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Understanding the Disclosure Document: Financial reporting and payments

By Peter Snell
Over the next several issues of Canadian Business Franchise, this column will explore the franchise agreement, to give you a better understanding of its basic elements. In this issue, it is time to look at franchisees’ payment and reporting obligations.

As always, it is extremely important to take the time to fully analyze a franchise agreement before signing it. While the following information can serve as a general overview, prospective franchisees must also seek their own legal advice when reviewing any franchise agreement. Only then can they obtain specific information and advice relevant to their particular circumstances.

Possible payments
On an ongoing basis, franchisees are typically required to make regular payments to their franchisor. Depending on the specific franchise system, these may include royalties, advertising fund contributions, rent under a sublease arrangement, software licensing and other technology fees, group insurance premiums and payments for inventory, supplies and any items unique to the system.

In the past, for example, many franchisees were required to make payments for group marketing efforts, such as advertising in the Yellow Pages. These efforts have largely been replaced by other forms of joint marketing programs and online marketing, such as Google AdWords.

Royalties and ad fund contributions are generally based upon a percentage of a franchise’s gross sales. This percentage varies from system to system, however, as there is no rule as to how much any particular type of system may charge.

As such, prospective franchisees should compare different systems to get a sense of their ongoing operational costs. Some franchisors will charge a higher upfront franchise fee, while others will institute higher royalties or ad fund contributions.

Each system’s structure will have its own pros and cons, but the amounts charged will often reflect how mature a particular franchise system is and the existing market demand for new franchises. That is to say, a popular, well-established franchise concept can justify higher payments from franchisees to the franchisor.

Potential franchisees should also make enquiries of a system’s existing franchisees, to see if the franchisor has ever mad any special deals with them that differ from the standard royalty or ad fund rates.

Reporting revenue
In the past, at the end of each month, franchisees would calculate how much revenue their business had generated over the preceding month, then prepare and mail a revenue report to their franchisor, accompanied by a cheque for the royalties and any other amounts owing. Not only was this a cumbersome process for franchisees, but it also led to difficulty for the franchisor, in terms of monitoring and auditing the true performance of each franchise in their system.

Today, the process has changed significantly. While the excuse “the cheque is in the mail” used to be as common as “the dog ate my homework,” no franchisor would accept such a situation anymore. With the advent of computerized systems that can monitor their franchises’ performance on a daily or even hourly basis, together with the ability to direct-debit a franchisee’s business bank account, few franchisors still rely upon their franchisees to develop a monthly report or to send cheques for the payment of royalties.

The franchise agreement will still normally require franchisees to provide financial reports to their franchisor, setting out their gross sales figures, and to substantiate the calculation of their amounts of royalties, ad fund contributions, etc. What has changed is many franchisors no longer rely upon written reports; instead, they use their own customized software and point-of-sale (POS) systems to track the same information.

As a result of these enhanced capabilities for tracking sales, a franchisee’s obligation to submit royalties and other payments to their franchisor has in many cases changed from a monthly to biweekly or even weekly plan.

In systems where the franchisee must obtain some or all of the inventory or supplies needed for the business directly from the franchisor, the reporting of gross sales by the franchisee may also involve greater detail as to which goods have been sold or used. This greater level of detail will help both the franchisee and the franchisor on a regular basis for the purpose of inventory control and reordering supplies.

It is understandable if the prospective franchisee initially expresses concerns about the franchisor having an enormous amount of access to his/her business and accounting books and records, but the franchise agreement is likely to limit such ongoing rights of access only for inspection and audit purposes. As such, the franchisor’s extensive degree of access should not present any concerns.

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