By Andy Cheetham
Managing Director of Lime Licensing Group
Interestingly, some franchisees will risk their entire business and personal reputations by deliberately breaching their franchise agreement with their franchisor. They also risk being sued and it’s likely the franchisor will win if the breach is proven. That leads to financial damages too. Don’t get me wrong, I am perfectly aware that some Franchisors breach their agreements too, but that’s a topic I’ll cover on another day.
Some franchisors don’t need to ever audit for financial reasons, maybe because they are fixed fee networks for example, or they have access to all of the numbers automatically due to the nature of the business. However, audits aren’t just financial they have operational value too and can bench mark all sorts of things including operational manual and legal compliance. For now though let’s just concentrate on the financial side of it to illustrate an important point.
I’m talking about royalty declarations here.
Audits are part and parcel of the franchise landscape. Often randomly picked franchisees are asked to comply with the clauses that give their franchisor full access to company records. It’s a contractual right that gives unfettered access to inspect all of the documents, admin, assets, and often premises involved in the business.
If it turns out that the franchisee is on the fiddle then there are consequences beyond having to pay for the cost of the audit. This is usually down to royalty miscalculations which funnily enough are often in the favour of the franchisee and not the franchisor.
There’s a moment where all seems fine between all parties in the agreement. Then the franchisor triggers the audit clause, and everything becomes worrying to the non-complaint franchisee. There’s no halfway house – the audits coming and it’ll find you out. They always do.
It’s interesting what Franchisors know about a franchisees business that the franchisee is unaware of. I’ve known issues come to light from a chance social media comment by a previously unknown client, or a chance comment, even disgruntled staff or suppliers sometimes make it known without meaning to that there’s something not quite right. When we were in retail supply a franchisee mistakenly returned someone else’s unsold seasonal stock to us. I did an immediate audit and terminated the agreement as a result of its findings. Her franchise was probably worth tens of thousands of pounds, the audit found out a lot of material flagrant breaches, so I had no choice. Whenever you’ve got other franchisees, the franchisor has no realistic option but to follow the contract and set an example to the network.
Some Franchisors are obsessed by the accuracy of figures. I know Franchisors who spend significant amounts of time policing their network activity. Many will routinely mystery shop a franchisee and then look for the evidence of that booking or payment in the franchisees CRM or bookkeeping software later. We even found out that one of Lime’s clients had trackers secretly installed on all franchisees vans whilst they were being “fitted out” prior to delivery. The MD even had an app on his phone that showed him everywhere the franchisees went! For this and many other reasons we stopped representing them!
There is a half step to a full franchisee audit.
If the franchisor is minded to consider it then there’s an interesting second option. I’m talking about the self audit. It’s an olive branch sometimes extended by a curious franchisor or one that randomly draws straws. Hey – we all know errors are made. This is everyone’s chance to reset those errors without blame or contract breaches. Because non payment of royalty or incorrect reporting is no minor matter.
A self audit amnesty allows for a self conscience examination.
Here’s how a franchise self audit works.
The franchisor notifies whichever franchisee or all of them that they intend to trigger their right to audit. But rather than just dive in and examine the records they grant the franchisee a preliminary self audit which is basically an amnesty before the audit itself happens – or may happen!
The franchisee provides whatever information is required, confirms they’ve re checked it and warrants that it is therefore accurate. The key point is that they are warranting that they’ve done the audit on their own business and are saying that everything is tickety boo. If not then anything that turns up is rectified financially, or otherwise – not legally. That’s then the end of it. Everyone stays friends and accepts that mistakes happen. Because mistakes do happen.
The franchisor then checks this audit against what is now freshly reported and compares it to all of those interesting nuggets of information they already have or suspect about the franchisees business. If the self audit doesn’t match up, or even just don’t “feel” right to what the franchisor is expecting then the full audit follows. Now, if the franchisee is then found to still be in breach of the agreement then there will likely be no mercy in how it’s dealt with.
The franchisee has been offered an amnesty, have they taken that opportunity?
It’s where trust meets conscience.
The audit reveals an issue or three. There’s no hiding place for the franchisee now. The invoice for the audit is generated and the franchisor re reads the termination clauses, because this would be, in effect, a second material breach because the self audit is a second go at declaring everything accurately.
The non compliant franchisee has just failed again at being accurate and failed miserably at being honest. Let’s just hope they didn’t make the same mistake with their vat returns. No amount of explanations can probably disguise the fact that it’s a deliberate falsification.
Deliberate under reporting means they’re fiddling their colleagues too.
There are implications for the wider network here. Franchisors survive on royalty because they have waived their rights to trade in a franchisee’s location. Franchisees get everything the brand has and a royalty is the trade off. That royalty supports the entire network so franchisees who declare incorrect royalty are also fiddling their colleagues in the network. The reason for this is that Franchisors make spending decisions on the level of royalty PLUS the level of marketing levy. Every franchise brand I have owned (that’s 6 so far) has overspent the marketing levy using royalty money. The amount of over spend is based upon declared royalty levels. Other expenditure is considered and it’s always considered against royalty levels. Sure, some franchisors just receive and spend the marketing levy but many have done as I do and that’s investing more. It would be a shame if a key marketing opportunity was declined because the cost was just too much of a stretch for the Franchisor – but maybe they would have spent it if there was more cash available through ad levy or royalty?
So, there is a direct link between marketing that benefits everyone, and the individual franchisee that doesn’t declare their true royalty. By auditing the network a franchisor isn’t being unfair to the franchisee, they’re being kind to the commercial interests of the entire franchise network. If I was a franchisee, knowing what I know, I’d actually want my franchisor to audit the network.
Meet the minimums as a minimum
Apart from being another one of my catchy phrases this matters for the Franchisor too. Franchisors should self audit themselves. Have they been fully compliant contractually and ethically? Have they themselves done what they should have done? As a franchisor be sure that you are at least meeting the minimums whatever you do. I’m talking about things like where has all the marketing levy been spent and what costs can be met from franchisees contributions etc.
When you as Franchisor meets the minimums, the moral and legal high ground becomes easy. When you’re honest with your franchisees, and they know that you are being honest your relationships with your franchisees will be better. So, it’s a two way street, and although the audit power is with the Franchisor it’s still a process that every party should professionally respect and comply with.