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How to Give a Franchise the Once-Over

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A good amount of information has been written about how to evaluate a franchise opportunity. Here is a way to do an initial franchise review before spending a lot of time and money.

When individuals are considering a franchise opportunity I recommend that they follow a specific process. I devote over 130 pages in my latest book, The Franchise Buyers Manual, to the franchise process.  The majority of this content includes the franchise evaluation process.  However, there are situations when a prospective franchisee or a franchise consultant or broker would prefer to conduct a franchise program review without devoting much time or money to this activity. In order to perform this evaluation youíll need a copy of the franchise disclosure document. When it comes too seriously considering a franchise opportunity a complete and detailed evaluation needs to be conducted which should include the utilization of legal and financial professionals.

Here is how I give a franchise the once-over:

  • Franchisor Management-I review the management background and experience of the key executives and support staff. Itís important to me that they have experience in the business and in franchising. The franchisor should have leadership that reflects a cross section of skills and experience.
  • Franchisor Litigation- the legal history is an indicator of franchisee and franchisor disputes. I want to know if the franchisor has taken action to protect its system and brand or is it case of franchisees having disputes with the franchisor because they are not receiving support or making a profit? Some medium to large franchisors report no litigation while some smaller franchisors may have had a number of legal disputes. The amount and type of litigation is an area that can serve as a red flag.
  • Franchisee Fees-If the franchisor charges various fees for services above and beyond the royalty and ad fund fee I would take a closer look at their program.  Some franchisees charge fees for attending meetings and conventions. Be sure that the initial franchise fee and royalty is comparable to similar franchises.
  • Required Suppliers and Rebates-I review whether the franchisor requires purchases from specific vendors and then relate that to the information in Item 8 which shows the percent of purchases from the franchisor and other vendors and suppliers. In addition, does the franchisor receive rebates from vendors and suppliers?
  • Franchisor Training Programs-these should be comprehensive and presented by more than one person. I like training that includes some onsite training for the new franchisee.
  • Franchisee Territory-The territory should be defined in a consistent manner and large enough to allow for franchisee growth. Franchisors that grant small territories without true exclusivity make me nervous.
  • Item 19-If the franchisor doesnít make a financial disclosure under Item 19 Iíll want to know why, especially if itís a franchisor with a minimum of 100 units. This doesnít need to be a reason to disqualify the franchisor but I would want to know their reasons for not disclosing franchisee revenues.
  • Franchise System Growth-Has the number of new franchisees reflected steady growth? I look for gaps in the number of franchisees. The tables in Item 20 contain a wealth of information which can indicate a cause for concern.
  • Financial Statements-The franchisor financials can tell a story. Unless the franchisor is a start-up there should be three (3) years of audited financials available. I look for a steady stream of revenues from franchisee royalties.  Initial franchise fees should not represent the preponderance of revenues unless itís a start-up. Look for a profitable franchisor operation; however, there may be cases where a franchisor may take bonuses or distributions to lower taxable income.

Here is some advice from the FTC:

 ďThe disclosure document gives important information about the companyís financial status, including audited financial statements. You can find explanatory information about the franchisorís financial status in notes to the financial statements. Investing in a financially unstable franchisor is a significant risk; the company may go out of business or into bankruptcy after you have invested your money.

Itís a good idea to hire a lawyer or an accountant to review the franchisorís financial statements, audit report, and notes. They can help you understand whether the franchisor:

  • has steady growth
  • has a growth plan
  • makes most of its income from the sale of franchises or from continuing royalties
  • devotes sufficient funds to support its franchise systemĒ

Before getting deeply involved with evaluating a franchise opportunity you can perform what I refer to as a doing a franchise once-over. This is an initial step in the franchise process that can give you an overview of a franchise opportunity before expending lots of time. If you decide to move ahead with a specific franchise opportunity, be sure to utilize an accountant and franchise attorney to guide you along the way.

© 2011 FranchiseKnowHow, LLC

Ed Teixeira is the President of FranchiseKnowHow, LLC. He can be reached at franchiseknowhow@gmail.com

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