Acquiring a franchise is an exciting endeavor and entails several steps. Aspiring franchisees should take note that prior to becoming the owner of a franchise, it typically takes an average of three to six months to complete the acquisition process. Keep in mind that no two franchisors are the same—they vary in terms of complexity, expenses and time when it comes to becoming an official franchisee.
Purchasing a franchise can be the perfect business decision for a potential small business owner who doesn’t want to undergo the tedious process of creating a new business from scratch. Ideally, franchisees get a proven business model in every single facet—from marketing to pricing. Still, capitalizing on a franchising opportunity is a much more involved process than simply identifying an appealing brand and throwing money at it.
If you are contemplating becoming a franchisee, how should you go about setting yourself up for success? It all starts with a detailed analysis of the franchise disclosure document (FDD). This document is packed with key data pertaining to how much you will be expected to invest upfront, whether the brand is trending upwards or downwards, how exorbitant operating expenses/fees will be and whether there is any pending litigation between other franchisees and the franchisor—all of which will ultimately need to be factored into your decision on whether or not a given franchising move is the right fit for your long-term goals. The following is an itemized breakdown of some of the most important sections of the FDD you should focus on when conducting your due diligence.
The first of the twenty-three items on a standard FDD contains pertinent details about the franchisor, its predecessor and any affiliates. You will be able to deduce if and when there has been any change in ownership of the franchisor. Are frequent ownership changes a positive or negative factor for you as a possible future franchisee? The key is what prompted the ownership change of hands and what changes the present owners have implemented. Be sure to ask questions about the corporate history so that you have a complete understanding of the underlying dynamics of the organization that you are buying into.
Legal Issues in the Franchise
It is mandatory for franchisors to disclose all litigation associated with their company over the last five years. Even well-run organizations often have a few lawsuits on their track record—but proceed with caution if there is ongoing lawsuits or if a significant number of franchisees are currently or have in the past sued the franchisor for fraud or misrepresentation. A good general rule of thumb is to generate a ratio of the number of court cases to the number of franchises—and steer clear if the ratio is over 2%. To illustrate, assume a potential franchise has 500 stores, and eight to ten lawsuits. That’s a ratio of 5% and it’s likely not a brand you want to become associated with.
Financial Woes in the Franchise
Just like litigation, you will want to take note of any reported bankruptcy listed on the FDD. They will be disclosed in Item #4 of the FDD and indicate whether either the franchisor or any of its main affiliates have filed for bankruptcy. If there are any evident cases of unresolved bankruptcy proceedings, it’s worth doing a bit of digging to determine if the issue is critical to the long-term viability of the business itself or simply a matter of personal financial mismanagement on the part of one of the associated parties.
Growth Trends for the Franchise
Is the franchise expanding or shrinking? Are there company outlets in addition to franchised operations? Do franchisees that open stores actually remain solvent, or do they go out of business after a few months? To uncover key insights regarding the overall health of the collective franchise, pay special attention to item #20 of the FDD which lays out the number of storefronts or units for the preceding three years as well as how many were terminated or failed to renew their initial contracts. Seasoned franchise professionals place a lot of emphasis on turnover—which is the ratio of franchise terminations to openings. The main takeaway is to not get involved in a system where there is a track record of franchisees not being able to generate the requisite profit margin to continue operations.
Item #7 of the FDD provides an estimated initial investment comprised of the capital you will need to provide in order to become a franchisee—which includes not only the standard franchise fee, but additionally money to cover marketing signage, equipment, real estate and other essential business items. A key metric to note in this section is the ‘additional capital’ which is a forecast of further funding you might need to come up with in order to get the business up and running. The majority of franchisors utilize a three-month estimate, but be careful: some franchisors will list lowball estimates to entice potential franchisees. Ideally, franchisors will allocate around 10% of the initial investment towards the additional capital requirements estimate—so a franchisee paying a $1 million franchise fee should expect around $100,000 in additional costs.
Cash Flow Analysis
The financial statements provided in item #21 of the FDD allow potential franchisees to determine whether the franchisor is making the majority of its profits from ongoing royalties (a positive indicator) or from selling newly-opened franchises (potentially a red flag). The financial performance representations provided in item #19 provide anticipated sales and profits for franchisees. Although these projected financial performance analysis are optional for franchisors to provide in their FDD, they are increasing in popularity with nearly 60% of the industry offering them. If the franchise you are considering joining offers this bit of insight, take a close look at the data they are basing their projections off of. Some franchisors only use revenue numbers, while other detail gross margins. Industry experts like to see both overall averages and the metrics broken down on a quarterly basis—allowing franchisees to clearly see major disparities in anticipated revenue between the top performing stores and those at the bottom of the stack.
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For more about Due Diligence while evaluating business transactions, read our article here.
This is article 2 in a 3-part series. If you missed our first article, Franchising: Pros and Cons - Part 1 of a 3 Part Series on Franchising in New York, click here.
Francine E. Love is the Founder & Managing Attorney at LOVE LAW FIRM, PLLC which dedicates its practice to serving entrepreneurs, start-ups and small businesses. The opinions expressed are those of the author. This article is for general information purposes and is not intended to be and should not be taken as legal advice.