Steps To Take Prior To Purchasing a Franchise
Have the Franchise Disclosure Document Analyzed
Mitchell J. Kassoff, Esq. (firstname.lastname@example.org/973-762-1776) is an attorney who has been involved in the legal, business, litigation and corporate aspects of Franchising in all 50 states for more than 30 years. For complete information about Mr. Kassoff and to read the articles that he has published in Law Journals and other periodicals see http://legal-franchise.com/curricul/. Mr. Kassoff provides complete legal and other assistance for all areas of Franchising.
You can reach Mr. Kassoff by email at email@example.com days, nights and weekends. You can also reach Mr. Kassoff by telephone 9 A.M. to 5 P.M. Eastern Time Monday through Friday at (973) 762-1776.
Unlike other attorneys and law firms who engage in many areas of the law, Mr. Kassoff only engages in Franchise Law. Which attorney or law firm would you want to represent you and your interests, an attorney or law firm that splits their interests and attention among many areas of the law or Mr. Kassoff who spends his entire time exclusively on Franchise Law? In addition, unlike franchise companies and many other attorneys, Mr. Kassoff represents both franchisors and franchisees in court throughout the entire United States. This provides to Mr. Kassoff the current and up to date knowledge and experience as to all legal matters concerning franchising.
In deciding whether to have the Franchise Disclosure Document (FDD) analyzed and the other services performed by Mr. Kassoff you should recognize that your investment in your franchise in many cases will be hundreds of thousands of dollars, not simply the initial franchise fee. You will also be investing a huge percentage of your waking hours on your franchise. Therefore, the fee to analyze the FDD and the other services offered by Mr. Kassoff will most likely be only a small percentage of your actual investment. Quite simply, before you make such a huge investment in time and money you should ascertain the problems and liabilities that you might encounter and how they can be rectified.
If you are considering the purchase, setup and/or the operation of a franchise, Mr. Kassoff offers the following choices, of which you can choose as many or few as you like. They are as follows:
- Analysis of the FDD. (Legal fee of $3,000).
a. You will be provided with a written analysis on a page by page basis for the entire document from beginning to end by e-mail.
b. The importance of this analysis is not only what is stated in the FDD, but in addition, what is not stated.
c. Since you will be investing a large amount of time and money (most likely over a ten year period) in the franchise, the legal fee to analyze the FDD is a very small price to pay to obtain information vital to your decision as to whether or not to purchase the franchise.
d. This is the document that will determine your entire financial future. It is probably the most important item that you will ever see. In most cases, your financial life for the next ten years will be determined by this document.
- Nationwide search of the litigation history of the franchisor for all federal and state reported cases. (Additional legal fee of $1,000).
- Many litigation items are not included in the FDD in the Item 3 (Litigation) section of the FDD.
- The items that are included in the Item 3 (Litigation) section of the FDD to a large extent are limited to violations of franchise, antitrust and securities laws, fraud, unfair and deceptive practices. There are many other reasons why a franchisor might be sued. Just to provide one example, if a franchisor is not paying his bills to his suppliers this would not be stated in Item 3. You should be aware of this since it would show (a) the franchisor is in financial trouble or (b) the franchisor is not honest. In either event, you would not want to have your financial future tied to such a business. It is important to know how many times a franchisor has been sued, for what reasons a franchisor has been sued and what the outcome was.
- Before becoming legally entangled with the franchisor you want to know if it is likely that the franchisor will sue you.
- It is also important to see how often the franchisor is sued by others.
- This search will give you an idea of how litigious the franchisor is.
- You will receive by e-mail the full text of all reported cases in which the franchisor was either a plaintiff or a defendant.
- Mr. Kassoff strongly suggests that you consider the litigation review since this can be quite important to your decision. The FDD litigation section only shows a small part of possible litigation. You should know if the franchisor is sued frequently, and for what reasons. If the franchisor is being sued for not fulfilling his agreements, you should not invest with him and have your future dependent upon him. If the franchisor sues frequently, you should know this since you would have a far greater chance of becoming a defendant in a lawsuit.
- Nationwide search of newspapers and periodicals in which the franchisor is mentioned. (Additional legal fee of $1,000).
- This is done using a lawyer’s search service that has a very comprehensive database of this type of information.
- This information is important since you want to know the type of publicity that the franchisor has received in the past.
- If the publicity is favorable, you will know that you have a better chance of success.
- If the publicity is not favorable, you will know that you should reconsider your purchase of the franchise.
- If the franchisor does not have any publicity, this is important information. Part of what you are paying for is recognition by the public. If there is no public recognition, your purchase of a franchise should be reconsidered.
- Mr. Kassoff strongly suggests that you consider the search of newspapers and periodicals. It is important to know the publicity that the franchisor has received (both good and bad) in various parts of the country. If you find that the franchisor has received negative publicity you might want to reconsider your purchase of the franchise. If you find that the franchisor has received positive publicity this will be a factor in your purchase of the franchise.
- Telephonic Discussion with Mr. Kassoff- (No additional charge to discuss the conclusions of any of the above reports by telephone).
- Meeting with Mr. Kassoff at his New Jersey office- (Additional legal fee of $1,500).
- Meeting with Mr. Kassoff at your location- (Additional legal fee of $1,500, plus travel time and expenses).
It is your choice as to which of Mr. Kassoff’s services you want to utilize to learn about your potential franchisor prior to paying your money to purchase a franchise and then protecting your investment. Most people choose who wish to have the maximum amount of information before investing their money, time and a huge portion of their lives decide to take Options 1, 2 and 3. You should send by FedEx the franchisor’s FDD (the franchisor will be glad to send you another FDD if you wish to purchase a franchise) and your check for Mr. Kassoff’s services, which will be based on your choice of the services you desire.
It is strongly recommended that you send both a hard copy and an e-mail (many franchisors will supply an e-mail version in addition to a hard copy) of the FDD. The e-mail version of the FDD can be in pdf, MS Word or any other format. If you send an e-mail version of the FDD you do not have to send a hard copy of the FDD if you pay by credit card. You will receive your report by e-mail within four business days after Mr. Kassoff receives your package.
You can make all or part of your payment by your
credit/debit card, if you pay the bank charge associated with this method of payment. In fact, this method of payment would probably be less expensive than making a photocopy of the FDD and paying FedEx charges.
If you provide the FDD electronically and you choose to pay by credit card nothing has to be mailed to Mr. Kassoff for him to provide his analysis. If not, the FDD, check, instructions as to which of the services offered by Mr. Kassoff you wish to utilize and your e-mail address should be sent to Mitchell J. Kassoff, Esq., Two Foster Court, South Orange, New Jersey 07079-1002. The use of Federal Express is strongly recommended (call 800-Go-Fedex and FedEx will pick up the package at your home or office). Do not send anything by U.S. Postal Service Express Mail, Certified Mail or Registered Mail!
Mr. Kassoff can file your business as a corporation or LLC in the state of your choice. Since Mr. Kassoff deals exclusively with franchise matters, he can also handle all matters that concern your franchise of every kind and nature. This will enable you to concentrate on the business aspects of your franchise.
Most non-litigation work can be done by Mr. Kassoff on a flat rate basis. This will enable you to know your entire cost before you decide to proceed.
Work That You Can Do Yourself
- The first thing that you must do is to obtain the FDD from the franchisor.
- The next step is to carefully read the entire FDD from beginning to end. Even though this is a long and tedious document, your future depends on the information contained in it and should be read and understood.
- The next step is to contact as many franchisees as possible to determine what the relationship is between the franchisor and its franchisees.
- A general description of franchising and information and work to do is as follows:
Franchising is big business. Franchises in the United States generate more than One Trillion Dollars in total sales.
Franchising provides a unique opportunity to people by allowing them to start their own business with the support and resources of a large and established organization. It is hard to start from scratch and risk one’s money on an untested idea. That is why franchises can offer a wonderful opportunity. However, for those investors who are considering purchasing a franchise, caution is most important. The same reliance on the franchisor that makes franchising so attractive can also open up the door for abuse if the franchisor proves to be someone who is untrustworthy or simply can’t live up to his promises. Careful investigation and consideration is vital before deciding whether or not to purchase a franchise.
While the Act helps to protect current and potential franchisees, it is important that investors take the proper steps before purchasing a franchise. In order to make a sound investment decision, here are several tips that all prospective franchisees should know:
BE CERTAIN THAT YOU OBTAIN A COPY OF THE FDD
The FDD is your first line of defense against franchise fraud. It contains vital information that you should know before making a decision. Under the law, the franchisor must give you an FDD at least 10 business days before you sign a contract or pay money to a franchisor, or at the first personal meeting, whichever is earlier. If a franchisor is pressuring you to invest right away and does not give you this time, then you are probably dealing with a suspect company. If you do not receive an FDD at least ten business days before you invest or at the first personal meeting, contact the Attorney General’s Office immediately.
READ THE FDD CAREFULLY AND INVESTIGATE ALL CLAIMS
Franchisors are required to file the FDD with some states. However, they are not checked for accuracy, merely completeness of disclosure; there is no guarantee that the FDD is accurate, even if it is filed. It is important, therefore, to contact current franchisees in the area from the list that is provided in the FDD. Ask them about how their businesses are doing so you can compare the representation in the FDD with the real world, and determine the reliability of franchisor’s claims. If possible, you should visit the franchisees and observe all the facets of the business in practice. Try to communicate with as many of the franchisees as possible. The more franchisees you talk to, the better informed your decision will be. Make sure you contact not only just franchisees that the franchisor tells you to, but also other franchisees that you know of.
CAREFULLY EXAMINE RISK FACTORS
Franchisors must list certain €œrisk factors€ in the FDD. For example, if the franchisor designates a state outside of your state as the forum to resolve a dispute or file a lawsuit you may have to incur additional expenses and loss of time in traveling to that state. Also, be cautious if a franchisor has a very low net worth and pay attention to the number of franchises that were terminated during the past three years. An unusually large number may be a sign of danger. The FDD should disclose the names and addresses of franchisees that have dropped out of the system within the last year. Contact them to find out why they dropped out.
ITEM BY ITEM DESCRIPTION OF THE FRANCHISE DISCLOSURE DOCUMENT
Item 1. FRANCHISOR, ITS PREDECESSORS AND AFFILIATES
Some of the information that a franchisor is required to reveal in a FDD, such as disclosure of bankruptcies and lawsuits in the franchisor’s past, may be embarrassing and detrimental to the sale of franchises. If a franchisor were to transfer its franchise operations to a related company with a clean bill of health, it could evade these disclosure requirements. To make this impossible, numerous disclosures about predecessors and affiliates are required in Item 1.
Item 2. BUSINESS EXPERIENCE
In some FDDs, biographies of the franchisor’s key people only cover the last five years and do not mention educational background. This is because some franchise examiners will not approve an offering circular unless the franchisor deletes all non-required information from its Item 2 biographies, not because all franchise executives have a maximum career span of five years and no education.
Item 3. LITIGATION
Franchisors and their personnel must tell prospective franchisees about lawsuits and arbitration proceedings brought against them. But they do not have to tell prospective franchisees about actions they have brought to collect debts owed to them by franchisees who have lost money trying to follow their franchised systems.
Item 4. BANKRUPTCY
Among other things, any franchise executive who has filed bankruptcy within the past ten years has to tell all in Item 4. Often, however, the requirement catches some poor man who is an employee of a franchisor and is just trying to quietly live down a personal bankruptcy.
Item 5. INITIAL FRANCHISE FEE
In Item 5 the franchisor has to disclose whether the initial franchise fee is uniform. Supposedly, this lets a prospective franchisee know that he is getting as good a deal as everyone else. In reality, the required disclosure is not effective. This is because it is only applicable to franchisees currently buying franchises. If the price was different in the past or changes in the future, these facts do not have to be revealed. The exception is California, which obliges franchisors fill out a form each time it sells a negotiated franchise and attach these forms to the back of its offering circular. Virtually every FDD says that the initial franchise fee is nonrefundable. This means that the franchisor does not have to give a franchisee’s money back if he gets cold feet, fails to locate financing, or, as is often the case, cannot find a satisfactory site. It does not mean that franchisors never refund these nonrefundable fees (because they often do), but only that a franchisee should not rely on it. If the franchise agreement does not require the franchisee to pay the initial fee until the franchise is ready to open for business, or if the initial fee will be paid into escrow, this means that the state is worried about the franchisor’s ability to survive. No franchisor sets its agreement up this way voluntarily. The state must have required it to defer or escrow the fee as a condition of registration. Just because the state is concerned, however, does not mean the State is correct.
Item 6. OTHER FEES
These fees are listed in this section.
Item 7. INITIAL INVESTMENT
This chart is supposed to give a franchisee a realistic notion of how much money he needs to get up and running with the franchisor’s system. Although the chart is supposed to be based on actual data, many franchisors base it on their €œexperience€ instead (in other words, they guess). Franchise litigation histories show that the figures in Item 7 are often highly optimistic. Prospective franchisees should test the reality of these figures by pricing key expenses, such as rental of office space.
Item 8. RESTRICTION ON SOURCES OF PRODUCTS AND SERVICES
The franchisor is supposed to disclose, in Item 8, whether it takes kickbacks from suppliers in return for requiring franchisees to buy from those suppliers. The franchisor is also supposed to disclose whether it makes money on the franchisee’s purchases from vendors the franchisor designates or recommends. However, the FDD guidelines on this subject are phrased so confusingly that many franchisors are not sure what is required and therefore the responses may be inaccurate.
Item 9. FRANCHISEE’S OBLIGATIONS
These obligations are listed here.
Item 10. FINANCING
In this Item, the franchisor is supposed to tell the franchisee all about the financing it provides or arranges for the franchisee to obtain from someone else. Franchisors hate to answer all the detailed questions in Item 10 because of the work required and requires knowledge of esoteric matters such as how to calculate APR. So they answer Item 10 by saying they don’t offer or arrange financing. The fact that the same financial source has funded 9 out of every ten franchised store build outs in their systems is apparently just a coincidence. If a franchisee expects to need financing and no information about it appears in Item 10, he should get the information in writing, even if it is just a letter from the franchisor’s bank.
Item 11. FRANCHISOR’S OBLIGATIONS
This is the part of the offering circular where the franchisor is supposed to describe in detail everything it is going to do for its franchisees. However, the disclosures are primarily directed toward revealing what the franchisee has to do, instead. This isn’t the franchisors’ fault. The Guidelines for preparing a FDD are set up this way. Part of this section concerns computer equipment. The franchisor is required to disclose whether it can independently access a franchisee’s computer data via modem and examine the franchisee’s data without contractual restriction. In the section on advertising, the franchisor is required to reveal how much of the advertising money paid by franchisees it can use to reimburse itself for operating the advertising fund. Many franchisors take no compensation at all, contributing more to the advertising fund than the franchisees do. Even though many franchisors promise franchisees to use their expertise to help the franchisees find good business locations, careful reading of Item 11 of most offering circulars reveals that the franchisor has no responsibility at all for site selection. Instead, the franchisee has to get the franchisor’s permission to develop a given site, but cannot hold the franchisor responsible if the site turns out to be bad.
Item 12. TERRITORY
If the franchisor can build a competing outlet or grant a franchise right on top of another franchisee’s location, it is supposed to be disclosed in Item 12. If a franchisor can compete with its own franchisee by selling its branded product in supermarkets or other outlets at a lower price than its nearby franchisee can afford to charge, Item 12 should say so.
Item 13. TRADEMARKS
If a franchisor’s name turns out to belong to someone else, and that someone else sues the franchisee for infringement because the franchisee uses the name, does the franchisor have to defend the franchisee? If the franchisee is forced to change its signs, stationery, advertising, and so on, will the franchisor reimburse the franchisee for the expense? This information is contained in Item 13.
Item 14. PATENTS, COPYRIGHTS AND PROPRIETARY INFORMATION
Patent, copyright and proprietary information is contained here.
Item 15. OBLIGATION TO PARTICIPATE IN THE ACTUAL OPERATION OF THE FRANCHISE BUSINESS
The obligation to participate in the actual operation of the franchise business is contained here.
Item 16. RESTRICTIONS ON WHAT THE FRANCHISEE MAY SELL
The restrictions on what the franchisee may sell is contained here.
Item 17. RENEWAL, TERMINATION, TRANSFER AND DISPUTE RESOLUTION
The renewal, termination, transfer and dispute resolution terms are contained here.
Item 18. PUBLIC FIGURES
If a famous person recommends that franchisees buy a particular franchise, the franchisor is supposed to reveal in Item 18 how much it paid the famous person for making the recommendation.
Item 19. EARNINGS CLAIMS
Does anyone make any money with this franchise? If so, the figures can be presented in Item 19. If the franchisor has something to brag about, this is where it should do it. If the franchisor does not give any information in Item 19, you have to ask yourself, why not? The answer is that franchise lawyers spent years telling franchisors how dangerous it is to provide earnings information in case they are sued, so that some franchisors who should be proud of their franchisees’ financial performance are afraid to tell anyone.
Item 20. LIST OF OUTLETS
Item 20 tells prospective franchisees how many franchises a franchisor has sold and how many of the franchised businesses have survived. If this Item shows there have been lots of terminations, a person might conclude that it is hard to stay in business in this business.
Item 21. FINANCIAL STATEMENTS
The last three years of audited financial statements are contained here. Does this franchisor have enough cash to provide the benefits to franchisees that it says it will? The financial statements referenced in Item 21 and attached as an exhibit should provide an answer. If the letter from the auditor at the beginning of the financial statements contains a going concern notation–a statement that continued operation of the franchisor’s business is in question, watch out! Read the footnotes to the financial statements.
Item 22. CONTRACTS
You can make all or part of your payment by your cards4.gif credit/debit card, if you pay the bank charge associated with this method of payment
All contracts that the franchisee must sign are contained here.
Item 23. RECEIPT
The franchisor will ask you to sign this to prove you received the FDD.
CONSULT WITH AN ATTORNEY WHO DEALS EXCLUSIVELY WITH FRANCHISING
Remember, you are making substantial commitment in both time and money and like all other important decisions; you should seek competent advice before you act. Except for the purchase of a home, this will be the most money that you will spend on anything in your life. Since Mr. Kassoff deals exclusively with Franchising and has done so for more than a quarter of a century, he is an excellent choice.
UNDERSTAND THAT YOU WILL NOT BE COMPLETELY INDEPENDENT
As a franchisee you will be required to conform to certain rules designed by the franchisor to assure, that the product and service you deliver to your customers is the same type and quality delivered by all the other franchisees. While the franchisor may take into account the needs of each individual store when formulating its policies, there is the possibility that the needs of the many will outweigh the needs of the few and you might have to conform to a franchisor’s policies, such as selling products that may be unprofitable in your particular location. Furthermore, you may be unable to institute innovative ideas that you come up with yourself. If you are the type of person who is fiercely independent and does not like following rules, then buying a franchise may not be the right choice for you.
Of tremendous importance, is your need to know the franchisor’s rules prior to making your decision. For example, there may be rules regarding the number of hours you must operate per week, or the number of employees you can hire. Also, look carefully into rules requiring you to make additional expenditures in the future in order to keep your franchise up to date. A franchise system must, in order to be successful, keep up with the times and match innovations and new products offered by competitors. In your franchise outlet, you may be required to make expensive improvements, hire additional personnel, etc., even though you would not have done so if given the choice or you cannot afford it.
STUDY THE ESTIMATE OF INITIAL EXPENSES
Franchisors frequently underestimate the initial expenses in an effort to make the cost of purchasing a franchise seem lower than it really is. If the estimate is too low, you may find yourself with insufficient cash to carry on until the business produces a positive cash flow. You should conduct your own investigation on the cost of items, especially big-ticket items, such as real estate and construction renovations.
GET TO KNOW THE FRANCHISOR
It is important to know the reputation and customer recognition of the franchisor’s product as well as the actual people behind the franchisor. As you are buying into a name, trademark or idea, the more recognized that name the better your chances for success. When a new store from an established chain is opened, there is already customer recognition and loyalty that you can capitalize on. Conversely, if the franchise is unknown, or worse, has a bad reputation, you may be starting from ground zero or possibly at a disadvantage. Remember that you have no control over other franchisees that will be using the same name as you. If the franchisor does not monitor them properly, then their actions and mistakes could impact directly upon your business.
Also, know the people you are dealing with. Make sure the people in the main office are people who you can work with. Look at the experience that these people have and ask yourself if they are people that you can trust, and from whom you can get competent advice. Also, check to see if these people have any criminal records and inquire into the litigation history of the franchisor. This information should be contained in the FDD.
Franchising has become an increasingly popular way to market goods and services and can be a lucrative way to conduct business when done correctly. An individual who follows the above strategies, is likely to increase his chances of investing in a legitimate franchise.
What to Consider Before Buying a Franchise
Don’t Let This Happen to You
The terms of the deal were clear. The franchise agreement spelled it all out, and dozens of franchisees invested in the franchise. In return, they were given a route along which to sell the franchisor’s exclusive line of snack and beverage products. The franchisees ordered the products from the franchisor and sold them to stores, keeping the profit. The franchisor advised the franchisees that they should also buy equipment, rent warehouse space and purchase a truck, and the franchisees complied because they were told it was essential for their business. However, the products arrived months late and when they did arrive on time, they were of poor quality. For instance, the potato chips were stale and there were foreign particles in the beverages. Soon after the new franchisees paid the initial fees, the franchisor closed down his warehouse, stopped answering his phone and disappeared with the franchisees’ money.
The victims in this case thought that they were investing in a legitimate franchise business. They were normal, everyday people who lost their life savings because of a lack of thorough research and skepticism. They trusted what they were told instead of doing their homework and checking up on each aspect of the franchise. Consulting with an attorney knowledgeable about franchising would have aided purchasers in learning about some of these risks. As it turns out, not only was this franchise not registered with the state, but the President and owner had previously been convicted of a felony, a scheme to defraud. If the franchisees had known what to consider when buying a franchise, they would not have invested.
Warning Signs that You Might Be Getting Involved in a Fraud
Failure to Disclose All Necessary Documents and Details
The franchisor who does not properly disclose all relevant details to the potential franchisee is probably trying to hide something. The franchise may not be profitable or the franchise may be a scam. Before you sign anything, be sure you learn all of the relevant information, make sure all of your questions are answered fully and be certain that all relevant details are clear.
High-Pressure Sales Tactics
You should never feel pressured to buy a franchise or to make your decision quickly, for any reason. Remember that you are making an investment and you should be cautious with your decision.
Claims of Minimal Risk and Promises of Unrealistic Profits
There is a large amount of risk associated with buying a new franchise. Even the franchisor with the most successful chain cannot legitimately promise that you will make money. Be wary of any franchisor who guarantees that you will definitely make a lot of money with little risk.
Unjustified Start-Up Fees
Initial fees are sometimes very high, but be sure you know where your money is going. Fees that seem too high may very well be just that. Many crooked franchisors have sold franchises and disappeared with the initial franchise fee.
The Truth about Legitimate Franchises: What Every Investor Needs to Understand
One reason why many franchises are so successful is that the system creates a certain synergy. Businesses brought together under one trademark can achieve things not possible for individual business people, such as group advertising and buying power. Along with success, however, comes a certain number of failures. There is no guarantee of success. Therefore, it is vital that potential franchisees understand that:
- Franchises are not guaranteed to make money. Even if you own a business which is part of the most successful franchise in the country or the world, your store may lose money, especially in the beginning. Be prepared to deal with this type of situation.
- A franchise is a long-term investment. You will not get rich quick. It may take you several years to develop your business to a point where you have paid off any loans and are making the amount of money you anticipated. If your business does not make money or you tire of it, you cannot simply close up shop and forget about it. Like it or not, you must continue to work for the full amount of time agreed to in your contract.
- Franchisees cannot under any circumstances deviate from the norm. You will be told exactly how to run your business, right down to how to organize your finance books or where to keep the napkins. Even if you believe that the franchisor’s decision is not the best one for your particular store or regional location, you will be required to follow the rules. If you are a natural entrepreneur who has a creative mind and wants to operate your business your own way, franchising is probably not for you.
- A franchise requires a very large amount of money. The startup fees may number in the hundreds of thousands of dollars. Make sure you and your family can afford to sustain this kind of loss, should your business fail. There will also be continuous fees for royalties and advertising which will continue for as long as you own the business. They may be quite high and you may not want to pay them after learning the business and doing all the work, but you will be bound to continue to pay them as part of your contract.
- You are not guaranteed the right to alternate vending of inventory, product, service or supplies beyond those that are disclosed in the FDD. The franchisor may require you to buy everything you need from an approved vendor or group of vendors. Often, these vendors charge more than independent vendors do because they give the franchisor a part of the earnings. Even if you know that you could buy the same items elsewhere for significantly less money, you may be required to use only the vendors accepted by the franchisor. Also, find out what factors could affect the franchisee’s ability in the future to obtain essential goods economically from a reliable source.
- The franchisor may be bought out or may go out of business. If the franchisor sells to or merges with a company that does not understand franchising or if it has different goals that allow the system to deteriorate, you may suffer.
Tips for Prospective Franchise Purchasers to Remember
1. Make sure the seller of the franchise supplies you with a copy of the FDD approved by the state in which you are located and that you read it carefully.
You must receive an FDD at least 10 business days before you are asked to sign a contract or pay money to the franchisor. When you receive an FDD you will be asked to sign a receipt for it. Make sure that the date on this receipt is correct, and keep a copy for your records. A dishonest franchisor may attempt to satisfy the 10-day rule by back-dating the receipt without your knowledge. The franchisor may also ask you to consent to the back-dating in order to complete the transaction at an earlier date than allowed by law. You should refuse. The 10-day rule is designed to afford you time to thoroughly examine the FDD and make an unhurried decision about whether or not to invest in the franchise.
2. Consult with an attorney with experience in the field of franchising before paying any money or signing any documents.
In the business world, you get what you pay for. If you cut corners on professional advice, you will regret it later. You should seek professional legal advice, especially from someone who is familiar with the field of franchising, to help you make an informed decision. An attorney can help you understand the franchise contract, which is part of the FDD. Choosing a lawyer you are comfortable with and that you can afford may take some investigation, but will be worth it. Find out in advance the cost of the initial consultation will be before seeing the attorney.
Carefully study the estimate of initial expenses contained in the FDD. Franchisors may underestimate these expenses in an effort to make the cost of purchasing a franchise seem lower than it really is. If the estimate is too low, you may find yourself with insufficient cash to carry on until the business produces a profit. Relying on the FDD without consulting a professional and hoping that the franchisor has told the truth is setting you up for potential fraud. See page 16for a list of associations and government agencies to help you in your research.
3. The experience of others is one of the most effective guides you can use to determine how you would do if you purchased a franchise.
The FDD should disclose the names and addresses of individuals currently operating franchises in your state and adjacent states. Contact them and ask them how their franchises are doing. Visit the franchised premises and observe the volume and type of business being done. Pay attention to the number of franchises terminated during the past three years an unusually large number may be a telling sign of how the franchisor does business. The FDD should disclose the names and addresses of franchisees who have dropped out of the system within the last year. Contact them to find out why they dropped out.
It is important for you to communicate with every listed franchisee, if this is practical, or a large sample of them, if it is not. The more franchisees to whom you talk, the more you will learn about the franchisor and the chain. A franchisor may attempt to supply you with a list of selected franchisees to contact. View this with suspicion. Those on the list may be shills, franchisees being paid by the franchisor to give you a good opinion of the business. Indeed, if the franchisees on the list are far away and not likely to be visited personally, they may not be franchisees at all, just dishonest people on the other end of the telephone.
4. Look for a territorial protection clause in your contract.
Encroachment is one of the most litigated issues in franchising. Whether you are a fast food franchisee who finds another unit has opened up a few blocks away, an ice cream franchisee who sees his product being sold in the corner grocery store or a franchisee who discovers that his franchisor is taking orders over the Internet, all of this adds up to lost profits for a franchisee who has spent years building up a business.
Protected or exclusive territory is the area around the franchisee’s business location in which no other branch of the franchise is allowed to open a store. The extent of the protected territory may be defined by the radius from the outlet’s location, the number of households and businesses in the area, the number of people living in the area, zip codes, state or highway boundaries, or some other measure. Sometimes, the franchisee must meet certain sales quotas or performance standards in order to keep the exclusive territory. Before signing the contract, you should determine if the protected territory is large enough to carry out the franchise’s business objectives in light of the competition which will come from other branches of the franchise.
The protected territory clause in the original contract, as discussed above, will clarify exactly what is and is not considered exclusive territory. Courts often uphold the idea that if there is no specific protected territory clause in the original contract, the franchisee has no legitimate encroachment claim, so make sure you are clear on exactly where your franchisor can and cannot open stores. Sometimes, the franchisor will make a deal with an existing franchisee. The franchisor will allow a store to open within the exclusive territory and the franchisee will receive a percentage of the profits from the new store. This is called a reverse royalty.
5. You should understand that although you will be the owner of your own business and thus bear the consequences of its success or failure, you will not be independent.
You will be part of a chain and will be expected to conform to certain rules designed to assure that the product or service which you deliver to your customers is of the same type and quality as those delivered by other franchisees in the chain. Uniformity is very important to a franchise chain and you will be required to observe the rules concerning it, even though you may find them ineffective or unprofitable and have better ideas of your own. If you are an independently minded person, franchising may not be for you.
6. Be aware of non-compete clauses.
Even after you have relinquished control of your outlet, your contract still holds and it will probably contain a non-compete clause. This section prevents you from owning or operating a competing business within a certain geographical area for a specific time period.
7. Widespread customer recognition of a trade name is the equivalent of goodwill in franchising.
The trade name is the symbol of the franchise chain’s quality. Anyone familiar with a trade name has an idea, whether true or false, of the quality that the name represents. The same is true of the name you will be purchasing when you buy a franchise. If the name is unfamiliar to you and your friends, you should ask yourself whether you are getting your money’s worth in buying the franchise. If the franchise name is recognizable, you will have a head start in the marketplace. Opening a franchise center may give you the benefit of a well-known reputation, but it is not a guarantee that you will make a profit. No franchisor can guarantee that your outlet will be profitable. Franchising is similar to other businesses in that it takes a large amount of resources, especially time and money, to operate successfully.
No doubt you intend to do your best to see to it that the franchise name will stand for high quality, but the decision is, once again, not entirely in your hands. The performance of the other franchisees in the chain will also affect the quality associated with the name, as will the leadership and imagination of the franchisor itself. If others in the system do a poor job, the ill will which ordinarily attaches to such performance may be transferred to your business. Also, the franchisor’s willingness to keep the name before the public through advertising and to keep things up-to-date through research and development is of key importance. A franchisor or other franchisees who fall down on the job may ruin a franchise name no matter how hard you work.
Extra caution should be taken when a franchise is being acquired from a new franchisor or from a franchisor who does not have its trademark federally registered. What type of trademark protection has the franchisor sought? Are there any possible conflicts with its marks that could affect you, the franchisee? In the event a problem arises with the franchisor’s mark or if another chain acquires the franchise system, does the franchisor have the right to require the franchisee to change its mark?
8. Examine the site selection process outlined in the FDD, as the location of a franchise is very important.
A poorly selected site may well doom a franchise no matter how attractive its features. Determine what the franchisor will do to assist you in selecting an appropriate site and whether you will be able to change the site if it proves to be unsatisfactory. Find out if relocation rights are granted to the franchisee in the event of condemnation, lease expiration, or pure business results, or is relocation a matter of the franchisor’s then-current policy. Is there any type of territorial exclusivity included in the contract? If so, what is the exact nature of any exclusivity or protection granted? Is it contingent upon achieving certain performance levels? If the franchisor’s participation in the site selection process appears to be perfunctory, or if the franchisor offers no assistance, think twice about buying. If you are purchasing an existing store or route, find out why the previous franchisee is no longer with the company.
9. Training is one of the distinct advantages of franchising.
It enables the franchise operator to acquire within a short time the skills that an independent operator might take months or years to acquire. If the training described in the FDD is not sufficiently detailed, ask about it. Also ask existing franchise operators about the training they received. While a well thought-out training program can be an effective substitute for the trial and error of experience, you should be aware that there is no complete substitute for experience or natural business talent. Ask any businessman; learning a business can take years and that one never stops learning.
10. Look for the existence of franchisee advisory groups and associations.
Both advisory groups and associations are organizations of franchisees, but they differ in their roles in the franchise chain. Advisory groups are organized by the franchisor and are composed of franchisees and franchisor representatives. They help the franchisor make decisions, voice complaints, and form relationships with other franchisees. Franchisee associations, on the other hand, are usually independent of the franchisor. They have their own system of organization, rules and membership requirements. Franchisees pay dues in order to fund the activities of the association. In some cases, an advisory group and an association coexist in the same franchise chain. If your franchise has an association or advisory group, it usually implies that the franchisor takes seriously the requests and ideas of the franchisees, and these are often the strongest franchises, with franchisees who feel that their voices are being heard. You should speak to representatives from the franchise advisory group/association to ensure that franchisors listen to their franchisees.
11. Know the franchise seller.
A franchise agreement is only as good as the people behind it, regardless of how good it looks on paper. The FDD gives certain information concerning the employment background of the principals of the franchisor and their litigation histories. Check their employment background in the FDD to see if they have been employed in franchising or a business related to the franchise being sold. Examine their litigation history. An excessive number of claims against them may mean that they have not been performing according to their agreements.
The franchisor’s experience in selling franchises and managing a franchise chain is as important to you as the training you will receive to operate your own outlet. If the franchisor has little experience in managing a chain of franchises, you will find that the guidance, training and other support you receive may be unreliable.
Frequently Asked Questions about Franchising
- What is a FDD?
A FDD is a detailed disclosure document for each potential franchise purchaser. Included in the disclosure document is over twenty different items of information about the franchise, including the history of the company, required fees and investment costs, information about the franchisor, and any litigation in which he has been involved. When you are given the disclosure document, you must sign and date a statement acknowledging that you received it.
- What is the regulatory framework governing franchises?
There are three distinct bodies of law governing franchising: federal and state registration and disclosure laws, franchise relationship laws, and business opportunity laws.
State Franchise Registration and Disclosure Laws
State registration and disclosure laws provide that, unless an exemption is available, no offer or sale of a franchise can take place until the franchisor has registered a FDD with the state in which the sale is occurring, the FDD has been approved and the potential purchaser has received a copy prior to signing any agreements. To be approved, a FDD must honestly and in detail explain all of the material facts of the franchise and the sale. These registration and disclosure laws are looking to prohibit misrepresentation in the offering of franchises to potential buyers and to make sure that these potential buyers have at their disposal all of the necessary information to make an informed decision. Criminal and civil penalties may apply to franchisors who do not fully disclose all of the necessary information or who misrepresent the truth.
The Federal Trade Commission Franchise Rule
The FTC Rule states that franchisors must make full pre-sale disclosure in an FDD, or FDD. However, the FTC Rule does not require that the FDD be approved prior to distribution. Enforcement under the Rule is bolstered by penalties of up to $10,000 per violation.
Franchise Relationship Laws
A franchise agreement, like any other contract, has a fixed term. Also like any other agreement, a franchise contract may be terminated before it actually expires. Many states require just cause for termination. Just cause is defined as the failure of the franchisee to comply with some aspect of the deal as put forth in the contract, as well as the failure of the franchisee to correct, or cure, the problem once it has been pointed out. Other relationship laws address such aspects of the franchise relationship as discriminatory treatment, market protections, ability of franchisees to belong to franchise associations and the minimum advance notice of termination or expiration that must be given to franchisees.
Business Opportunity Laws
Some states have enacted business opportunity laws. These laws regulate the sale of opportunities to engage in new business ventures, so they often impact franchises. The laws require registration and disclosure in the same manner as state franchise registration laws do and usually also require the posting of some kind of financial security investment. Some states exclude franchise offerings from business opportunity laws because they comply with federal or state franchise regulations, while other states hold franchises to both the business opportunity laws and the state regulations.
The Costs of Buying and Owning a Franchise
Make sure you are prepared to make an investment of a large magnitude before you buy. Compare your estimates with the estimates of other franchise chains. Will you get a better deal from a competitor’s franchise?
Initial Franchise Fee
This includes all fees and payments for products and services received from the franchisor before the business opens. The initial franchise fee is usually non-refundable and paid up front. In some cases, it is payable in installments, but the franchisor must disclose the terms of payment in the contract. Sometimes the initial franchise fee is deferred or placed into an escrow account until the franchisor has completely performed all of its obligations to help the franchisee start up the business. This usually indicates that the franchisor is financially weak or that the franchise is newly organized.
These fees are usually explained in the form of a table which clarifies how much money must be paid to whom and when such payments are due. This may include, but is not limited to, fees for royalties, advertising, transfers (payable only upon a transfer of the franchise agreement), renewal (payable only upon renewal of the franchise agreement), training, additional support and assistance, and membership in a franchisee membership organization.
Financing the Franchise
Any financing arrangements offered by the franchisor are contained in the FDD. Often, this part will simply indicate that the franchisor does not provide any type of financing. If any financial aid is provided, the amount, interest rate, required collateral, potential liabilities upon default and any other terms and conditions must be included. Remember that you do not have to use the franchisor or its lender simply because they offer to help. Compare loan and lease services at other financial or leasing organizations as well.
Rights and Responsibilities of the Franchisee and Franchisor
The FDD contains information regarding the franchisee’s obligations to buy or lease from the franchisor or a supplier designated by the franchisor. The franchisor must also disclose any revenues or other benefits it received as a result of any required purchases or leases. Don’t forget that there are many costs not paid by the franchisor. Be sure to include these in your financial estimates.
Make sure you understand the circumstances under which you and your family members may be held personally liable. Under what circumstances will you be personally liable when a customer, vendor or other person sues? Who will be responsible for the various obligations under the contract? Are there restrictions on other activities of the franchisee and hiher family members with regard to ownership, employment, participation in competitive businesses, etc? Do certain restrictions conflict with any current or foreseeable business interests of the franchisee or family members?
The franchisor’s obligations lie in many different areas, such as obligations prior to the business opening, obligations during the term of the franchise agreement, obligations relating to site location, obligations to provide a training program, and an estimate of the length of time needed to open a center following the signing of a franchise agreement or the payment of a fee to the franchisor.
Ask if there is an operations manual. If so, read it carefully. It will tell you what standards of operation the franchisor expects of the franchisees. You may have to sign an agreement to keep the contents of the manual confidential. Does the manual provide for all aspects of the business? Does it contain an accounting or inventory system? If any of the systems are computerized, is the cost of the computer included in the amounts paid to the franchisor as part of the initial franchise fee?
Find out what training you will receive. Will you learn by hands-on experience at another franchise outlet? If so, how long will you be expected to work there? Will you be paid? Are you the only one who will be trained or will any employees be trained as well? Is there a course? How long is it? What type of ongoing training, management assistance and advice will you receive if and when problems arise? The amount of training you will need will depend on your present business knowledge and experience and on the operating standards you will be expected to keep.
The franchisor is not required to include an earnings claim in the FDD. If the franchisor does not make a claim of this sort, discussing projected earnings is prohibited, whether it is orally or written on the proverbial cocktail napkin. There are many reasons why the franchisor may choose not to include an earnings claim in the FDD. If the numbers turn out to be inaccurate or misleading, the franchisee can sue and the franchisor may even be held personally responsible and face both civil and criminal charges.
Be skeptical about earnings claims that are presented. A franchisor will only make an earnings claim to portray the business in a positive light; for example, he may creatively use a small portion of franchised units in making the earnings claim. Determine how the franchisor arrived at the numbers he gave you. For the franchises whose numbers were used, where is each business located? What is the competition there? How long has that branch been in business? Also, understand that it takes a while for a new business to turn a profit, so even if you are given an earnings claim, you may not realize that kind of profit for at least a few years.
If an earnings claim is made, a description of the factual basis behind those numbers must be included as well. If an earnings claim is not made, there are still ways of estimating how much money any given unit of the franchise might make. Ask other franchisees in the system how much they net and gross monthly. They are not required to disclose this type of information, but often they will at least give you an idea of the amount of money their businesses draw in. If the franchise is a public company, it is required to provide the Securities and Exchange Commission with financial reports.
Most franchisors require franchisees to give a certain amount of money each year to the franchisor for national advertising campaigns. This is a perk of being part of a franchise, since most local businesses cannot afford to advertise on the national or even the regional level. The national advertising fee is usually determined based on some percentage of sales, although it is occasionally a flat rate. You may be asked or required to join a local or regional group, putting money into a fund for advertising in the area. Pooling money in this fashion is usually beneficial because it allows for more ads to be produced and for each one to be shown more often.
Like every other aspect of the franchise agreement, however, the advertising fee section requires cautious review before signing the contract. Where does the money go exactly? What happens to any extra funds at the end of the year? Is the franchisor permitted to change the requirements at any point? Do the franchisees have any input in the matter? Who creates the ads? Do all stores contribute at the same rate?
Renewal, Termination and Transfer
If you are content with the level of business you are doing at your unit of the franchise, you will probably want to renew your franchise agreement. You must make sure that the franchisor wants to renew with you. The franchisor reserves the right to refuse to grant you a renewal, usually due to extenuating circumstances. For instance, if you are behind in your royalty payments or do not comply with regulations regarding some other aspect of the business, the franchisor may not want to continue doing business with you. In some cases, renewal clauses are included in the initial contract. Some franchises do not permit renewals at all, while others limit the number of times you can renew.
The franchisor will probably charge a renewal fee. It should be less than the initiation fee you paid when you bought the franchise, because this time you are starting with a solid base instead of starting at ground zero. You do not need to buy equipment, train employees, etc. because those aspects of the business are already in place. However, be aware that renewal is often a time when a franchisor will mandate a significant change or expense in the operation of the franchise that you may not have anticipated.
Be aware that the franchise system and the marketplace are subject to change. The last agreement you signed may have been written 10 or 20 years ago, and will probably need to be updated to keep up with current trends. Look out for changes in royalty and advertisement fees, territorial rights, remodeling requirements, new equipment, training requirements, renewal terms and material terms of the relationship, such as dispute resolution. These are the aspects that are probably most likely to change. Also, note whether the Internet has affected your business. You or the franchisor, or both, may want to address this in the renewal agreement.
Termination is also a highly litigated area in franchising. Note what your initial agreement says about each side’s right to terminate the relationship. The franchisor is usually allowed to terminate the agreement if he can prove that there is just cause for doing so. This means that the franchisee must fail to uphold some part of the agreement, which would justify the franchisor’s decision to terminate. Therefore, it is of the utmost importance that you understand each provision under which the franchisor has the right to terminate the agreement. These should be clearly stated in the original contract. Also, see what the contract says about the franchisor giving you notice of your failure to complete some aspect of the agreement. Will you have time to correct the error before the franchisor moves ahead with termination of the agreement?
It may seem odd to think about selling your franchise before you have even purchased it, but a prudent investor will do so now in order to prevent problems later. Check your contract to see what the rules relating to transfer agreements are. Some franchises do not allow transfers of any kind, while others have specific rules governing procedure.
Your franchisor may have a right of first refusal if you decide to sell. This means that if a potential buyer makes an offer, the franchisor has the right to match the buyer’s price and, in effect, buy out the business from right under the potential buyer.
Your franchisor may also have a right to reject potential buyers. This can be extremely frustrating for a franchisee looking to sell and may also result in a franchisee selling his franchise for much less than he wanted to. This is usually done in an effort to find more potential buyers, hopefully one who will be acceptable both to you and to the franchisor. New buyers do not want to come in at the very end of the line, they want to come in while your franchise is still up and running and has a long life. Therefore, contracts with years left on them and with renewal options are very valuable, as are leases which are not yet due.
Both the franchisor and the franchisee will probably want to settle any disputes in the least costly, least time-consuming, least adversarial way possible. One option is arbitration. The arbitration proceeding may be court-supervised or before a private third party. Many franchise agreements require arbitration as the sole means of dispute resolution. Franchisors may also mandate that any arbitration take place in the franchisor’s home city, which can be a significant cost to franchisees.
In some cases, it is necessary to have a court decide on an answer to your problem. This is where it is particularly important to understand what is stated in the contract. Can you afford litigation? Will you be required to litigate in the jurisdiction where your business is located, or must you file suit in the state or country where the franchisor is located? This may vary, so make sure you are aware of the contract terms before you sign the contract.
Another method of dispute resolution is mediation. A mediator will facilitate the process and help both sides clarify their arguments, but will not make a judgment on the matter. The franchisor and franchisee will resolve the dispute themselves, making all of the major decisions together. Therefore, none of the decisions made are binding.
The difference between arbitration and mediation is that an arbitrator renders a decision which must be followed, while a mediator shuttles between the two parties, attempting to discern their needs and ultimately bring them together while suggesting creative conclusions. Mediation should be used only if you wish to continue operating as a franchisee.
Important Questions to Ask Present or Former Franchisees
Call and visit several branches of the franchise. It is important to see how they operate. Be considerate of the franchisees you talk with. They do not have to talk with you and it would be unfair to expect them to spend time with you during their busiest hours. Explain who you are and ask when would be a good time for them to talk with you. Have questions ready when you speak with them.
- Why did you select this particular franchise system over others in the same type of business?
- What was your employment background prior to becoming a franchisee?
- Did you get the training, quality products and support you paid for and were promised? Did the promised training take place when you needed it and did the training prepare you to compete with other businesses providing similar products or services?
- What problems did you encounter with the franchisor, the site, establishing your business and how did the franchisor respond to problems?
- How would you describe your overall franchisor/franchisee relationship?
- Is there a franchisee association or advisory council? Was there some incident or problem that caused the franchisees to band together? How long has the association existed? Who controls the association, the franchisees or the franchisor? What current issues are being dealt with? Is there a meeting scheduled that I could attend?
- What is your opinion about how competitive your franchise is with similar businesses? What, if any, trends do you see in the industry, in the franchisor’s business, and in your particular market area?
- Are there any other franchisees or former franchisees whom you might recommend I contact?
- How often have you found it necessary to refer to your franchise agreement after your business opened? Did the agreement provide the answer to your questions? What do you wish the agreement had included? If many franchisees are turning frequently to their agreements to solve problems with the franchisor, the franchisor/franchisee relationship may not be a healthy one.
- Consider asking a cooperative franchisee if you could work with her/him for a period of time for free before you commit to buying your own franchise.
- If the person is a former franchisee:
- Why did you leave the franchise system?
- Did the franchisor cooperate in helping you sell your franchise?
- Do you own any other franchise or would you buy a franchise from a different franchisor?
- If there was a termination or nonrenewal, did the franchisor explain why and provide a reasonable opportunity for you to cure the problem?
CONSIDERATIONS IN PURCHASING A FRANCHISE
Many people dream of being an entrepreneur. By purchasing a franchise, you often can sell goods and services that have instant name recognition and can obtain training and ongoing support to help you succeed. But be cautious. Like any investment, purchasing a franchise is not a guarantee of success.
THE BENEFITS AND RESPONSIBILITIES OF FRANCHISE OWNERSHIP
A franchise typically enables you, the investor or franchisee, to operate a business. By paying a franchise fee, which can be very expensive, you are given a format or system developed by the company (franchisor), the right to use the franchisor’s name for a limited time and assistance. For example, the franchisor may help you find a location for your outlet, provide initial training and an operating manual and advise you on management, marketing and personnel. Some franchisors offer ongoing support such as monthly newsletters, a toll free telephone number for technical assistance and periodic workshops or seminars.
While buying a franchise may reduce your investment risk by enabling you to associate with an established company, it can be costly. You also may be required to relinquish significant control over your business, while taking on contractual obligations with the franchisor.
Below is an outline of several components of a typical franchise system. Consider each carefully.
In exchange for obtaining the right to use the franchisor’s name and its assistance, you may pay some or all of the following fees.
Initial franchise fee and other expenses. Your initial franchise fee, which may be non-refundable, may cost several thousand to several hundred thousand dollars. You may also incur significant costs to rent, build and equip an outlet and to purchase initial inventory. Other costs include operating licenses and insurance. You also may be required to pay a grand opening fee to the franchisor to promote your new outlet.
Continuing royalty payments. You may have to pay the franchisor royalties based on a percentage of your weekly or monthly gross income. You often must pay royalties even if your outlet has not earned any income during that time. In addition, royalties usually are paid for the right to use the franchisor’s name. So even if the franchisor fails to provide promised support services, you still may have to pay royalties for the duration of your franchise agreement.
Advertising fees. You may have to pay into an advertising fund. Some portion of the advertising fees may go for national advertising or to attract new franchise owners, but not to target your particular outlet.
To ensure uniformity, franchisors typically control how franchisees conduct business. These controls may significantly restrict your ability to exercise your own business judgment. The following are typical examples of such controls.
Site approval. Many franchisors pre-approve sites for outlets. This may increase the likelihood that your outlet will attract customers. The franchisor, however, may not approve the site you want.
Design or appearance standards. Franchisors may impose design or appearance standards to ensure customers receive the same quality of goods and services in each outlet. Some franchisors require periodic renovations or seasonal design changes. Complying with these standards may increase your costs.
Restrictions on goods and services offered for sale. Franchisors may restrict the goods and services offered for sale. For example, as a restaurant franchise owner, you may not be able to add to your menu popular items or delete items that are unpopular. Similarly, as an automobile transmission repair franchise owner, you might not be able to perform other types of automotive work, such as brake or electrical system repairs.
Restrictions on method of operation. Franchisors may require you to operate in a particular manner. The franchisor might require you to operate during certain hours, use only pre-approved signs, employee uniforms and advertisements, or abide by certain accounting or bookkeeping procedures. These restrictions may impede you from operating your outlet as you deem best. The franchisor also may require you to purchase supplies only from an approved supplier, even if you can buy similar goods elsewhere at a lower cost.
Restrictions of sales area. Franchisors may limit your business to a specific territory. While these territorial restrictions may ensure that other franchisees will not compete with you for the same customers, they could impede your ability to open additional outlets or move to a more profitable location.
TERMINATIONS AND RENEWAL
You can lose the right to your franchise if you breach the franchise contract. In addition, the franchise contract is for a limited time; there is no guarantee that you will be able to renew it.
Franchise terminations. A franchisor can end your franchise agreement if, for example, you fail to pay royalties or abide by performance standards and sales restrictions. If your franchise is terminated, you may lose your investment.
Renewals. Franchise agreements typically run for 10 years. After that time, the franchisor may decline to renew your contract. Also be aware that renewals need not provide the original terms and conditions. The franchisor may raise the royalty payments, or impose new design standards and sales restrictions. Your previous territory may be reduced, possibly resulting in more competition from company-owned outlets or other franchisees.
BEFORE SELECTING A FRANCHISE SYSTEM
Before investing in a particular franchise system, carefully consider how much money you have to invest, your abilities and your goals. The following checklist may help you make your decision.
How much money do you have to invest?
How much money can you afford to lose?
Will you purchase the franchise by yourself or with partners?
Will you need financing and, if so, where can you obtain it?
Do you have a favorable credit rating?
Do you have savings or additional income to live on while starting your franchise?
Does the franchise require technical experience or relevant education, such as auto repair, home and office decorating, or tax preparation?
What skills do you have? Do you have computer, bookkeeping, or other technical skills?
What specialized knowledge or talents can you bring to a business?
Have you ever owned or managed a business?
What are your goals?
Do you require a specific level of annual income?
Are you interested in pursuing a particular field?
Are you interested in retail sales or performing a service?
How many hours are you willing to work?
Do you want to operate the business yourself or hire a manager?
Will franchise ownership be your primary source of income or will it supplement your current income?
Would you be happy operating the business for the next 20 years?
Would you like to own several outlets or only one?
SELECTING A FRANCHISE
Like any other investment, purchasing a franchise is a risk. When selecting a franchise, carefully consider a number of factors, such as the demand for the products or services, likely competition, the franchisor’s background and the level of support you will receive.
Is there a demand for the franchisor’s products or services in your community? Is the demand seasonal? For example, lawn and garden care or swimming pool maintenance may be profitable only in the spring or summer. Is there likely to be a continuing demand for the products or services in the future? Is the demand likely to be temporary, such as selling a fad food item? Does the product or service generate repeat business?
What is the level of competition, nationally and in your community? How many franchised and company-owned outlets does the franchisor have in your area? How many competing companies sell the same or similar products or services? Are these competing companies well established, with wide name recognition in your community? Do they offer the same goods and services at the same or lower price?
Your Ability to Operate the Business
Sometimes, franchise systems fail. Will you be able to operate your outlet even if the franchisor goes out of business? Will you need the franchisor’s ongoing training, advertising or other assistance to succeed? Will you have access to the same or other suppliers? Could you conduct the business alone if you must lay off personnel to cut costs?
A primary reason for purchasing a franchise is the right to associate with the company’s name. The more widely recognized the name, the more likely it will draw customers who know its products or services. Therefore, before purchasing a franchise, consider:
The company’s name and how widely recognized it is. — If it has a federally registered trademark.
How long the franchisor has been in operation.
If the company has a reputation for quality products or services.
If consumers have filed complaints against the franchise with the Better Business Bureau or a local consumer protection agency or a state governmental agency.
Training and Support Services
Another reason for purchasing a franchise is to obtain support from the franchisor. What training and ongoing support does the franchisor provide? How does their training compare with the training for typical workers in the industry? Could you compete with others who have more formal training? What backgrounds do the current franchise owners have? Do they have prior technical backgrounds or special training that helps them succeed? Do you have a similar background?
Many franchisors operate well-established companies with years of experience both in selling goods or services and in managing a franchise system. Some franchisors started by operating their own business. There is no guarantee, however, that a successful entrepreneur can successfully manage a franchise system.
Carefully consider how long the franchisor has managed a franchise system. Do you feel comfortable with the franchisor’s expertise? If franchisors have little experience in managing a chain of franchises, their promises of guidance, training and other support may be unreliable.
A growing franchise system increases the franchisor’s name recognition and may enable you to attract customers. Growth alone does not ensure successful franchisees; a company that grows too quickly may not be able to support its franchisees with all the promised support services. Make sure the franchisor has sufficient financial assets and staff to support the franchisees.
Shopping at a Franchise Exposition
Attending a franchise exposition allows you to view and compare a variety of franchise possibilities. Keep in mind that exhibitors at the exposition primarily want to sell their franchise systems. Be cautious of salesmen who are interested in selling a franchise in which you are not interested.
Before you attend, research what type of franchise best suits your investment limitations, experience and goals. When you attend, comparison shop for the opportunity that best suits your needs and ask questions.
Know How Much You Can Invest
An exhibitor may tell you how much you can afford to invest or that you can’t afford to pass up this opportunity. Before beginning to explore investment options, consider the amount you feel comfortable investing and the maximum amount you can afford.
Know What Type of Business is Right for You
An exhibitor may attempt to convince you that an opportunity is perfect for you. Only you can make that determination. Consider the industry that interests you before selecting a specific franchise system. Ask yourself the following questions:
Have you considered working in that industry before?
Can you see yourself engaged in that line of work for the next ten years?
Do you have the necessary background or skills?
If the industry does not appeal to you or you are not suited to work in that industry, do not allow an exhibitor to convince you otherwise. Spend your time focusing on those industries that offer a more realistic opportunity.
Visit several franchise exhibitors engaged in the type of industry that appeals to you. Listen to the exhibitors’ presentations and discussions with other interested consumers. Get answers to the following questions:
How long has the franchisor been in business?
How many franchised outlets currently exist? Where are they located?
How much is the initial franchise fee and any additional start-up costs? Are there any continuing royalty payments? How much?
What management, technical and ongoing assistance does the franchisor offer?
What controls does the franchisor impose?
Exhibitors may offer you prizes, free samples, or free dinners if you attend a promotional meeting later that day or over the next week to discuss the franchise in greater detail. Do not feel compelled to attend. Rather, consider these meetings as one way to acquire more information and to ask additional questions. Be prepared to walk away from any promotion if the franchise does not suit your needs.
Get Substantiation for Any Earnings Representations
Some franchisors may tell you how much you can earn if you invest in their franchise system or how current franchisees in their system are performing. Be careful. The FTC requires that franchisors who make such claims provide you with written substantiation. Make sure you ask for and obtain written substantiation for any income projections, or income or profit claims. If the franchisor does not have the required substantiation, or refuses to provide it to you, consider its claims to be suspect.
It may be difficult to remember each franchise exhibit. Bring a pad and pen to take notes. Get promotional literature that you can review. Take the exhibitors’ business cards so you can contact them later with any additional questions.
Avoid High Pressure Sales Tactics
You may be told that the franchisor’s offering is limited, that there is only one territory left or that this is a one-time reduced franchise sales price. Do not feel pressured to make any commitment. Legitimate franchisors expect you to comparison shop and to investigate their offering. A good deal today should be available tomorrow.
Study the Franchisor’s Offering
Do not sign any contract or make any payment until you have the opportunity to investigate the franchisor’s offering thoroughly. The franchisor is supposed to provide you with a disclosure document containing important information about the franchise system. Study the disclosure document. Take time to speak with current and former franchisees about their experiences. Because investing in a franchise can entail a significant investment, you should have an attorney review the FDD.
Investigating Franchise Offerings
Before investing in any franchise system, be sure to get a copy of the franchisor’s disclosure document called a FDD. 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.
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.
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. You should also be aware that there are many types of lawsuits that can be filed against a franchisor that is not listed in this section.
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.
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.
Financial and accounting advice.
Compliance with local ordinances, such as zoning, waste removal and fire and other safety codes.
Employee salaries and benefits.
It may take several months or longer to get your business started. In your total cost estimate, include 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.
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.
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 think the training might be insufficient to handle day-to-day business operations, consider another franchise opportunity more suited to your background.
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.
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 franchisor is required 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.
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.
Retain an attorney who deals exclusively with franchising lawyer 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 attorney 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?
Additional Sources of Information
Before you invest in a franchise system, investigate the franchisor thoroughly. In addition to reading the company’s disclosure document and speaking with current and former franchisees, you should speak with the following:
Attorney who deals exclusively with franchising
Investing in a franchise is costly. An attorney who deals exclusively with franchising 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.
Franchise contracts are usually long and complex. A contract problem that arises after you have signed the contract may be impossible or very expensive to fix. An attorney who deals exclusively with franchising will help you to understand your obligations under the contract, so you will not be surprised later. Choose an attorney who deals exclusively with franchising. It is best to rely upon your own attorney, rather than those of the franchisor.
Banks and Other Financial Institutions
These organizations may provide an unbiased view of the franchise opportunity you are considering. Your banker should be able to get a Dun & Bradstreet report or similar reports on 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.
A DISCUSSION OF FRANCHISING
Not so long ago, franchising was identified only with fast food outlets or a handful of other business establishments in our communities. It is no longer; franchising has become a major influence in today’s business.
Franchising is expected to continue to expand as a major force in the economy, as it allows the growing number of small businesses to affiliate themselves with a network of businesses with economic clout.
However, franchising can be complicated, legally dangerous and fraught with tangles and taps for the unwary.
What is Franchising?
The term itself does not refer to a particular products or a service. It refers to a method of doing business; it is the process by which a particular business relationship operates.
Franchising arrangements may differ widely, but some common characteristics exist. The franchise is generally a small independent business providing products or services, with a franchise agreement tying it to a network of other businesses. The knot tying these businesses together is called the franchisor, generally a corporation that distributes its goods or services through the franchise network.
The franchisee has the advantage of being tied to a larger business entity (which may have a respected, recognized name); it has the disadvantage of being obligated to pay the franchisor an agreed-upon sum and submit to a potentially wide range of controls.
Two themes run through the franchise relationship: use of a trademark, or service mark, and standardization.
Franchising is defined under two major categories:
- Package and product franchising;
- Business opportunity ventures franchising.
1. Package and Product Franchising
Package franchising includes many familiar businesses, such as fast food outlets and convenience stores. Package is an apt description since the arrangement can be comprehensive in governing the relationship between parties.
A first cousin of the package franchise is the product franchise, where the emphasis is more on provision of a distribution outlet for the franchisor’s product.
Both package and product franchises have these three elements:
- The franchisor grants the franchisee the right to provide goods or services using the franchisor’s trademark or service mark;
- The franchisor receives compensation for this right. It can take a combination of forms. For example, up front franchise fees and continuing royalties. The franchisor’s plan of operation is mandatory to varying degree; it can control such things as quality of products, hours of operation, advertising, training and methods of conducting business. The franchisor can provide, in fact, require, various forms of technical assistance.
- The licensee must pay the licensor $ 500 before or within six months after the business commences
2. Business Opportunity Ventures Franchising
A key ingredient of the package and product franchises is missing here; the requirement that the licensor’s trademark be used. Businesses handling vending machines and racks fall into this category. In other respects, this relationship looks similar, and, it is person where these criteria are met:
- The licensee (or investor) sells goods or services supplied by the licensor (or seller) or its affiliate or by a supplier with whom the licensee is required to do business.
- The licensor, or person controlling the supply of goods or services, must provide significant assistance to the licensee. This involves securing retailing outlets or accounts for the goods or services securing vending racks or machines for the product, or providing the services of someone who performs those acts.
- The licensee must pay the licensor $500 before or within six months after the business commences.
Typically, the licensor supplies the product and promises to provide a minimum number of outlets. Examples include vending machine routes and distributorships.
3. What Franchising Is Not
Some business relationships bear a resemblance to franchising, but they would not be defined as such. They include situations where:
- No payment of at least $500 is made to the franchisor.
- An established distributor adds products or services from another company (the €œfractional franchise€ exemption).
- An independent retailer leases space in a larger store (the leased department exemption)
- No written evidence exists to support the franchise cooperative.
- The business relationship is actually in the form of a cooperative.
- The relationship is actually between employer and employee.
- Organizations authorize the use of their trademark to all parties who comply with their standards and pay their fee.
What to Look For
The formal disclosures may not cover all items of interest to you; and they may be incomplete or even inaccurate. A prospective franchise must make independent inquiries about franchise opportunities. Start by asking the person who owns a franchise of the type you are considering. No one is more of an expert in that particular franchisor-franchisee relationship.
Another source of information on the franchise to be considered. It is advisable to obtain some basic financial data about the franchisor, including:
- The financial health and history of the company. Does it have a track record to make you comfortable? If the franchisor is financially sick, the franchisee will likely catch the same disease. Have your accountant help you here.
- The quality of the company Officers. They are not just names, they are the persons who have to make the business work. Do their background and experience give you confidence? If not, think twice about the relationship.
- The source of the company’s earnings. Remember that the franchisor can make money from the franchisee in several ways, including front-end franchise fees and royalties from sales. If the bulk of those earnings come from front-end fees, be cautious. Franchisors that make most of their earnings from royalties are more likely to be interested in the ongoing success of the franchisees’ businesses.
- The intrinsic appeal of the product or service. Forget the sales literature here. Think of yourself as a customer; how does the franchisor stack up against the competition? Is this a McDonald’s or a Burger Chef.
- The type and degree of training and field support provided by the franchisor. Since this is one of the primary reasons for affiliating with a franchisor, evaluate this area with a critical eye. Examine the scope, frequency, and quality of training guaranteed. Are additional costs involved?
- The types and frequency of advertising support. Look especially at national and regional advertising and plans for future campaigns. How much does the franchisee pay as a share for such advertising?
- The overall operating rules and restrictions on the franchisee.
These are a key part of the franchise relationship, designed to ensure uniformity or quality of the product or service. Ask yourself whether they are reasonable and sensitive to market conditions in your area.
Advantages and Disadvantages
When you go into business, you basically have three options: Start a new business, buy an existing business, or buy or start a franchised business. There is no right answer; there is only an appropriate answer, consistent with your personality, your circumstances and the market.
If you are seriously considering a franchised business, prepare a balance sheet€ of pros and cons. This involves looking at a combination of legal obligations and pragmatic business considerations.
Obviously, the time to examine this balance sheet is before you sign a franchise agreement; try to discover and avoid as many potential pitfalls as possible before you are locked into a legal relationship.
Your starting point is to understand the basic advantages and disadvantages of franchising. If you decide that franchising is for you, then get down to specifics- the specific business, the specific franchise agreement.
Some of the potential advantages and disadvantages of franchising
- You can use someone else’s good name, trademark, and credibility. This is a big advantage.
- You have the opportunity to buy not just a business but of the risk and guesswork from the process of opening up your own business.
- Even if you have only limited business experience, you can get advanced training and continuing business support from a company that can save you from learning the hard way, through trial and error. You have access to management expertise that would not be readily available to you as an independent small business.
- With some franchisors, you can expend relatively little capital and still establish a strong credit rating. In some instances, you may also receive financing help from the franchisor. This is not an act of charity on the part of the franchise and enhancing the financial reputation of the franchise operation.
- You can tap into technical expertise with regard to such things as site selection, facility design, and layout and business operations.
- You can benefit from national and regional advertising and publicity campaigns, all of which help pre-sell your product or service.
- You may be able to realize savings from quantity purchases of supplies, products, and services by the franchisor.
- You are not your own boss. You have a franchisor partner. He might be a very strong and opinionated partner, who will be involved even in the most minor details of your business. This partner may require you to conform to detailed operating plans; to handle all his products or services, even though you might not like all of them; and sometimes to make business decisions for the sake of the entire franchise network, even though they may not be best for you.
- In addition to sharing authority, you also share profits. That is part of the price you pay for all the potential advantages. Usually, this takes the form of a royalty or gross sales, thus, sometimes payment must be made whether or not you make a profit. To get a realistic idea of what the downside may be, prepare financial projections, with an accountant’s help, for several sales volume assumptions lower than the franchisor’s estimates. This helps you avoid potentially burdensome payments of under the franchisor’s estimates.
- Your ability to adjust to local market conditions may be limited. Remember that uniformity is one of the characteristics of franchise products and services. Thus, the franchisor may deny you the opportunity to tweak prices to meet the competition, or to refine your product line to satisfy local tastes.
- The franchise agreement may contain many details that favor the franchisor. After all, the franchisor is experienced in this business and understands it better than you. Numerous opportunities exist for the franchisor to gain an edge: required sales quotas, termination of franchise agreement, exclusive territorial rights, mandatory purchases of supplies and equipment from the franchisor.
- If the franchisor generates negative public or community relations, you share in it. Management scandal or a health scare are examples.
- Extra paperwork goes with a franchise business. Your franchisor partner wants a detailed knowledge of what you are doing and the results.
- Enforcing grievances against the franchisor may prove to be burdensome, even impossible. Terminating an unsatisfactory franchise relationship can be extremely time-consuming and difficult.
Caution: You should never sign a franchise agreement in a rush; and never sign it without having an experienced attorney review it in detail with you.
Some Basic Franchising Dangers
It is apparent that a considerable amount of potential protection and useful information is available, if you take advantage of it. This information is an important resource in sidestepping some of the franchising dangers.
Danger No. 1: Rushing into the deal. It is impossible to know too much, so study the documents thoroughly and talk to other franchisees.
Danger No. 2: Going it alone. Franchising is complicated, so ask for help from an attorney.
Danger No. 3: Reading the franchise agreement through rose-colored glasses. Do not try to put the best light on provisions in the contract; instead, imagine the worst case consequences under the explicit terms of the contract. Remember that honeymoons end quickly, even in business, and a happy divorce can be difficult to come by in the franchise business.
Danger No. 4: Dropping your guard. Legitimate franchisors comply with the rules and treat you professionally. Anyone who makes exorbitant promises, holds back on information about the franchisor or its officers, promises profits through chain sales or pyramid schemes, pushes you to act immediately, promises large income form work at home or spare time efforts, or uses names that sound like but are unconnected with nationally known businesses- these franchisors should put you on your guard instantly.
The Franchise Agreement
The document actually governing the franchisor/franchisee relationship is the franchise agreement. Franchise agreements can be quite lengthy, since the relationship has many elements. They should be clearly written. Although you attorney should review the document, you also should understand each provision. Following are typical provisions of a franchise agreement.
Terms of the Agreement
Most franchise agreements have a fixed term, with a provision for renewal. The franchisor wants the opportunity to review the relationship after a certain period of time. The franchisee wants to hold the franchise long enough to preserve his equity- the expenditure of time, effort and expense- and to coincide with his lease term. Of course, renewal is usually conditioned upon satisfactory performance by the franchisee. This point should be clearly spelled out.
Termination of the Agreement
Termination usually comes toward the end of the agreement, but it is discussed here since it can be a condition of the term of the agreement. Franchisors crank out standard contracts that probably favor their interests; a franchisor’s bargaining power is usually superior to a franchisee’s bargaining power.
Therefore, detailed provisions under which the franchisor may terminate the agreement are common. Keep in mind that performance by the franchisor in a timely manner is critical to the success of the franchisee. Similarly, detailed provisions under which you can terminate the agreement also need to be spelled out.
These normally include initial franchise fees, which may be made in a lump sum or installments; royalties, or service fees, which may be based on various factors but are often based on gross revenues, and miscellaneous fees, which can include such things as training fees, required product or service purchases, and advertising fees.
Rights of the Franchisee
The franchisee is allowed to use the franchisor’s trademark or service mark (and concurrently agrees to certain limitations on use of such marks). The franchisors may also stipulate requirements for maintaining the reputation of the trademark. The franchisee is also allowed to use trade secrets (secret recipes or other processes), but agrees to keep them confidential. Exclusive territorial rights for the franchisee may also be spelled out in this section, or in a separate section of the agreement.
Service by the Franchisor
The list can be long and varied; just make sure you understand what realistically to expect one the agreement is singed. Some typical examples:
- Standard specifications and plans for the facility, furnishings decor, layout, and signs;
- Pre-opening training programs;
- Opening supervision and assistance;
- The franchisor’s business operating policies and manuals;
- Marketing, advertising, and merchandising research data and advice;
- Consultation and advice from the franchisor’s field supervisors;
- Standardized accounting, cost-control, and other business systems;
- Site-selection assistance;
- Group purchasing programs;
- Continued operating assistance and consultation;
- Access to new products and services;
Location and specifications of the premises are important in some franchises and may be covered in detail. This section may set out the obligations of both franchisor and franchisee in choosing the site and completing lease or purchase negotiations. It may also set forth minimum requirement for the site itself and for the property lease.
Premises and Signs
Minimum requirements and uniformity in the appearance of the premises and signs are so important to maintaining the public perception of the franchise that they may be spelled out in some detail. The franchisor may also retain the right to initiate changes or improvements.
In addition to the premises and signs requirements, the franchisor may also stipulate requirements for:
- Hours of operation;
- Accounting and record-keeping;
- Authorized products and services;
- Compliance with laws;
- The franchisee’s degree of participation in the business;
- Employee qualifications, dress, appearance and behavior.
Training opportunities and requirements are an important part of the agreement. From the franchisee’s standpoint, ongoing training programs offer some assurance of continuing business growth and competence. From the franchisor’s standpoint, such programs validate the competence of the franchisee. This provision could cover what programs are available and required; specific contents of the programs; costs of the programs; fees for the programs; and whether the franchisor has any recourse in the event of the franchisee’s failure to participate or poor performance.
Advertising and Public Relations
The franchisor may want to maintain an active advertising and public relations program to bolster the entire franchise network. To maintain this program, the franchisee may be required to participate in (and contribute funds to) national or regional programs, or to conduct minimal local advertising or public relations.
Purchases of Goods and Services
To help maintain quality and uniformity, the franchisor may require that it be the source of goods and services; or, Certain restrictions may be placed on suppliers to be used. This provision may also cover participation in group purchasing programs.
Record-keeping and Reporting
Reference was made earlier to paperwork requirements in operating a franchise, and this is the provision where you probably will find them. The requirements enable the franchisor to assure that the franchisees are holding up their end of the deal, and provide an early warning system if problems develop. These warnings also benefit the franchisee.
Other provisions may deal with: Ability of the franchisee to transfer the franchise; how to handle contract disputes; right of entry and inspection by the franchisor; and non-competition restrictions on the franchisee.
As you can tell from the foregoing materials, the checklist for evaluating a franchise opportunity can be very long. It should cover the pros and cons of operating a franchised business; the record and reputation of the franchisor; the record and reputation of the product or service; the market area under consideration; and the franchise agreement itself.
Always remember to have your attorney and business adviser help you review all the following areas. There are 17 key questions to ask about a franchise:
- Have you checked the franchisor out with franchisees and the Better Business Bureau?
- How long has the company been in business, and what is its track record?
- How about the principals in the company? What is their record and reputation?
- What are the company’s financial strengths, and from where does it derive most of its income?
- What are its plans for future development, and how selective is it in choosing franchisees?
- What is the product’s reputation and quality? Is it a fad, or does it have staying power?
- How does the product stack up against the competition?
- Is it priced and marketed competitively?
- Do you have an exclusive territory? Is it clearly defined?
- What are the opportunities for growth in the area? What is the competition?
- Does the franchise agreement seem fair, or is it one sided? Do both parties benefit?
- Do you know the full cost of obtaining and operating the franchise?
- How can the franchise agreement be terminated?
- Are the operating controls reasonable or burdensome?
- Are the services you receive from the franchisor adequate and useful? Are they clearly spelled out?
- What kind of support will you receive in opening and operating the franchise?
- Is financing help available from the franchisor?