Home building franchisor David Reid Homes awarded $2.85 million after legal fight with former master franchisee

The founder of a New Zealand construction franchise has won a court case against a partner in his collapsed Australian company that  failed to pay the whole of the $3.75 million purchase price for the business.

The Queensland Supreme Court has awarded David Reid, who set up the franchise David Reid Homes with his father, more than $2.85 million against Russell Stephens and his luxury home company.

David Reid Homes earned its income from fees paid by franchisee builders. Founder David Reid and his wife held half-stakes in the master franchise business until they were approached by Stephens in 2007 about buying into the company.

Stephens had no background in building but had become a David Reid franchisee in Brisbane.

Stephens agreed to pay $3.75 million for a half-share in the master company but shortly after this purchase DRH Australia failed and Stephens lost virtually all his money.

Stephens tried to argue that he should not have to pay the outstanding money he owed because he was misled about the business and the franchise model used in the business wasn't viable.

The court did not accept this argument and Justice Jean Dalton found David Reid Homes Australia "failed and failed spectacularly in a fairly short time".

"However, there was no evidence placed before me as would allow me to even guess at the cause of that failure, much less any safe basis for me to assume that it was because of the existence of the four impecunious franchises, or information which would have come to light had enquiries been made following the disclosure of the existence of these four impecunious franchisees," Dalton said.

Stephen Giles, partner at Norton Rose, says the case provides some useful warnings to prospective franchisees.

"The real lesson is probably that if you make a poor business decision a court is not going to fix that for you," says Giles.

"Similarly in franchising, the regulatory framework is built not just on proper franchisor disclosure and behaviour, but effective franchisee due diligence. "

Dalton found that Stephens "made a deliberate choice not to investigate the businesses of the franchisees" during the due diligence process.

"Given the business model, as described above, and the short time for which the business conducted by David Reid Homes Australia had been operating, this was another remarkable omission," the judge found.

Giles says it is fundamental to speak to existing franchisees about the business before buying in.

"One of the most important things to do is speak with existing and past franchisees, a process facilitated by the Code requirement that includes contact details in the disclosure document," he says.

Giles says it is also important to be wary of businesses that rely on sales of franchises for revenue.

In this case the primary source of revenue for David Reid Homes Australia was sales of franchises.

"Although this model had been successful in New Zealand, so had been the underlying housing construction business," says Giles

"It appears Stephens paid scant regard to ensuring or investigating the success of the underlying Australian business, focusing perhaps instead on the lure of making money by selling franchises.

"That is fool's gold – the best franchise systems have strong underlying businesses, and simply use the franchise model as an operating format.

"A good franchise model will not cure defects in any underlying business."

David Reid Homes franchisees in New Zealand have suffered a string of recent failures as the construction sector has struggled.

The David Reid Homes franchise in Nelson went into liquidation in 2010, following the collapse of other franchisees in Wellington, Manawatu, Pukekohe and Marlborough.

This article originally appeared on SmartCompany.