The requirement does not force franchisors to guarantee franchisee profitability. It does require franchisors to have discussions with prospective franchisees about whether there is a reasonable opportunity to recover their investment and make a return.

What does a reasonable opportunity to make a return mean?

Importantly, this does not require a franchisor to guarantee that a franchisee will make a profit. The ACCC nevertheless expects the franchisor to consider the commercial substance of the opportunity, including:

• the required investment;
• the length of the term of the agreement;
• the business model;
• the business model;
• the location;
• the fees and costs;
• competition;
• the franchisee's skills and resources; and
• the support the franchisor will provide.

An acknowledgment in the franchise agreement that the franchisee had a reasonable opportunity to make a return may help identify the parties' intention, but it will not remedy an agreement term that is too short, a site that is not suitable for the required investment, or a business model that leaves no realistic margin after fees and operating costs.

As a general guide, the greater the investment required by the franchisor, the longer the franchise agreement will ordinarily need to run to give the franchisee a reasonable opportunity to recoup that investment and make a return. This is not a fixed rule, and the appropriate term will depend on the business model, expected margins and other circumstances of the proposed franchise.

Start the process before issuing documents

Franchisors should address return on investment in two stages. Firstly, before issuing franchise documents, they should test whether the proposed term and commercial structure provide the prospective franchisee with a reasonable opportunity to recoup the required investment and make a return. If not, they should revise the commercial terms, provide additional support or, where appropriate, decline to proceed.

Secondly, after issuing the disclosure document, and before the parties enter into, renew or extend the term or scope of the franchise agreement, the franchisor should resolve any outstanding issues and complete the mandatory discussion about disclosed significant capital expenditure.

A franchisee’s willingness to proceed does not cure an agreement that fails to provide the required opportunity.

A structured conversation before issuing documents allows the franchisor to:

• identify every material investment that the franchisor will require at commencement and during the term;
• understand the proposed site, territory, lease and transaction structure;
• identify any mismatch between the franchise term and the expected timeframe to make a ‘return’ on investment;
• assess whether the prospective franchisee has the skills, resources and funding needed to operate the model; and
• decide whether to change the commercial terms, provide additional support or in some cases, decline to proceed.

It is important to note that a franchisee’s willingness to proceed will not cure an agreement that does not provide the required opportunity.

Franchisors should treat the process as having two stages.

Pre-documentation conversation checklist

Before entering into a new franchise agreement, or renewing or extending an existing agreement, franchisors should:

• confirm the proposed franchise site, and raise any site-specific concerns with the franchisee;
• identify and discuss with the franchisee a complete list of anticipated upfront and ongoing required investment;
• compare the expected time period to make a return on investment against the initial franchise term and lease term;
• address any questions from the franchisee about the assumptions used in financial information provided, including assumptions about profit margins, operating costs, working capital and debt servicing;
• address local competition in the franchise territory;
• assess the prospective franchisee’s skills, role, funding and support requirements;
• decide, before sales discussions begin, whether the franchisor will provide historical or projected earnings information, who may provide that information and the approved form in which it may be provided; and
• document all conversations relating to the franchisee’s ability to make a return on investment.

Significant capital expenditure

The return-on-investment requirement overlaps with the new significant capital expenditure rules. The franchisor should identify planned or reasonably foreseeable expenditure, including refurbishments, relocations, rebranding, new equipment, software and technology upgrades.

Before the parties enter into, renew or extend the term or scope of the agreement, the disclosure document must include as much information as practicable about significant capital expenditure required by the franchisor. The parties must also discuss that expenditure and the circumstances in which the franchisor considers that the franchisee is likely to recoup it, having regard to the geographical area.

Why franchises may still fail

Properly structuring the franchise agreement and complying with the disclosure and discussion obligations can reduce the risk of franchise failure but cannot eliminate the ordinary risks of operating a business. It should be noted, however, there are myriad of reasons why a franchisee may fail.

Franchisee-related factors that may contribute to failure include:

• inadequate business or management experience;
• failure to follow the franchise system;
• poor customer service or staff management;
• inadequate attention to financial records, cash flow and key performance indicators;
• absentee ownership where the business requires hands-on management;
• failure to comply with employment, tax, licensing or workplace safety obligations;
• personal illness, family problems or disputes between business partners; and
• unrealistic expectations that purchasing a franchise guarantees success.

Needless to say, comprehensive due diligence by prospective franchisees is a no-brainer.

For advice on franchise agreements, disclosure obligations, capital expenditure requirements or broader franchising arrangements, contact Velocity Legal’s Commercial team.