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Scam Alert

How do you spot a franchise scam?

Back before California started the move to regulate the offering of franchises during the 1960s, and long before the Federal Trade Commission published its franchise rule at the end of the 1970s, buying a franchise could be as risky as putting your 401(k) into Enron or Talk magazine. Before disclosure, the franchise industry suffered from companies that had lots of hype, little substance and an absence of management talent. What they did have were great salespeople.

Some of the franchise offerings back in the '50s, '60s and '70s were for companies that had never opened a single unit before selling franchises. Some had management that had never been in the business but did have experience in bankruptcies, litigation and problems with regulators. Some of the companies were so weak financially that they needed the proceeds from franchise sales to meet payroll or to pay for the franchise ads the prospects responded to. There were even stories of franchisors whose furniture was being repossessed in one room while the prospective franchisee was in the other. Just because the government regulates something, though, doesn't mean things are always better. While not common, there are still franchise offerings today that are such poor opportunities, they would have fit in nicely with the other bandits back then.

How is that possible? In part, due to the ease of developing a franchise system, the lack of consistency in franchise regulations and to the way franchises are sold. But the primary reason franchise scams still exist today is there are still individuals who don't do their homework, and end up investing in these "opportunities." They allow the bad opportunities to remain in business.

There's no single indicator of a franchise scam, and you need to weigh all the indicators in making your assessment. Just remember, hundreds of superior franchise opportunities are available today, and there's absolutely no reason to settle for less than the best opportunity in your investment range. There's little you can do about the ease of development or the inconsistency of regulations, but you can protect yourself by doing your homework.

The disclosure document is a wonderful tool for prospective franchisees to have. At your first personal meeting with a franchisor, that franchisor is required to provide you with one. Some franchisors will even mail you a disclosure document; others post them on their Web sites.

Even before you get to the point of contacting a franchisor, you can get a sense of whether their opportunity is for real. Go online and research news stories about the company and the industry. If the company is public, look at the information available from their SEC filings. Visit their Web site and get information about their consumer offering as well as their franchise offering. Learn what you can about their management and thoroughly research their background. Compare the company to its competition-both franchised and non-franchised. Locate some of their stores and speak to existing franchisees. Then, when you're satisfied, contact the company.

When you first contact the company, ask them about the process they use in selecting franchisees. If you get the sense that they don't select franchisees but are in the business of selling franchises, that's your first indication the franchise is risky.

Remember, a franchise system is only as strong as its brand, and that brand rests to a great extent on how well the other franchisees in the system perform. If the franchisor lets anyone who has money in the system and does not have selection criteria, then your investment will probably be at risk.

If the company is willing to "sell" you a franchise and doesn't require you to visit with them at their company headquarters so you can perform a thorough evaluation of them and they can perform a thorough evaluation of you, that's another sign of a poor franchise system. If the salesperson you're talking with isn't an employee but an outside sales broker, that's even a stronger indication. Remember, unless you buy the franchise, the broker doesn't earn any money. And, since he isn't an employee of the franchise system, he doesn't risk much more than the chance to earn a future commission check if he recruits franchisees destined for failure.

When you visit the franchisor's headquarters, meet as many of the franchise support people as you can. Assess whether they have the experience to do their jobs. Make sure they're required to provide you with the level of support you expect. Take a look at the condition of their offices. Do you get the feeling of success or impending doom? Do all the company's resources seem to go into marble and brass, or does the company seem to be investing in computers, personnel, training programs and other components of support?

Be prepared to thoroughly analyze your disclosure document. If you're still interested after you read the company's information, engage a qualified franchise attorney, consultant or accountant to help you in conducting your due diligence. Franchise salespeople or brokers work for the franchisor. No matter how friendly or professional they may be, you shouldn't rely solely on their advice.

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