Before investing in any franchise system, read the booklet entitled “Look before You Leap: a Guide to Buying a Franchise” published by the California Department of Corporations. Also read the United States Federal Trade Commission publication entitled “Buying a Franchise: A Consumer Guide.” These helpful publications are full of excellent tips, advice, and resources that will assist you how to go about evaluating your proposed purchase of a franchise as well as evaluating your own skill sets to get you thinking about whether the franchise opportunity you’re considering is going to be a good match. One significant piece of advice therein is worth heeding: “In addition to reading the franchisor’s disclosure document—including any updates—and speaking with current and former franchisees, consider talking to an accountant and a lawyer.”
Assuming that you are purchasing a franchise in order to make money as opposed to engaging in a hobby where you do not need to make money, your decision should be driven primarily by economics rather than emotions. Many persons who purchase franchises do so because they want to work for themselves and think that franchising will provide them with a relatively quick and easy way to do that. Often times, the decision to go into business for oneself is driven by emotional factors arising from dissatisfaction in or loss of a current job or perhaps a required early retirement. At these times, one needs to be very thoughtful and careful about making decisions that have long-term consequences not only for themselves but for their families. Many franchise clients have jumped into franchises with borrowed money from their retirement accounts, relatives and/or the small business administration or other lending institution. Many have secured their homes as collateral for such loans, only to have the franchise fail and lose everything. Do what you reasonably can beforehand to minimize that risk.
Be sure to get a copy of the franchisor’s uniform franchise disclosure document. Although many portions of this document will be difficult to understand, you should try to read the entire disclosure document and flag areas where you have questions or concerns. You should consider consulting with an experienced franchise attorney to assist you. But whether you do or not, there are certain areas in which you should pay particular attention.
Evaluate Litigation And Bankruptcy History
The franchise disclosure document will discuss the litigation and bankruptcy history of the company as well as its principal officers and owners. Pay particular attention to whether there seems to be an abnormal amount of litigation or the types of litigation are violations of franchise laws, fraud, breach of contract etc.
Evaluate Estimated Costs
The franchise disclosure document should give you an estimate of the costs involved to start the franchise. There will be initial franchise fees as well as other estimated cost for inventory, signs, equipment, build outs, and other such costs. You should also consider having an appropriate amount of money for working capital and don’t forget you will need money to survive while you’re business is ramping up. An accountant can help you to evaluate this information. An experienced franchise attorney may help you negotiate the amount of costs that a franchisor would otherwise expect you to expend.
Evaluate Various Competitive Restrictions
The franchise disclosure document tells you if the franchisor imposes limits or restrictions on a variety of business areas. For example, franchisors might limit the suppliers from whom you might purchase goods and/or services. Certain services may not be available for sale under the franchise system. There may be certain customers that you’re not permitted to service and/or you may be limited in terms of the geographic area for which you might offer goods and services. All of these restrictions might limit your ability to operate a successful business. You may wish to try to negotiate away such restrictions.
Evaluate Termination Conditions
The franchise disclosure document tells you the conditions under which the franchisor may terminate your franchise and your obligations to the franchisor after termination. These provisions are negotiable and you should understand exactly what the implications are. For example, franchisors may reserve on to themselves the right to collect future royalties for the balance of the term beyond a termination even though you, as the franchisee, will no longer be in business and have a source of income from which to pay such royalties. While, intuitively, this might seem like a preposterous result, many courts have been forced such very provisions.
Interview Current and Former Franchisees
The disclosure document provides important information about current and former franchisees.. O large number of terminated, canceled, or non-renewed franchises may indicate problems. Also, determine how many franchises are currently operating. A large number of franchisees in your area may mean increased competition and an attempt to saturate the market with franchises.
The disclosure document gives you the names and addresses of current franchisees that have left the system within the last year. Speaking with current and former franchisees is an excellent way to gather information about the franchise and validate the franchisor’s claims. By visiting franchises you can see for yourself the volume and type of business being done. Finally, investigate whether there is an independent franchisee association and contact its board members and learn their views.
Evaluate Earnings Potential
You may want to know how much money you can make if you invest in a particular franchise system. Franchisors are not required to make earnings claims, but if they do, the FTC’s Franchise Rule requires franchisors to have a reasonable basis for these claims and to provide you with a document that substantiates them. This substantiation includes the basis and assumptions upon which these claims are made. Some things to consider:
- Average figures tell you little about how individual franchises perform. A few very successful franchisees can inflate the average. Consider the following: you receive a travel brochure describing a beautiful and reasonably priced luxury vacation on a private island with an “average temperature of 75°.” You book the vacation and travel to the island looking forward to a week of relaxation only to find that the temperature is 0° at night and 150° in the daytime. It is true the average temperature is 75°, but the representation was clearly misleading in light of the facts that were not disclosed.
- Some franchisors provide figures for the gross sales revenues of their franchisees. These figures, however, do not tell you anything about the franchise’s profits. An outlet with high gross sales revenue on paper actually may be losing money because of high overhead, rent, and other expenses.
- Earnings may vary in different parts of the country. An ice cream store franchise in a southern state, such as Florida, may expect to earn more income than a similar franchise in a northern state, such as Minnesota. If you hear that a franchisee earned a particular income, ask where that franchisee is located.
Make sure you get and closely review the earnings claims document and consider consulting with an experienced franchise attorney or accountant to assist you in evaluating any earnings claims.
Evaluate Financial History And Financial Statements
The disclosure document provides you with important information about the company’s financial status, including audited financial statements. Be aware that investing in a financially unstable franchisor is risky; the company may go out of business or into bankruptcy after you have invested your money. Consider hiring an experienced franchise attorney or an accountant to help you review the franchisor’s financial statements.
Lawyer and Accountant
An accountant can help you understand the company’s financial statements, develop a business plan, and assess any earnings projections and the assumptions upon which they are based. An experienced franchise attorney can help you to understand your obligations under the contract. It is best to rely upon your own lawyer or accountant rather than those of the franchisor.
Better Business Bureau
Check with the local Better Business Bureau (BBB) in the cities where the franchisor has its headquarters. Ask if any consumers have complained about the company’s products, services, or personnel.
Several states regulate the sale of franchises. Check the resources area of our website for links to the various government agencies.