Research the Risks of Buying a Franchise Beforehand
Buying a franchise is a major life and financial decision. Make the right decision and it could be a significant investment in your future. Make the wrong decision and you could pay for it for years—both in dollars and in lost business opportunities.
Fortunately, franchising is governed by federal and state laws that require franchisors to provide specific documents and legal disclosures to prospective franchisees. There are two main legal documents required by the Federal Trade Commission for all franchise transactions— the Franchise Disclosure Document (FDD) and the Franchise Agreement.
Franchise Disclosure Document
The FDD lays out all the details of a franchise opportunity. It includes information about the franchisor, the franchise system and process, and all agreements the franchisee will have to sign. By law, a franchisor cannot sell to a franchisee without providing a FDD. Fifteen states require franchisors to register their FDDs and get approval of documents before engaging in franchising activity.
A few of the franchisor details you’ll find in the FDD include:
- The franchise company’s key staff and experience in franchise management
- Bankruptcy and litigation history
- Costs and expenses to operate a franchise
- Required investment and purchases
- Territory rights
- Responsibilities of both the franchisor and franchisee
- Names and contact information of other franchisees in the system.
There is a “14-day rule” that acts as a cooling off period to allow prospective franchisees 14 days to review the FDD and think about their decision before signing the franchise agreement.
When evaluating the FDD, pay attention to the following items:
- Unit counts. Check to see if the number of operating franchises is growing, remaining constant, or declining. If the number is heading south, that may be a red flag indicating the business is not doing well.
- Litigation. Are franchisees suing the franchisor? If so, are these cases increasing? If it looks like a lot of legal action is taking place, it could be cause for concern.
- Financials. It’s important that the franchisor is financially stable and that they have sufficient capital reserves to survive an economic downturn. Make sure they are profitable and show positive cash flow, indicating the ability to provide the training and support you’ll need.
- Same store sales trends. Analyze specific store locations and see if sales are rising year-over-year. If sales are flat or declining, do additional research to discover why. If it’s due to lower product demand or trouble within a geographic location, you may want to tread carefully.
The Franchise Agreement is the legal document that governs the relationship between the franchisor and franchisee and lays out the terms of the franchise purchase. Specifically, the agreement will include information about:
- The franchise system, including the use of trademarks and products
- Rights and responsibilities of all parties to the agreement, including accepted standards and procedures
- The term of the franchise license
- All payments to be made by the franchisee to the franchisor, including franchise fee and royalties
- Termination procedures and any rights to transfer franchise ownership to another person
- Training and management assistance offered
- Advertising agreements.
You should carefully review the Franchise Agreement and consult with an attorney or expert in franchise transactions before signing any documents. Make sure the agreement spells out all the training you will receive and that it addresses geographic market competition or potential market saturation that might make it difficult to succeed, even with a strong brand.
Calling with Questions
As important as it is to thoroughly review the legal documents, it’s equally important to talk with other franchisees in the system you’re evaluating. The FDD includes franchisee contact information, so take the time to call and speak with five to 10 different owners. You can also search online for former franchise owners to discover why they are no longer part of the system.
Here are a few of the questions you should ask before finalizing your decision:
- Did your opening and first year go well? This will help you gauge the effectiveness of the franchisor’s systems, training, and grand-opening program support.
- Are you happy with the marketing programs? Most franchises have marketing initiatives in place to help build the business through customer outreach and promotion. Find out if the marketing actually increased customer numbers and sales.
- Knowing what you know now, would you still buy this franchise? There are likely valid arguments for answering yes or no, but pride of ownership means you’ll usually get a positive answer to this question. Even if they hesitate and say, “Yes,” or “No,” your follow up should always be, “Why?”
- How much money can I make? Often, this is the first question prospective franchisees ask of a franchisor. And franchisors are prohibited from providing projected income numbers. But you can find out what the actual franchisees are bringing in. You’ll want to understand the initial investment, the average unit sales, primary expenses, gross and net margins, and how long it took to break even and get the balance sheet into the black. You may want to ask this question last since many people are reluctant to discuss their finances with someone they just met. Establish some friendly trust first, and then ask about the money.
After talking with a number of franchisees, your interest level will either increase or decrease, based on the general feel you get from the owners. Ebbing interest is a red flag telling you that this probably isn’t the right opportunity for you. On the other hand, if you find yourself getting excited about the business, it’s a good sign that you’re on the right path. Like all business decisions, do thorough research, run the numbers, and then trust your instincts.