The Benefits and Risks of Income Guarantees

Alistair van Schalkwyk of ASCO Legal explores the legal considerations and best practices to follow when you consider buying a franchise in New Zealand that offers a guaranteed income.

The current media scrutiny of income and work guarantees in New Zealand franchise systems, as highlighted in recent articles by The Press and Stuff, has brought this issue to the forefront of public attention. As a franchise specialist lawyer, I would like to offer a legal perspective on the benefits and risks associated with income guarantees in franchise agreements, particularly for home and commercial services franchises.

What are income guarantees?

Income or work guarantees in franchise agreements are contractual assurances given by franchisors to franchisees that they will receive a minimum level of income or volume of work, particularly during the initial phase of the franchise relationship. These guarantees are often marketed as a way to reduce the perceived risk for new franchisees entering the system.

The appeal of income guarantees

In times of economic uncertainty, such as those New Zealand is currently experiencing, the allure of guaranteed income is strong. For prospective franchisees, these guarantees can:

• Provide security: They offer peace of mind that a minimum income is assured, helping franchisees manage cashflow and meet financial commitments.

• Aid in financing: Lenders may look more favourably on applications supported by guaranteed income, potentially making it easier for franchisees to obtain funding.

• Facilitate decision-making: The promise of an income floor can help prospective franchisees overcome hesitancy about entering business ownership.

How income guarantees are structured

The structure of income guarantees varies widely between franchise systems. Common approaches include:

• Minimum weekly or monthly earnings: The franchisor promises a set amount per week or month.

• Work allocation guarantees: The franchisor guarantees a minimum number of jobs or leads.

• Top-up arrangements: If the franchisee’s actual earnings fall short of the guaranteed amount, the franchisor pays the difference.

It is crucial to examine the fine print. Guarantees are rarely unconditional and often subject to compliance with system requirements, minimum performance standards, and other obligations.

Legal considerations and risks

While income guarantees can provide comfort, they also carry significant legal and commercial risks for franchisees.

• Reliance on the guarantee: Franchisees may be tempted to rely too heavily on the guarantee, neglecting the need to develop their own customer base.

• Stringent conditions: Guarantees often require strict compliance with operational procedures, marketing efforts, and reporting. Failure to meet any requirement can void the guarantee.

• Misrepresentation risk: If guarantees are oversold or not clearly explained, there is potential for claims under the Fair Trading Act 1986 for misleading or deceptive conduct. These claims can be difficult to prove for a franchisee.

• Credit risk: If a franchisor is unable to meet its income guarantee obligations and is placed in liquidation, it leaves the franchisee’s claim to payment under the guarantee as an unsecured creditor and unlikely to be paid.

• Dispute risk: As seen in the recent media coverage, disputes can arise when franchisees’ expectations do not align with the reality of the guarantee’s terms or the franchisor’s ability to deliver.

Lessons from recent disputes

The recent articles referenced above detail cases where franchisees felt let down by income or work guarantees. Common themes include:

• Unrealistic promises: Some franchisees allege that sales material overstated likely earnings or failed to disclose restrictive guarantee conditions.

• Lack of transparency: Franchisees were sometimes unaware of the full extent of their obligations to qualify for the guarantee.

• Enforcement challenges: When disputes arose, franchisees often faced difficulty enforcing their perceived rights under the guarantee. These disputes underline the importance of robust due diligence by a franchisee on a franchise system before committing.

Best practice recommendations

For Franchisors

• Draft clear guarantee terms: Ensure all guarantee provisions are transparent, unambiguous, and comprehensively documented in the franchise agreement.

• Disclose all conditions: Provide full written disclosure of all requirements for accessing the guarantee, including performance benchmarks and reporting obligations.

• Avoid overpromising: Marketing material should be factual and avoid making representations that cannot be substantiated. Ensure all franchisor personnel are fully aware of the terms and conditions and their obligation to be clear about these.

For Franchisees

• Conduct thorough due diligence: Investigate the franchisor’s track record and speak to existing franchisees about their experience with guarantees.

• Understand the fine print: Carefully review all conditions attached to any guarantee and seek independent legal advice before signing.

• Plan for self-sufficiency: Treat any guarantee as a safety net rather than a substitute for building a sustainable business.

Approach with caution

Income guarantees can play a valuable role in supporting new franchisees and enhancing the attractiveness of franchise systems in New Zealand. However, franchisees must approach them with caution as this is essentially a promise given by a franchisor and a promise is only as good as the party that provides it.

Franchisees should therefore due their due diligence and ensure that they are dealing with a reputable franchising system. Ask for additional information about the system including a disclosure document with upto-date information about the franchise system and financial position of the franchisor.

In addition, well drafted agreements and realistic, mutually agreed expectations are essential to minimise disputes and ensure a fair outcome for all parties.

If a guarantee is important to you, it’s important to know what it is and what it covers. In general, guarantees are divided into two types: work guarantees, where the franchisee is guaranteed a certain value of work that they must go out and do in order to generate income, and income guarantees, where the franchisee is guaranteed a minimum income. Income guarantees are less common, so make sure you find out which is being offered.

Whichever type of guarantee is offered, there are certain to be a number of conditions that have to be fulfilled before the franchisee can collect upon it. For this reason, franchise buyers need to be careful to confirm exactly how any guarantee operates before making their decision. Here are some questions that may help:

• What is the purpose behind the guarantee being offered?

• Is it a guarantee of work to an agreed value or of income to a set level?

• What is the guaranteed amount?

• Under what circumstances will it be paid?

• How long will it be paid for?

• What special conditions apply (eg. must I accept any work given anywhere? Must I contact the franchise office every day for work?)

• When is the guaranteed amount payable?

• What happens if the franchisor cannot afford to pay the guarantee for the specified period?

• What evidence is there that the guarantee has actually been paid out?

• If you take the guarantee out of the package, does the franchise still appear to be attractive and viable?

This last question is perhaps the most important of all. Franchising is generally a very low-risk way to go into business, but if you want to lower the risk even further, don’t rely solely on guarantees. Choose wisely, do your research and above all take advice from a franchise-experienced lawyer and accountant. These questions are from a previously published article available at www.franchise.co.nz/articles/2475

About the Author

Alistair van Schalkwyk is a franchise specialist lawyer at ASCO Legal, advising on all aspects of New Zealand franchise law.