Check It Out

The Paper Trail

The best document for investigation purposes--and it is head and shoulders above any other single source--is the Uniform Franchise Offering Circular (also known as the UFOC, the disclosure document or the prospectus). For a detective, it is the smoking gun, the name written in lipstick next to the body, and the Maltese Falcon all rolled into one. It is an information find that will be unparalleled in your investigation.

The UFOC is designed by lawmakers to provide prospective franchisees with all the information that is considered important in making an investment decision. It consists of 23 items describing various aspects of the program, copies of up to three years of the franchisor's audited financial statements, and a copy of the franchise agreement and each related contract you will be asked to sign.

A remarkable number of prospective franchisees don't bother to read the UFOC. Don't make that mistake. Sure, it's imposing: A comprehensive UFOC can run a few hundred pages in length. If you have no experience reading a balance sheet or a complex legal contract, put those sections aside for professional review later. You should read the narrative items and flag anything you don't understand. Pay particular attention to the following sections:

  • Item 1 offers a concise description of the franchisor and the franchise offering.
  • Item 2 gives the five-year business experience of the franchisor's key executives.
  • Item 3 is a list of material litigation against the franchisor over the past 10 years.
  • Item 4 notes whether the franchisor or any of the individuals described in Item 2 have been through a bankruptcy.
  • Items 5 through 7 list in table form the initial franchise fees, ongoing royalty fees, advertising contributions and an estimate of the franchisee's total investment.
  • Item 8 notes the restrictions placed on the supplier sources for any of the franchisee's purchases.
  • Item 11 details the franchisor's contractual obligations, advertising requirements and training program.
  • Item 19 contains information about the financial performance of the franchise, if the company elects to provide this information. If there is no information about performance in Item 19 (and only about 20 percent of franchisors provide this information), ask why. It may be that the performance story doesn't paint an attractive picture of the franchise.
  • Item 20 lists statistics about the growth or shrinkage of the franchise system and the names, addresses and telephone numbers of existing franchisees. You will also find the names and last known addresses and phone numbers of franchise owners who left the system in the prior fiscal year.

What warning signs in the UFOC does the investigator look for? There are several areas where problems may be revealed. If the company has a long track record of litigation involving claims made by franchisees or if there is a significant bankruptcy described, inquire further. If the franchisor has a small net worth, it should tell you that it may not have long-term financial stability. Compare the company's current assets to its current liabilities for a quick ratio of its financial health. If the ratio is less than 2:1, look deeper and talk to your accountant about it.

Is the company's principal trademark effectively registered with the U.S. Patent & Trademark Office? If it isn't, the system could face the risk that another user of the same or similar mark will create legal problems for the company. If the mark application is pending or the franchisor claims that its state trademark registration is completed and tells you that's sufficient, consult your lawyer about it.

Another red flag: the statistical charts in Item 20. What do they tell you about the number of franchisees who left the system in the past year? Be careful here--the numbers can lie. All franchise systems have turnover in ownership, and a departure from the system does not necessarily mean there was a business failure. If the turnover seems high, ask more questions of the franchisor. Find out the real story. The lists in Item 20 will be most useful when you begin interviewing franchisees in the system.

Carefully study the company's initial and ongoing fees; these will tax your operation, so make sure you understand how they work. Most franchise fees will be assessed according to the gross sales of your operation, without regard to the profits the business makes. This means even if you're losing money in the business, you're still expected to pay royalties.

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This article was originally published in the January 1998 print edition of Entrepreneur with the headline: Check It Out.

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