What Is "Due Diligence" in the Franchise Evaluation Process?

by Jason Gerhke, Director
Franchise Advisory Centre

At the point of receiving disclosure documentation, many potential franchisees are recommended by their franchisors to use the Franchising Code's 14-day waiting period to undertake their due diligence on the franchise investment.

The problem for many potential franchisees at this point is that they don't know what due diligence is and may have never heard the term before. They may figure due diligence must be something that is expensive and complicated and therefore done by the lawyers or other professional advisors that they might engage to handle "the paperwork" of the sale.

In other words, it's something difficult done by somebody else. Nothing could be further from the truth.

Due diligence is no more complicated than looking at the facts of a deal from all angles to make sure they stack up.

In short, due diligence assesses the risks and opportunities of a proposed transaction, be it buying a business or entering some other arrangement.

Conducting a building inspection and title search as a condition of buying a house is an example of due diligence in a real estate transaction.

Getting engaged and taking the time to know someone before getting married is a form of due diligence (occasionally supplemented today by Googling a potential partner's details, or searching their Twitter and Facebook pages, etc).

Most people who buy a secondhand car insist on first taking it for a test-drive, conduct a title check, get a mechanic to look over the vehicle, and ask questions of other people who have owned the same type of car. This is considered natural behaviour when buying a car and forms part of our pre-purchase due diligence.

By comparison, why wouldn't a potential franchisee or business buyer want to do the same thing when going into business for the first time?

Unfortunately, many franchisors can recount examples of franchisees who have been too eager to join the system and then conducted little or no due diligence - with the result that their businesses failed to meet their expectations and both franchisor and franchisee become estranged.

Here are some other definitions of due diligence to help potential franchisees understand the concept:

• The process of investigating a potential investment;
• The care a reasonable person should take before committing to a transaction;
• An assessment of the desirability, value and potential of an investment opportunity;
• Background research to determine the worthiness of an acquisition.

Who is responsible for undertaking due diligence?

The potential buyer is responsible for undertaking due diligence. Although there is a statutory requirement for disclosure under the Franchising Code of Conduct, franchisors are not required to ensure that franchisees actually undertake due diligence.

Even where a statutory disclosure obligation exists under the Code, buyers should - as much as possible - seek to independently verify information presented to them in order to reduce the risk of making a purchase decision based on false, out of date or incomplete information.

Buyers will usually involve professional advisors to assist in the due diligence process. These will generally include accountants (to assess financial data and issues), lawyers (to assess legal, contractual and mandatory compliance issues) and specialists relevant to the industry or market sector in which the business operates.

Irrespective of the use of advisors, the buyer takes ultimate responsibility for the decision to invest in the business offered. The buyer takes full responsibility both for the investment decision, and for the completeness of the due diligence process which gave rise to that investment decision.

Buyer to act in own interest
In any commercial transaction, the buyer has a choice to proceed or not proceed with the deal. It is expected that a seller will act in their own interest to maximise their benefit from the transaction, and by the same token, so should buyers.

However, many people who buy small businesses or franchises have little or no prior experience in undertaking such deals. As a result, they may have little or no understanding of due diligence, and instead rely solely on their accountants and lawyers, and the veracity of the information provided by the franchisor.

Unfortunately, without an adequate knowledge as to what a proper due diligence process should involve, the buyer is limited in their ability to protect their own interests. They may fail to seek professional advice in the first place, or fail to understand the advice provided. More importantly, they may simply fail to verify the information provided by the franchisor, and rely on untested detail.

If the buyer does not act in their own interests, they cannot expect that their advisors alone will be able to do so, or that sellers will either.

The cost of due diligence
There are at least two types of cost involved in conducting due diligence: hard and soft costs.

Hard costs are cash outlays, which can be substantial. It requires an investment of time and cash to research information and pay advisors. The Franchise Advisory Centre recommends that potential franchisees be prepared to pay at least between 2-5% of the cost of a franchise on due diligence alone.

In other words, if the franchise costs $100,000, then the potential franchisee should be prepared to spend between $2,000 and $5,000 on their due diligence. If, after conducting a due diligence process a buyer decides not to proceed, then the cost of due diligence will be significantly less than the potential losses the buyer would have incurred if they had proceeded with the business and it subsequently failed.

By far the greatest cost of any due diligence process is the cost of professional advisors (ie. accountants, lawyers and other professionals engaged for their expertise). These advisors will usually work on a per hour or project rate, and so it stands that the greater the investment, the more diligence required, the greater the advisor costs will be.

It goes without saying that professional advisors acting for the buyer will require payment whether or not the buyer completes the sale.

While this could mean that the buyer will "lose" the cost of the due diligence by not completing the sale, this might be a very small loss compared to the cost of buying an unsuitable or unsustainable business.

Soft costs are the costs of the buyer's time. Time spent researching a business is not something a buyer can expect to be paid for or have deducted from the purchase price of the business.

The buyer invests their time and energy in considering the transaction, and should the transaction not be completed, the buyer at least is usually better-prepared and more experienced to undertake the next due diligence process.

As a general rule, potential franchisees should make a due diligence soft cost investment of one hour of time per $1,000 to be invested in the business.

This can be spent on researching the specific business opportunity, as well as the industry and business in general and will ensure that a reasonable amount of time is allocated to assessing the risks and opportunities of the proposed transaction.

Verify disclosure information
Potential franchisees will rely primarily on information provided in the franchisor's disclosure document, and should make every attempt to independently verify each item in the document to ensure that the information presented is current and correct. It is important to remember that disclosure documents under the Code are required to be updated within four months of the end of the financial year (which for most systems will be October 31 for the preceding 12 month period July to June).

Consequently, a franchisee who receives a disclosure document in July, August or September in any given year could be looking at information which is 12 months or more old.

If this is the case, the potential franchisee may choose to request a more recent disclosure document, or defer a purchase decision until after the disclosure document is updated.

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About the Author
Jason Gehrke is a director of the Franchise Advisory Centre and has been involved in franchising for 18 years at franchisee, franchisor and advisor level. He provides consulting services to both franchisors and franchisees, and conducts franchise education programs throughout Australia. He has been awarded for his franchise achievements, and publishes Franchise News & Events, Australia's only fortnightly electronic news bulletin on franchising issues.