There are some wonderful entrepreneurial opportunities available in today's market, but there are also increased risks because this is a tough economic climate in which to start a new business. In these times, your most important success skill may be knowing which franchises to avoid. As the old saying goes, "Success leaves clues." So does failure. You need to know how to spot the signs that point to problem opportunities so you can steer clear of them--and find better opportunities without wasting too much time.
In this article I will identify five simple tests you can use to quickly eliminate opportunities that carry excessive risk. Most of the information you'll need can be found in the company's Franchise Disclosure Document or through simple phone conversations you can complete fairly early in your due diligence process.
1. Unit Counts: This is the simplest test of all. Find out if the franchise company's number of operating units is growing, staying constant or declining.
Year-to-year units information is published in Item 20 of the FDD, and you can also get this data for hundreds of franchises from annual studies like Entrepreneur's Franchise 500. If the number of existing units is declining (regardless of any explanation you might receive), this is a huge red flag suggesting increased risk to joining the franchise.
2. Litigation Experience: You need to determine if there has been an increase in litigation between the franchisor and franchisees during the last couple of years. This information is contained in Item 3 of the FDD.
When franchisees are struggling or failing, you almost always see an increase in litigation because many people blame others whenever something doesn't work out. If you see a pattern of significant or increasing litigation (again, regardless of any explanation offered), this is a franchise you probably want to avoid.
3. Franchisor Financials: The franchise company is required to provide copies of their last three years' audited financial statements as part of their FDD. There are two things you want to learn from these financial statements, and you can get the answers very quickly.
First, you want to know if the franchisor is financially stable and has the resources to survive for the long run. Look for a financial statement indicating that the operation is profitable, that cash flow is positive and that capital reserves are strong.
Second, you want to make sure the franchise company does not have a rapidly increasing balance in the accounts receivable entry of the balance sheet. For most franchise companies, their largest accounts receivable are payments from their franchisees, so a rapidly increasing balance would indicate that their franchisees are struggling to pay their bills, and that's never a good sign.
4. Same-Store Sales Trends: This is also a simple factor to test, though it is not a required disclosure item in the FDD so you'll have to ask the franchisor for the information. What you want to ask is, “Have the same-store sales figures for your system gone up, down or stayed the same over the past couple of years?”
As you can imagine, most systems make every effort to increase the average performance of their units year over year because this provides a direct benefit to both the franchisee and the franchisor. If the sales trend for a company's units is flat or down in spite of these efforts, it is a clear indicator that the business volume is susceptible to economic downturns. That might not be an automatic disqualifier, but it is a clear warning sign that you should carefully investigate prior to moving forward.
5. Existing Franchisee Calls: You can get a very fast read on the attitude of the existing franchisees by randomly selecting a few for some quick preliminary calls.
Later in the process of investigation you'll want to spend quite a bit of time actually visiting with franchisees, but at this early stage in your research you just want to make a few short calls to take the general temperature of the franchisee base. You'll only need to ask two to three basic questions (How do you feel about the business? How have the past couple of years been? Knowing what you know now, would you do it again?) to get an impression of how things are going. Usually you'll see a clear pattern in the input after only a few of these calls. If your gut feeling is queasy or troubled, this is not the right franchise opportunity to pursue.
You'll usually have to complete a short form questionnaire with the franchise company in order to receive their Franchise Disclosure Document, but you can do this online in a few minutes. Once you have this document, you can complete all five of these tests in about an hour of your time. Doing so will greatly improve your chances of avoiding risky ventures and instead finding the right franchise opportunity for you.
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Comments:
Dr Bill that is a load of rubbish. When a franchisee fails he can be pursued for lost revenue amongst other opportunitits that the franchisor may find available depending how the franchisee reacts to going broke. At risk can too often be everything an investor owns. Harmony and core values are fine if you are looking for a wife but investors better look a lot deeper and a hell of a lot more carefully - with specialist help - or they might just doom their family and following generations.
Hi Mephistopholis, I have the same problem as you but a different franchise. I have bought a franchise now for almost three years and they have the 49%, and no matter how much profit the place makes the franchise states on financials that I am still making the same amount of money every month. I have paid more than the worth that it actually was suppose to. They don't provide financial statements with what we pay from our pocket and every year even though the sales are high I am always in debt. What happens in those circumstances in your suggestion? because it seems like you are knowledgeable in this area.
Having been a franchisee for ten years with Second Cup...I can tell you that if you are looking into getting in this franchise you should do you due diligence before you purchase. If anyone can show me that there is a provision of this business practice I would appreciate it. But if there is no such provision then just think of how many franchisees would e interested in renewing with Second Cup or better yet how many perspective franchisees would be interested in buying into a franchise? Furthermore, this information also impacts the financial institutions and suppliers that do business with the company and franchisees. If the franchisees are left hanging with financial obligation then think of the dominoes affect this has on everyone! Franchisees are having their right taken away to sell their café. As in my case Second Cup was in a position to sell the franchise to who ever they wish up to a year or maybe more in some cases prior to the end of the term and reap the profit of a new franchise fee and kick backs from the renovations. There are others who have had this happen to them but have not challenged Second Cup because of the head set "David and Goliath." Therefore, lies the question - Has the decision not to renew been made in good faith or can Second Cup do it arbitrarily? Section 3 of the Franchise Disclosure Act clearly states: Good Faith, Fair Dealing, and Reasonable Commercial Standards. Since there is no disclosure in the franchise agreement for this business practice mentioned above, this fact technically gives it the terminal value of holding the license a zero value. If you have had a similar experience or would like to share your thoughts write on my blog - Second Cup.
Why don't the franchisors themselves have any obligation under the law to disclose "churning" and unprofitability of units within the franchise system? This flaw in mandated government disclosure is ignored by you experrts. Why??
thanks for great news...
Reading FDD's is one piece of the equation...they're full of stats that can interpreted or mis-interpreted. Choose a franchise that is in harmony with your core values, one that inspires you and then give it all you've got. Worst case scenario you blow your savings and acquire valuable education to apply to your next business adventure.
One more observation: Never trust the veracity of articles such as this one written by somebody involved in franchise sales. I've heard that some franchise sales reps are paid as much as 50% of the franchise fee, by the franchisor. Where do you suppose their interests lie? They're certainly not an impartial third party.
Good suggestions but a few observations: 1. unit count growing A growing unit count may not indicate franchisee success. It could simply reflect successful churn (reselling failed franchises) and effective marketing. 2. litigation experience Most franchisors now include mandatory arbitration clauses in the franchise agreements. Arbitration records are not publicly accessible. Further, some disgruntled or failed franchisees may be allowed to exit, and paid compensation by the franchisor, for such things as misrepresentation. They may or may not show up as "litigation". 3. franchisor financials A ponzi artist can have good financial statements. What's most meaningful is not how much the franchisor is making but how are the franchisees doing? It's unlikely you'll be able to find an honest, unbiased, representation of that information. 4. same-store sales trends Could be a helpful indicator but equally important is profitability. Look at Burger King's $1 double cheeseburger promotion. It probably increased sales but franchisees said they lost money on it. 5. existing franchise calls Many franchisees won't say anything bad -- even if their experience is bad. That's because (1) they probably hope to sell theirs some day and don't want to foster or promote negativity and (2) if they say something negative, they may fear it will get back to the franchisor and could be problematic for them. Talking to former franchisees would be helpful but (1) a failed franchisee may be difficult to locate, (2) a failed franchisee may be emotionally drained and may not want to talk and (3) some franchisors, such as CertaPro Painters, may required departing franchisees sign a non-disclosure agreement, agreeing to never publicly say anything negative about the company.