help you assess the financial status of the franchise operation before you make a final decision.

Paying Up

When it comes to franchising systems, there is a general principle which most people are unaware of. “Franchisees should not pay more than 25% of profits to the franchisor,” says Honey. “This figure may vary slightly depending on the value add and services provided by the franchisor, as well as the profit margin of the franchised outlet, but it’s good to bear in mind.”

The average fee in South Africa is 8% for royalties and 3% for advertising, depending on profitability. Because this figure is linked to the turnover of the outlet, the franchisee is not affected by fluctuations in exchange rates as the royalty is reflected as a percentage of profit.

“If the net margin is bigger than average,the franchisee can sustain a higher royalty,” adds Honey. “It’s important to assess this upfront. The whole point of a franchise system is that it’s a partnership which must result in a win-win situation for those involved.”

Don’t expect to qualify for a lower up front franchise fee just because you’re a pioneering franchisee. By the time a franchisor is ready to expand internationally, the system is well developed and all business processes have been refined; it is therefore highly unlikely that you will qualify for a “discount”.

Should you wish to exit the franchise at any point, the franchisor or master franchisee will generally have first option to buy the business from you. Note that this is not a buy-back option and there are no guarantees given in advance

The Legal Stuff

  • How do international tax laws affect local franchisees? “South Africa has double taxation agreements in place with most of its trading partners, eliminating the double taxation of income,” says Honey. “This means that franchisees do not have to pay tax twice.” As a rule, franchisees in any country are governed by the tax laws of their own state.
  • Are local franchisees subject to international legislation? They may well be because licensing agreements are often subject to the laws of the country in which the franchise system is headquartered. “A US franchisor, for example, is likely to want to be protected by US law,” says Honey. “However, where a franchisee signs a franchise agreement with a master franchisee, it is most likely to be governed by South African legislation as both the master franchisee and the franchisee are operating locally.

Thus, foreign laws generally come into play only when the local franchisee is dealing directly with the international franchise.”

  • Check trademark class registrations.Trademarks are registered in different classes in accordance with the International Classification of Goods and Services. The classification is divided into 45 different classes that sub-divide into 34 goods and 11 service classes. For example, wholesale and retail services fall into class 35, while clothing falls into class 25. The practicality of the classification lies in the fact that protection is afforded to the mark in the classed in which it is registered. Protection is also given to goods similar to those contained in the specification. “Check that trademarks which are being licensed from the franchisor are properly protected,” Honey advises. “Most franchises sell a range of products and services and it’s important to ensure that all are protected in this country.”
  • Check domain registrations. Very often the local franchise system will have its own website. Make sure that the domain name is registered in the name of the franchisor. If it is not, the franchisor may enforce their rights on the basis of trademark registration
  • Does the franchise agreement comply with local laws? You may be given disclosure

Documents that are used in the US or Australia, for example. Your legal advisor will be able to make any recommendations regarding changes that need to be made in line with South African law. This is particular pertinent at the moment, given the Competition Act and the new Consumer Protection Bill.

  • Does the franchise agreement comply with local industry regulations? A franchise in the food or restaurant industry, for example, will have to comply with local regulations. This is unlikely to pose any problems for local franchisees as they are generally aware of all these requirements before they go into the business.
  • Are local franchisees protected against change of ownership of the international franchise? There is little protection offered, but the overseas franchisor usually transfers its rights to the new owner and business continues as usual. Established international franchises are well organised and it is unlikely that the sale of the franchise will affect franchisees. Where the franchise system is smaller or newer, it’s best to be more cautious.

SA’s Changing Legislation

“Be aware that franchising law in South Africa is changing and developing, particularly around the Competition Act and the new Consumer Protection Bill,” cautions Honey. “Broadly speaking, the Competition Act states that franchisors cannot specify prices or maximum discounts, and that franchisees are entitled to charge what they feel is reasonable.

“The Consumer Protection Bill, expected to come into effect soon, affects every transaction in the country. It introduces the concept of contracts that are reasonable, fair and equitable into our law for the first time. In the past, a contract was binding on the parties involved. Now, if a contract or term is not reasonable, fair or equitable, it can be struck out.” Franchise agreements and disclosure documents should therefore be audited to ensure they comply with both the Bill and the Act.

For more information contact Bowman Gilfillan on +27 11 669 9000 or visit www.bowman.co.za or contact the Franchise Association of Southern Africa on +27 11 615 0359 or visit www.fasa.co.za.

Monique Verduyn
About the Author
Monique Verdyun is a regular contributor to Franchise Zone. Franchise Zone is published by Entrepreneur Media SA. It offers advice and franchising opportunities in South Africa.

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