Scam Alert

The Red Flags

To determine whether a franchise is legitimate or a scam, answer the following questions:

Does the company have experience in the business being offered? I'm not talking about a related business, but the exact business. If the company has successfully been operating 4,000-square-foot stores, but the franchise opportunity is only for 1,000-square-foot stores, it's not the same business, no matter what they say. The same works in reverse-bigger is not always better. If you plan to open your franchises in Boston, but the only experience the company has is in Texas, it's not necessarily the same either. Have they done the necessary research to determine if the concept will work in Boston, or are you going to be their cold weather guinea pig?

Does management have a history of success? Does the franchise management know how to operate your business successfully? If not, what type of support are you likely to get? How frequently have they changed jobs? How well are their former companies doing? If they seem to move just before the sheriff or process server arrives, that's not a good sign. If they've worked with other franchisors, call franchisees of those systems and find out how well this management did in the past. A mix of executives with experience in the business and as successful franchisors is a great benefit to franchisees.

What is the financial condition of the company? Your investment will probably be significant. In some franchises, between debt and equity, your investment may exceed seven figures. Will you have more skin in the game than the franchisor does? Do they have a history of profitability? Are they earning their revenue from royalties and other continuing sources of revenue, or are they relying on the sale of the next franchise to make payroll? Even new franchisors need to have financial resources to meet their commitments.

Are you getting value for your money? Sure, if it's a well-known, established brand and the franchisees in the system are doing well, although this means you'll probably have to pay a sizeable franchise fee. But, if it's a new franchise system and your training lasts only a few days, are you paying more than it's worth? Paying $25,000 or more for a franchise fee when you're only getting one week of training from a new franchisor with limited experience, simply because they have a great brochure, doesn't make sense. Ask the other franchisees in the system if they got value for their money. Keep in mind, though, that franchisees new to the system may not even know yet.

What's the franchisor's litigation or regulatory history? Franchisors must disclose relevant litigation. Sometimes litigation is good. Any franchisor that enforces system standards will occasionally need to sue its franchisees. If they're able to still maintain a good relationship with their other franchisees, that type of litigation is an indication of a strong and responsible franchisor.

However, if there are pages upon pages of lawsuits from franchisees listed in the disclosure documents, that's not a good sign. You need to understand the basis for the lawsuits and make a decision based upon the facts. Your attorney can help you analyze the franchise litigation.

Is the franchise offered only in the non-registration states? Only 12 states review franchise documents and require franchisors to register their offering before getting permission to offer franchises in their state. In the rest of the United States, no regulator ever sees the franchise offering. Sometimes companies don't offer franchises in the registration states simply because those states don't fit into their geographic strategy. But, if a franchisor is offering franchises all over the United States except for the registration states, that may indicate their franchise wouldn't meet the requirements. Be very careful when you come upon opportunities that go out of their way to avoid the registration states. For more information as well as a complete list of franchise registration states, click here.

Finally, I have to admit some bias toward membership in the International Franchise Association, since I'm on the IFA's Board of Directors; was chairman of the professional arm of the association, the Supplier Forum, and have been active in the organization for more than 15 years. While active membership in the IFA doesn't guarantee a franchisor is a worthwhile investment, it's a strong indicator of a responsible franchise system. Active IFA members have access to training programs, networking opportunities and meetings in which they can exchange best practices with other franchisors.

These are just a few of the questions you need to assess in determining whether the franchise you're interested in is a scam. Your outside advisors can help you put aside your entrepreneurial eagnerness to get into the game and assist you in conducting a proper due diligence. Don't get into a franchise unless you have the assistance of a qualified expert. The franchise salesperson who has befriended you has the advantage of having been through the selling process hundreds of times. This is likely to be your first experience.

Michael H. Seid is managing director of Michael H. Seid & Associates, a West Hartford, Connecticut- and Troy, Michigan-based management consulting firm specializing in the franchise industry. Seid recently co-wroteFranchising for Dummies(IDG Books) with Wendy's founder, the late Dave Thomas.

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