Erasibo Consulting

This is the fourth article in our series on franchising (especially restaurant franchising). Best to familiarise yourself with our other articles which sets our tone.

Continuing on our series of articles on the franchise industry in South Africa, we want to look at the Consumer Protection act and what it’s impact is on the franchise industry?

The Consumer Protection Act is the second major development in favour of consumer protection in recent years. The first being the National credit Act which is designed to improve transparency; prohibit unfair contract terms and practices; and prohibit anti-competitive practices. The Consumer Protection Act is designed to protect consumers from exploitation and unfair practices by unscrupulous businesses, and to empower consumers to make wise purchasing decisions. Together these Acts entrench the protection of consumers as prescribed under the Constitution of the Republic of South Africa.

Rights of Consumers

Under the act, franchisees are regarded as “consumers” and franchisors as “suppliers.” Franchisees are given a number of consumer rights, including the right to equality, privacy, choice, information, disclosure, fair and responsible marketing, honest dealing, fair agreements, fair value, good quality, safety, and supplier accountability. Franchisees are also protected against undue influence or pressure; unfair tactics; and false, misleading, or deceptive representations concerning material facts. This would also apply to the contracting arrangements between franchisor and franchisee.

Franchise Agreements

Under the Act a franchise agreement is defined as an agreement where a franchisor grants to a franchisee for consideration a right to carry on business under a system or marketing plan substantially determined or controlled by the franchisor. In addition, the franchisee’s business is substantially or materially associated with advertising schemes or programs or with the trademarks of the franchisor, or any combination of these that are licensed to the franchises. The agreement must be in writing and signed by at least the franchisee. The Act allows for a cooling of period of 10 business days, wherein a franchisee may cancel a franchise agreement they have signed without incurring any cost

The right to full disclosure is entrenched in the Act. This is in recognition of the number of cases where franchisees had been devastated financially after investing their life savings into franchises that were sold to them on the premise that the franchises would be far more profitable than they ever actually would be. Under the act, franchisors will be required to disclose certain information to prospective franchisees, as provided in regulations to be promulgated by the Department of Trade and Industry.

Monopoly on the Supply of Goods

Currently, franchisees in South Africa have limited protection against unfair practices by franchisors under that country’s Competition Act, particularly in relation to the tying or bundling of unrelated products by a dominant franchisor or when it comes to exclusive dealing. Complaints stemming from these activities are, however, difficult to prove, and the franchisor in question has to be dominant or have market share.

The Act has taken the foregoing prohibitions in South Africa’s Competition Act and applied them regardless of whether the franchisor is dominant. The new law prohibits bundling or tying of products by a franchisor, unless the franchisor can show either (i) that the bundling results in economic benefits for consumers or (ii) that the convenience of bundling outweighs any restriction on consumer choice. Alternatively, the bundled goods or services must be offered separately and at individual prices.

The Act guards the right to consumer choice by generally providing that franchisors must not require, as a supply condition or as a condition of entering into an agreement, that the franchisee purchase goods or services from the franchisor or from any other designated supplier. It is a valid defense to show that products or services that the franchisee was required to purchase are reasonably related to the branded products or services that are the subject of the franchise agreement. It remains to be seen how closely linked to the brand “reasonably related” will need to be to excuse such a requirement by a franchisor. As a result, many franchisors will no longer be able to be the sole supplier of goods and services to a franchisee, unless it can be shown that the products and services are “reasonably related” to the brand.

Franchisors should take care to ensure that products and services essential to the protection of their brand are explicitly listed in their franchise agreements, to reduce any later issues regarding interpretation. In other words, the Act suggests that franchise agreements provide for core and non-core products. Core products or services would be the primary, unique products related to the brand.

With regard to transitional provisions, it appears that the Act will not apply to pre-existing franchise agreements (or transactions) entered into before the general effective date, expected to be October 2010. However it will apply to renewals of contracts. The Act highlights a number of factors relating to fair and honest dealings and unfair unreasonable and unjust contract terms. The Act allows for the cancellation of contracts, whole or part should it be deemed to have contravened these principles as detailed in the Act.

Closing

The Act will have huge implications for the franchise industry. For while it has boomed has also become a place for corrupt, fly by night operations.  The Franchise Association of South Africa has expressed concern with regard to the implication of the Act and the burden it will place on its members. This is a concerning position as the Act can only create credibility for the franchise industry by ensuring that it closes the gap for illegitimate franchisors to operate.

Surely this would be a benefit to FASA, to cleanse the industry of undesirable operators. Franchisors who lack the capacity for adequate, transparent contracting and operations shouldn’t be selling off franchises. Organisations like FASA shouldn’t be accepting these franchisors as members or providing a potential front for their operations.

This is the third article in our series on franchising (especially restaurant franchising). Best to familiarise yourself with our other articles which sets our tone.

Commercial banks are part of legitimate business. We trust them with our savings, we store our incomes in them, and we borrow money from them, all the time assuming that the transactions are legitimate and reasonable and regulated to some extent. We rely on them for every aspect of functioning of civilised life-homes, cars, business, school fees and personal events.  We also expect that they will exercise reason in their interactions with us because their survival depends on the patronage of their clients. So their responses to us are based on good credit lending praFFrctices and when banks make errors in planning, governments are hard pressed not to finance their recovery with taxpayer’s money, as in the case of the US recently. Banks are essential to the stability of our economy; citizens and the banks share a common investment in our economic future.

But have banks gotten too big for us. Do they represent something untouchable? So when they repossess homes and cars in a panic about the money that is being lost like a waterfall without following the specified due processes outlined in those contracts is this acceptable under the circumstances or is this just a case of bullying. And what really is their responsibility as the credit provider?

In responding to this question I will share with you our own insightful experience with the banking environment recently, which has been the cause of much debate within our own inner circle.

We took out a loan to finance a franchised restaurant. After the bank evaluated our application they informed us that we were not disadvantaged enough to qualify for any form of BEE preferences (the words used were “not black enough”). This opinion of the banks was nether policy nor constitutionally justifiable. However, we were in love with the business idea, so we didn’t make a scene. We put up 40% of the financing required for the franchised restaurant we wished to buy. The bank confirmed that it had done a due diligence on the restaurant and the franchisor and was extremely happy with the results and would finance the deal.

In fact the franchisor was so highly credible to the bank, that the bank offered them great deals on banking and transacting facilities for their franchisees and they offered the group an approved financing facility for all new franchise restaurant setups. Since we knew what the obligations placed on the bank were by law to thoroughly assess any new deal we felt extremely confident in all the new “benefits” the bank was offering the franchisor.

So when the figures provided to us and the bank by the franchisor turned out to be deliberately exaggerated and show that a fraud was committed by the franchisor so as to ensnare us in the business deal the issue of what exactly is the responsibility of banks in this circumstances was raised by us. The answer apparently is that the banks have no obligation. The bank completed a FICA assessment of the franchisor; their results didn’t cry out any kind of foul – it should have. There was evidence of their foul practice’s aplenty, which at the time was outside of our sphere of access.

Now that the bank is aware that there was a fraud committed by the franchisor does it discontinue giving out loans to new franchisees wishing to purchase restaurants in the same group or does it blacklist the group? No of course it does not.

Granted our matter hasn’t been to trial yet, but we can supply details (irrefutable forensic evidence) to the banks legal department and they can make a judgment about the caliber of clients they want to maintain or their obligation to new investors. If the bank continues to give out loans to unsuspecting buyers wishing to take up opportunities within the same group, would the new franchisees be able to sue the bank for facilitating a fraud since the bank has knowledge that the franchisor is suspected of fraudulent behaviour?

At the very least the bank should consider suspending any new deals pending our case going to trial and being decided on, because should we win our case the franchisor may not be able to operate anymore and new franchisees would be placed at risk of defaulting on their loans, which is a risk to the banks bottom line.

At the very minimum this franchisor has committed FICA fraud? Should the bank not have called in SARS immediately? The bank leverages their risk on personal sureties signed by borrowers – the franchisees, so whatever happens with the business, the bank will get its money one way or the other. But should they? The National Credit Act outlaws irresponsible lending and by this it means that the banks assessment of whether a borrower is suitable for credit has to do with an assessment of the borrower’s ability to pay. If the borrowers ability to pay has everything to do with the business’s capacity to generate a certain profit, and the business was in fact never able to do that as the figures provided were a fake. Is the bank not responsible for irresponsible credit provision?

I’m not suggesting that the banks share responsibility for your business decisions or mine. You go to the bank for financing not buying into your idea. But they do have a role to play in not perpetuating a fraud when they know about it and they do have a job to ensure that there facilitation is not being used for money laundering or other such activities. The new Consumer protection Act certainly talks to the issue of facilitating fraud and specifies the right to have contracts cancelled in this case. What does that mean for a bank that knowingly provides financing to fraudulent franchisors. Can those loans be cancelled and they held responsible for the transaction?

On the cross side asking the banks to take more responsibility will be ensuring that loan facilities become even harder to access and you will pay for this risk in the repayments.

If you are hoping to see your banker as a partner in your business, best check out the development bankers, such as the Industrial Development Corporation or National Empowerment Fund. Since they accept a high percentage of risk they are better at evaluating the risk with you. If the business collapses they lose their cash too. So if you have to go after a franchisor that has defrauded you have a big partner on your side and you are out a considerably less amount of cash.

We have dedicated this blog to put up a number of thought pieces on the franchised restaurant industry in South Africa. We do this because the franchised restaurant industry has great personal interest for us as a result of our recent experience of having bought, run, cancelled the sales agreement and sued the franchisor.

As management consultants we have worked with researching, conceiving, redesigning, managing, marketing and evaluating all ranges of businesses- big and small. So when confronted with the challenge of buying a suitable franchised restaurant- it seemed like a “no brainer”!  After all we had evaluated and ran much bigger business investments, and restaurants have been an area we have researched extensively. In addition most franchisors we encountered were not the most sophisticated business people. In fact many were poorly educated but flamboyant characters. Plus we had resources to support our decisions- we had assistance from deal makers who put together billion rand investments and one of the oldest and largest law firms in the country (been around since the days of the gold rush). So we were ready to take on this industry and make it a success.

But still we got scammed.

Being scammed hurts your pride as hard as it does your pocket. But the experience of it has been priceless. We have interrogated all aspects of the business in detail. We have learn an incredible amount about the contracting, financing and operating a franchised business in South Africa We have also discovered a great interest in the prevention and investigation of fraud in businesses- which has become a new area of consulting for us. We have developed amazing contacts in forensics and with the specialised units of the police and security industry and banks.

There are unique aspects to South African businesses, from its closeness to organised crime to its labour issues. We (Garsen and myself) shall share with you some of the pointers and tricks to surviving a franchise investment in subsequent articles in the hope that you will benefit from our experience, research and learnings.

Lets fall in Love:

So we made a few mistakes. The first being that we found love. We found it in the business we wanted to buy- it was doing a great trade in a “recession proof” end of Johannesburg. We liked the franchisor they were young, daring and dynamic with a fast growing empire. We also liked the partnership approach they adopted to working with their franchisees and saw much potential for working together with them to build something better. This fit well with our needs. We did not originally come from a background in retail; in fact we have spent the last many years of our working career scoping, designing, marketing and rebuilding businesses of others. Broadly referred to as management consulting. Consulting is fabulous, intellectual, challenging and we had gotten really good at creating something from nothing. But we needed more ownership, more emotional investment. Food has always been my idea of sensuality-passionate love (sad I know!). So finding this fit of restaurant and franchisor felt like the coming together of a puzzle. That should have been the first warning sign. Anything too good to be true- usually is! But this was pure seduction and we were in love with the idea of the business. So this brings us to our first lesson we share with you, of loving the deal and not the business.

Whatever your motivating to get into franchising- whether you are looking for something low risk to start- working off a proven business concept, or have extra cash to put into an investment or been enticed by the advertised success rates or the business itself and the prospects thereof. Whatever the reasons, negotiating for the business has to be the prime focus and not the business itself.

How you negotiate for the purchase inevitably determines what happens thereafter in your business not sparing your leverage should you engage in legal battles with the franchisor. Unpleasant as this thought may be. A business doesn’t come with guarantees and no one is going to take care of your interests except you. So diligently cover all the areas of the contract and be more persistent than the franchisor is resistant, make sure you get what you want from a deal or you take your business elsewhere.

About the Contract:

The most important vetting exercise is really to find out how you can be in this business that you think you like without signing a franchise contract. If you can do that effectively, your return on investment over what would have been the franchise period will be at least double. And, no matter what they tell you, franchisees never have a better chance of success than independent, unaffiliated new business start-ups. The likelihood for success is exactly the same either way. Unless you are buying into a big brand concept, like a McDonalds or KFC which has a unique product that customers identify with. Being someone’s franchisee makes absolutely no difference whatsoever. There are usually many ways to obtain equivalent start-up and continuing support assistance without having to sign a franchise agreement. You just have to take the trouble to find out where they are. In most cases what you pay to set up a business or for the acquisition of an existing business is far in excess of the value of the business you are buying. Furthermore you continue to pay royalties for a name which in most cases has limited capital but comes with high restrictions that impact on your ability to survive in a changing economy. Also ensure that you know what comes along with your franchise contract. Franchise rules, license products, standard menus etc are all part of the package. These must enhance your business’s chance of survival and not just create another avenue of income for your franchisor- who is now able to force you to purchase new products which they have licensed that may be a lower quality, higher priced good that impacts on your business’s profitability. The Franchise contract must specify these products and the applicable quality standards. I have fond memories of returning deliveries of burnt coffee beans and putrid meats to the franchisor only to receive in return letters claiming breach of franchise agreement.

The representations about the wonderful support that you can expect to receive as a franchisee are always overstatements. ‘You are in business for yourself, but not by yourself’ is the mantra. Don’t believe everything you hear- read the contract to see what you are really being promised. The contract always says — in some form of legalistic sounding language — that you get whatever support the franchisor feels like providing from time to time. That’s it. There is never a contract covenant to provide competent and competitively effective support. But nobody ever figures this out before the franchise investment is made. It is always discovered after the fact, when it is too late and you have bought nothing but the right to sue, if you can afford to sue. Buying the right to sue is always a bad investment!

Consult a lawyer who specializes in franchising. Consider the time and money you put into hiring an expert as an investment in your future. A lawyer can tell you what your rights are in a specific situation and help you craft the right business plan to protect your business. As a business owner, you owe yourself nothing less. Consider the old saying” free advice is worth every cent that you have paid for it”.

One of the primary reasons that franchise scams still exist today is due to the individuals who do not do their homework and invest in these “opportunities”. They allow the bad opportunities to remain in business. Go on line and research news stories about the company and the industry. Visit their web site and get information about their consumer offering as well as their franchise offering. Learn what you can about their management and thoroughly research their background. When you first contact the company ask them about the process they use in selecting franchisees. If you get the sense that they don’t select franchisees but are in the business of selling franchises, that’s the first indication you should have that the franchise is risky. If the company is willing to “sell” you a franchise before you can perform a thorough evaluation of them and they can perform a thorough evaluation of you, that’s another indication of a poor franchise system. If on top of that the salesman you are talking with is not an employee but an outside sales broker that’s even a stronger indication. Remember, unless you buy, the franchise the brokers don’t earn any money. Never pay any monies or deposits upfront. Any franchisor who asks for money before you are happy to commit to an investment cannot be trusted- they are interested in making a sale and not the success of your business.

Conducting the Due Dilligence:

Start off with the disclosure document. Once you get the disclosure document be prepared to analyse it thoroughly. If this is an opportunity that still interests you after you read the company’s information, you should engage a qualified franchise attorney, consultant or accountant to help you in conducting your due diligence. The franchise salesperson or broker works for the franchisor and should not be a source of advice that you rely upon. Neither is your bank. Your bank’s only interest is whether you can pay back your loan- and it’s all the same to them if it’s from the proceeds of a successful business of the repossession of everything you own. So don’t rely on your banker’s advice with regard to the credibility of the franchisor. They will not take responsibility for this advice when the deal turns sour. Rely only on the qualified resources you hired to help you with the due diligence.

What is the financial condition of the company? Your investment is likely to be significant. In some franchises between debt and equity your investment may be more than seven figures. What about the franchisor, will you have more skin in the game then they do? Do they have a history of profitability? Are they earning their revenue from royalties and other continuing sources of revenue or are they relying on the sale of the next franchise to make payroll. Even new franchisors need to have financial resources to meet their commitments.

Whats the Franchisor’s Litigation History?

Franchisors must disclose relevant litigation. Sometimes litigation is good. Any franchisor that enforces system standards will occasionally need to sue its franchisees. If they are able to still maintain a good relationship with their other franchisees than that type of litigation is an indication of a strong and responsible franchisor. However, if there are pages upon pages of lawsuits from franchisees in the disclosure documents, that is not a good sign. You need to understand the basis for the lawsuits and make a decision based upon the facts. Your attorney can help you analyse the franchise litigation. These are just a few of the questions you will need to assess in determining whether the franchise is a scam. Your outside advisors will be able to help you put aside your entrepreneurial burn to get into the game and assist you in conducting a proper due diligence on the opportunity. Don’t get into a franchise unless you have the assistance of a qualified expert. The franchise salesman that has befriended has the advantage of having been through the selling process hundreds of times. This is likely to be your first experience.

No Current Franchises:

Treat a franchisor that has few or no current franchises with extreme caution. In the past, it has not been unheard of for companies that have never actually opened a single operating unit to aggressively sell franchises to unsuspecting franchisees. Naturally, the few franchisees that were eventually able to open for business failed because the company’s franchise business plan was ill-conceived and had never been tested. Minimally, the franchisor should be able to document the success of several existing franchises. They should also be willing to put you in touch with current franchisees so that you are able to confirm their success firsthand.

Inferior Selection Process:

Something else that should make you cringe is an inferior selection process. Quality franchisors run potential applicants through a fairly comprehensive selection process. This process screens applicants not only for their financial capacity to purchase a franchise, but also for their industry experience and their ability to manage a small business. If a franchisor doesn’t seem to be interested in any qualifications beyond your ability to buy into the franchise, bells and whistles should be going off. It’s quite likely that the success of the franchise isn’t a real concern for these franchisors. All they’re really looking for is a way to make a quick buck – at your expense.

Lack of Verifiable Financial Data:

Legitimate franchisors should also be able to produce verifiable financial data for the company as well as data for individual franchises. This information is vital in helping you assess the feasibility of owning a franchise should you decide to do so. You not only need to know the earnings of a typical franchise, but also whether or not the company’s financial position is sound enough to ensure its long-term survival. If a franchisor is hesitant or unable to produce financial data it’s usually because the numbers don’t paint a very rosy picture. Make sure that you get raw sales data as well as financial accounts. Financial accounts which are provided are only useful if they are audited statements and not internal management accounts. You must be able to get your auditors to do a verification of these figures from the raw data sources and an audit of equipment that is part of the sale. Remember the registration numbers of equipment on the audit must match that which you receive as part of the sale. Also compare the financials with what the franchisor says it is paying in tax- this gives you a good indication of income and/or the honesty of your franchisor. Avoid investing in a franchisor that is changing banks at the time of your deal. You may not know the reason for this decision, but it does break the “audit trail” and that prevents you from getting essential information.

Inadequate Disclosure Documents

Franchisors are required to provide franchisees with disclosure documents specifying the details of franchise ownership within their company. If the disclosure documents are overly vague and the franchisor is unwilling to fill in the blanks with details, run away from the opportunity as fast as you can. Otherwise, you risk becoming tied into a dead-end business with little (if any) legal protection for your interests. This disclosure must also include breech letters from landlords, financiers, health and other violations and summons and all licenses contained by the business.

Finally, make sure that the contract is everything it is supposed to be. If they promise that you will make a certain amount of money or that your expenditure is pitched at a certain level, you need to get it in writing in the contract, otherwise, you have no guarantee that they will follow through on that promise.  Also, it is strongly recommended that you get a lawyer to read through the contract before you sign anything, no matter how confident you are in your ability to understand it and the reputability of the company. Experience does count so bring in a specialist- much better to avoid the bitter personal experiences.

While some franchises do offer a good business concept, there are many scams out there and many businesses serve as fronts for organized crime and money laundering. Also many franchises are nothing more than a pyramid scheme the only beneficiaries being those first pioneers of the franchise. So beware in your dealings and look out for inconsistencies and hesitations- you could be dealing with a scam. Pay upfront for good advice its way cheaper than the forensic and legal costs that follow later if the business deal was not transparent and turns into a failure or a fraud. At the end of the day- all business is a risk. There are no guarantees against outright and clever fraud, as we had discovered in our own experience. But the above pointers protect you against the likelihood of you being a victim of a scam. Most importantly don’t begin any negotiations until you have worked out what you are looking for in deal. If the deal on the table is not the deal you want- simply walk away. There are many other options available to you. Do not compromise. Look for the deal you will love.

A concerning article which appears in the www.iol.co.za written by Ntokozo Mfusi which highlights that an 18 percent electricity price hike is proposed by Eskom for the next two years. It further notes that this increase will have a follow through impact on the price of water.

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The data for that article was sourced from the National Energy Regulator of South Africa’s public hearing on electricity prices which was held in Durban on 20 November 2007, where an Umgeni Water representative reported that the proposed hike in electricity tariffs would cause subsequent rise in water prices as well. He noted that electricity is one of the primary drivers in the process of purifying water; therefore the rise in electricity prices will necessitate an increase in water prices.

While there is unlikely to be single South African citizen at this point in time who is unaware that we have a problem with electricity supply and the need to conserve energy, given the rolling black outs that have become a way of life of late. Arbitrary, blanket increases are not the solution. We need to find a way to deal with poor long term planning of resources, poor spatial planning in urban areas, wastage etc. These are planning issues that need to be affected properly with a long term view and understanding of the impact it has on all other aspects of government and public functioning. It needs to be communicated well to the public and partnered with the public to find a resolution. Crisis functioning is the reason we have a problem in the first place. Punishing citizens with price increasing merely exacerbated the problem, as citizens believe that they are being forced to compensate for inept government functions.

Electricity and water are scarce resources in South Africa and many South Africa citizens still have no access to these resources or are unable to afford them at current prices. Providing services to all citizens has been a challenge for municipalities and has been the reason a Free Basic Service (FBS) policy has been championed by government. To ensure that all citizens can have access to services, as is their constitutional right. An increase in the cost of both electricity and water, will impact hardest on the poor, who are already unable to pay for these services and will impact on the ability of government to roll out the FBS programme. It will add a further financial burden to municipalities who at present are struggling to manage their functions in a fiscally responsible way and are forced to subsidise the costs of vast numbers of their constituency instead of relying on service delivery as a municipal income. This burden on municipalities will then have to be relieved by the national fiscus.