The franchise business model is a very solid, time-tested vehicle to prosperity – if approached properly! However, far too many investors, in my experience, make wrong or poorly informed assumptions about their chosen franchisor, which can lead them to foolishly spend thousands, if not millions on a bad deal. These assumptions may include: the franchise is a good investment because it is a recognizable and attractive brand; the Franchise Disclosure Document (FDD) is Federal Trade Communication compliant on its face and/or approved by their state’s securities examiners; or because a friend or a friend of a friend did well in the franchise.
Yes, these may seem like extreme examples, but they are not too far off the mark from how the average franchise investor conducts due diligence. The lesson today: thorough due diligence is critical to your ultimate success as a franchisee.
You would be shocked, for instance, to hear how few franchise investors engage professionals (legal and accounting) to assist them in the franchise selection process. In the ten or so years that I have represented one national franchisor (now listed in the upper half of Entrepreneur’s Top 500 Franchises), there have been very few instances when I was asked to communicate with a franchisee’s attorney about the FDD or Franchise Agreement (FA) terms. These are complicated legal documents, yet most people feel confident reading through a 300 page FDD and then presumably concluding that (1) they understand the meaning of the terms, and (2) all the terms are acceptable and will not hinder success. I have had intelligent clients skeptically state to me at the outset of an FDD review, “I have read every page, but I guess I’ll let you have a crack at it and see what you find.” Of course, what they are thinking is that they have wasted money involving me in the first place. These folks are almost universally surprised to hear my opinions and insight after a detailed, multiple-hour review of their FDD. Some even have second thoughts about proceeding with the franchise. This is a healthy process, and too few people take advantage of it while they still have the opportunity and some control over the transaction.
Having drafted and reviewed hundreds of FDDs, I promise that none of them were written with your best interests in mind, and all of them raise serious issues which will affect your lifestyle and finances for many years. So, be smart. Invest a little of that money on professionals to review the documents and give you good advice – advice which may save you hundreds of thousands of dollars in the long run. But enough self-promotion…
The risks involved with franchise businesses are still significant when compared to other business models, and for this reason, the franchise investor must engage in due diligence to limit these risks. Due diligence, or in other words, the comprehensive appraisal of a business undertaken by a prospective buyer, especially to establish its assets and liabilities and evaluate its commercial potential, is critical to the success of your franchise investment. So, how should franchise due diligence be conducted? Here are “4 Steps” to consider when you plan your due diligence phase:
#1. Decide on the Franchise Industry.
In what industry should you invest in a franchise? Food, health, fitness, pets? There are scores of industries that have adopted the franchise model. If you have no idea where to start, consider attending the International Franchise Expo at the Jacob Javits Center in NYC at the end of this month. There you will find hundreds of franchisors in multiple industries and have the opportunity to speak with them about their system and brand strength.
Is experience in an industry necessary? Many, if not most, franchisors, will say no, because their franchise system will train and support you in the industry. Be cautious and wary when you hear this assurance. It is simply puffing and often misleading. Certainly, there are some industries where this may be the case, but in my experience, not so for the food, signage and health care fields. Each franchisor can only give each of its franchisees so much training and support, and if you lack basic knowledge in a particular and competitive field, you may end up facing too great a learning curve to be successful.
Find out the basics about the industry: for instance, what is the typical cost for entry (franchise-related fees and your start-up investment)? Do you have this amount in savings or will you require financing? Is the SBA lending in that industry?
#2. What Franchises are Available in the Chosen Industry?
Once you decide upon an industry, then focus on the available franchises in that field. Which franchisor has the strongest brand (most recognizable)? Which of these franchises have been in business the longest time? Is their relationship with franchisees healthy (one bad sign – is there litigation going on between the franchisor and franchisees)? Is the branding attractive to you? Would you want to do business with these franchise units, or have you done so? Finally, is the franchise system controlled by the original owner, or has it been sold to an investment group? How often has the franchise’s ownership changed hands? Speak to current franchisees. Once you obtain the FDD, you will have the names and contacts of all current franchisees. Use this resource and ask as many of them as possible about their experiences in the franchise.
#3. Obtain the FDD and then Visit the Franchisor.
Franchisors may offer you their FDD before your visit. Take advantage of this offer and hire a franchise attorney to review the FDD before Visiting Day/ Discovery Day. This early review will prepare you for the important face-to-face meetings, and, specifically, allow you to maximize your valuable time by conducting due diligence directly with the people at the top of the franchise system, and perhaps even its principal owners.
Avoid being charmed or beguiled by the franchisor. The culture of a franchise is important, but do not let this cloud over your judgment on business basics. As a franchisee’s attorney, one challenge I often face is counseling clients who have already drunk the franchise’s Kool-Aid, are smitten by the owner-entrepreneur at “Discovery Day,” and dream that they are already part of the franchise family! “But would you please look at Items 11 and 19 for cripes’ sake!,” says I. They reply, “but [so-and-so] told me not to worry about all that legal stuff. They said I’m sure to make money in my [not as exclusive as you may think] territory.” Again, this is an exaggeration of my exchanges with clients, but the basic point is this: don’t be sold on the franchise until your eyes are wide-open and you know all the pitfalls as well as the good stuff the franchisor has been feeding you.
This is why reading the FDD before the visit is beneficial. You will have questions about its terms and the best way to get at the truth is face-to-face with the franchise principals.
#4. Read the FDD (and Exhibits)!!
Unfortunately, many franchises will not disclose their FDD until after your visit and an interview. They want to first be certain that you are a qualified franchise candidate. Whenever you obtain the FDD, please read it thoroughly. This document is the equivalent to a stock prospectus and is, under federal law, intended to be transparent. A well-written FDD should clearly set-forth the obligations of both parties and provide important information about fees and costs, as well as disclose the identities of required vendors and affiliates whom may also benefit from your FA. The FDD will also give you insight on the financial health of the franchise system: Is it growing at a healthy rate? Is it flat-lining or declining?
Understand that the franchisor is not likely to agree to amend the FA. This is largely due to the fact that their form FDD was probably reviewed and approved by one or more of the states requiring pre-sale registration. Any material changes to the FDD may require them to submit revised FDDs to these jurisdictions for approval, which is costly and time consuming. All the more reason why you need to understand this contract, the FA.
Be aware that any representations made to you on which you relied when making the decision to write that franchise fee check must be included in the FA to be binding. If it is not in the agreement, then the promise is not enforceable. If you are not seeing the language you had been told to expect, then ask them or have your attorney ask them to point out the important language you will be relying upon.
Have the audited financial statements reviewed by your accountant – follow the money! What are the franchisor’s primary income streams? You would expect it to be in royalties, but are they making an inordinate amount on franchise fees (a red flag)? How about monies earned on goods or equipment you are required to buy from them? How many franchisees are paying the fee, but not opening franchise units? What interesting financial statement notes were inserted by the franchisor’s accountants which may help you understand how the system runs and if it’s financially healthy? Have your accountant break it all down so that you understand the system thoroughly from a financial perspective.
I hope this article opened your eyes to realize the need for conducting thorough due diligence when purchasing the – always limited – rights to a franchise. Don’t be a fool and accept everything the franchisor represents without verifying and pressing for the truth. Do not skimp on professional fees during this critical time. It is well worth the money (read my reviews) and will represent a fraction of your overall investment. Further, it will give you an opportunity to bond with your attorney, and this is a relationship which can pay dividends to you for many years to come.
Best wishes on your search for a successful franchise investment!
BE ADVISED that these comments are not intended as legal opinions and are not to be relied upon as legal advice. If you need franchise-related legal advice, please contact us to discuss the specifics of your franchise business.
© KilcommonsLaw, P.C. 2019e