Investigating Franchise Opportunities
Before investing in any
franchise system, be sure to get a copy of the franchisor's
disclosure document. Sometimes this document is called a
Franchise Offering Circular. Under the FTC's Franchise Rule, you
must receive the document at least 10 business days before you
are asked to sign any contract or pay any money to the
franchisor. You should read the entire disclosure document. Make
sure you understand all of the provisions. The following outline
will help you to understand key provisions of typical disclosure
documents. It also will help you ask questions about the
disclosures. Get a clarification or answer to your concerns
before you invest.
Business Background
The disclosure document identifies
the executives of the franchise system and describes their prior
experience. Consider not only their general business background,
but their experience in managing a franchise system. Also
consider how long they have been with the company. Investing
with an inexperienced franchisor may be riskier than investing
with an experienced one.
Litigation History The
disclosure document helps you assess the background of the
franchisor and its executives by requiring the disclosure of
prior litigation. The disclosure document tells you if the
franchisor, or any of its executive officers, has been convicted
of felonies involving, for example, fraud, any violation of
franchise law or unfair or deceptive practices law, or are
subject to any state or federal injunctions involving similar
misconduct. It also will tell you if the franchisor, or any of
its executives, has been held liable or settled a civil action
involving the franchise relationship. A number of claims against
the franchisor may indicate that it has not performed according
to its agreements, or, at the very least, that franchisees have
been dissatisfied with the franchisor's performance. Be aware
that some franchisors may try to conceal an executive's
litigation history by removing the individual's name from their
disclosure documents. Bankruptcy The disclosure
document tells you if the franchisor or any of its executives
have recently been involved in a bankruptcy. This will help you
to assess the franchisor's financial stability and general
business acumen and predict if the company is financially
capable of delivering promised support services. Costs The disclosure document tells you the costs involved to start
one of the company's franchises. It will describe any initial
deposit or franchise fee, which may be non-refundable, and costs
for initial inventory, signs, equipment, leases, or rentals. Be
aware that there may be other undisclosed costs. The following
checklist will help you ask about potential costs to you as a
franchisee.
- Continuing Royalty Payments.
- Advertising payments, both to local and national
advertising funds.
- Grand opening or other initial business promotions.
- Business or operating licenses.
- Product or service supply costs.
- Real estate and leasehold improvements.
- Discretionary equipment such as a computer system or
business alarm system.
- Training.
- Legal fees.
- Financial and accounting advice.
- Insurance.
- Compliance with local ordinances, such as zoning, waste
removal, and fire and other safety codes.
- Health insurance.
- Employee salaries and benefits.
It may take several months or longer to get your
business started. Consider in your total cost estimate
operating expenses for the first year and personal living
expenses for up to two years. Compare your estimates with
what other franchisees have paid and with competing
franchise systems. Perhaps you can get a better deal with
another franchisor. An accountant can help you to evaluate
this information.
Restrictions Your franchisor may restrict how you
operate your outlet. The disclosure document tells you if
the franchisor limits:
- The supplier of goods from whom you may purchase.
- The goods or services you may offer for sale.
- The customers to whom you can offer goods or
services.
- The territory in which you can sell goods or
services.
Understand that restrictions such as these may
significantly limit your ability to exercise your own
business judgment in operating your outlet.
Terminations
The disclosure document tells you the conditions
under which the franchisor may terminate your franchise
and your obligations to the franchisor after
termination. It also tells you the conditions under
which you can renew, sell, or assign your franchise to
other parties.
Training and Other Assistance The disclosure document will explain the franchisor's
training and assistance program. Make sure you
understand the level of training offered. The following
checklist will help you ask the right questions.
- How many employees are eligible for training?
- Can new employees receive training and, if so,
is there any additional cost?
- How long are the training sessions?
- How much time is spent on technical training,
business management training, and marketing?
- Who teaches the training courses and what are
their qualifications?
- What type of ongoing training does the company
offer and at what cost?
- Whom can you speak to if problems arise?
- How many support personnel are assigned to your
area?
- How many franchisees will the support personnel
service?
- Will someone be available to come to your
franchised outlet to provide more individual
assistance?
The level of training you need depends on your
own business experience and knowledge of the
franchisor's goods and services. Keep in mind that a
primary reason for investing in the franchise, as
opposed to starting your own business, is training
and assistance. If you have doubts that the training
might be insufficient to handle day-to-day business
operations, consider another franchise opportunity
more suited to your background.
Advertising
You often must contribute a percentage of your
income to an advertising fund even if you disagree
with how these funds are used. The disclosure
document provides information on advertising costs.
The following checklist will help you assess whether
the franchisor's advertising will benefit you.
- How much of the advertising fund is spent on
administrative costs?
- Are there other expenses paid from the
advertising fund?
- Do franchisees have any control over how the
advertising dollars are spent?
- What advertising promotions has the company
already engaged in?
- What advertising developments are expected
in the near future?
- How much of the fund is spent on national
advertising?
- How much of the fund is spent on advertising
in your area?
- How much of the fund is spent on selling
more franchises?
- Do all franchisees contribute equally to the
advertising fund?
- Do you need the franchisor's consent to
conduct your own advertising?
- Are there rebates or advertising
contribution discounts if you conduct your own
advertising?
- Does the franchisor receive any commissions
or rebates when it places advertisements? Do
franchisees benefit from such commissions or
rebates, or does the franchisor profit from
them?
Current and Former Franchisees
The disclosure document provides important
information about current and former
franchisees. Determine how many franchises are
currently operating. A large number of
franchisees in your area may mean increased
competition. Pay attention to the number of
terminated franchisees. A large number of
terminated, cancelled, or non-renewed franchises
may indicate problems. Be aware that some
companies may try to conceal the number of
failed franchisees by repurchasing failed
outlets and then listing them as company-owned
outlets.
If you buy an existing outlet, ask the
franchisor how many owners operated that outlet
and over what period of time. A number of
different owners over a short period of time may
indicate that the location is not a profitable
one, or that the franchisor has not supported
that outlet with promised services.
The disclosure document gives you the names and
addresses of current franchisees and franchisees
who have left the system within the last year.
Speaking with current and former franchisees is
probably the most reliable way to verify the
franchisor's claims. Visit or phone as many of
the current and former franchisees as possible.
Ask them about their experiences. See for
yourself the volume and type of business being
done.
The following checklist will help you ask
current and former franchisees such questions
as:
- How long has the franchisee operated the
franchise?
- Where is the franchise located?
- What was their total investment?
- Were there any hidden or unexpected
costs?
- How long did it take them to cover
operating costs and earn a reasonable
income?
- Are they satisfied with the cost,
delivery, and quality of the goods or
services sold?
- What were their backgrounds prior to
becoming a franchisee?
- Was the franchisor's training adequate?
- What ongoing assistance does the
franchisor provide?
- Are they satisfied with the franchisor's
advertising program?
- Does the franchisor fulfill its
contractual obligations?
- Would the franchisee invest in another
outlet?
- Would the franchisee recommend the
investment to someone with your goals,
income requirements, and background?
Be aware that some franchisors may give
you a separate reference list of selected
franchisees to contact. Be careful. Those on
the list may be individuals who are paid by
the franchisor to give a good opinion of the
company.
Earnings Potential
You may want to know how much money you
can make if you invest in a particular
franchise system. Be careful. Earnings
projections can be misleading. Insist upon
written substantiation for any earnings
projections or suggestions about your
potential income or sales.
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 bases and assumptions upon
which these claims are made. Make sure you
get and review the earnings claims document.
Consider the following in reviewing any
earnings claims.
Sample Size
A franchisor may claim that franchisees
in its system earned, for example, $50,000
last year. This claim may be deceptive,
however, if only a few franchisees earned
that income and it does not represent the
typical earnings of franchisees. Ask how
many franchisees were included in the
number.
Average Incomes
A franchisor may claim that the
franchisees in its system earn an average
income of, for example, $75,000 a year.
Average figures like this tell you very
little about how each individual franchisee
performs. Remember, a few, very successful
franchisees can inflate the average. An
average figure may make the overall
franchise system look more successful than
it actually is.
Gross Sales
Some franchisors provide figures for the
gross sales revenues of their franchisees.
These figures, however, do not tell you
anything about the franchisees' actual costs
or profits. An outlet with a high gross
sales revenue on paper actually may be
losing money because of high overhead, rent,
and other expenses.
Net Profits
Franchisors often do not have data on net
profits of their franchisees. If you do
receive net profit statements, ask whether
they provide information about company-owned
outlets. Company-owned outlets might have
lower costs because they can buy equipment,
inventory, and other items in larger
quantities, or may own, rather than lease
their property.
Geographic Relevance
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.
Franchisee's Background
Keep in mind that franchisees have
varying levels of skills and educational
backgrounds. Franchisees with advanced
technical or business backgrounds can
succeed in instances where more typical
franchisees cannot. The success of some
franchisees is no guarantee that you will be
equally successful.
Financial History
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 a significant risk; the
company may go out of business or into
bankruptcy after you have invested your
money.
Hire a lawyer or an accountant to review
the franchisor's financial statements. Do
not attempt to extract this important
information from the disclosure document
unless you have considerable background in
these matters. Your lawyer or accountant can
help you understand the following.
- Does the franchisor have steady
growth?
- Does the franchisor have a growth
plan?
Does the franchisor make most of its
income from the sale of franchises or
from continuing royalties?
- Does the franchisor devote
sufficient funds to support its
franchise system?
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Additional Sources Of Information
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