Q: I'm considering buying an existing franchise operation from an acquaintance, and want to be careful. What should I look out for? How do I find out if the selling price of the business is reasonable? Does the franchise headquarters help out with such information? Do I need to hire an expert to assist me in this process?

A: We get asked about this topic all the time. In the next two installments of this column, we'll provide a roadmap for you to use as you go through this process.

In franchise terminology, the purchase of an existing unit in any system is referred to as a "resale." A resale can have some wonderful advantages over starting a new unit from scratch, but it can also be a nightmare. It's essential that you know what to seek and what to avoid in this process.

There are two types of franchise units offered for sale. The first group consists of successful operations that are making money. The other group consists of units that are not successful and are either losing money or barely making ends meet. Each group can potentially represent an opportunity for you, but the risk associated with the second group is substantially greater.

During your investigation, you must determine which group the unit falls into right now, and which group you think it will fall into after you've owned it for a while. Do not make the assumption that it'll stay in the same group it's currently in.

So how do you figure this out? The first question to ask yourself is "What is the motivation of the seller to sell the business? Why do they want to get out of the business, and why now?" Are they ready to retire, just want a change of pace, want to move to the Sun Belt? Or are they trying to escape an unbearable grind of 80-hour workweeks and constant employee hassles? Do they know about some future change that'll make the business less viable, and want to get out before it happens?

At the risk of appearing cynical, this is critical information. It'll probably take a little digging on your part to find the truth. Most sellers are smart enough to figure out that if they tell you the business is horrible, you're not going to want to buy it from them. They all dress up the business in its Sunday clothes for your inspection.

To be safe, you need to not only talk with the seller, but also to look at other sources of information. These other sources should include the franchisor as well as competing chains in the business or other industry sources.

From the seller, you need to find out:

  • What is their motivation for selling? Is their reason completely believable, and does it suggest anything negative in the future?
  • What has the financial performance of the franchise been over the past year or two? What are the trends, and what are the reasons given for the trends, particularly if the recent trend data is flat or negative?
  • What is the status of the employees of the franchise? How important is retaining key employees in successfully producing future projected results? How sure are you that they are going to stay?
  • If the franchise is site-dependent for success, what is the status of the real estate? Is there any challenge with the continuation of the lease? Is there any scheduled future road construction or other impairment that might affect otherwise positive results?
  • Do they know of anything that has not yet been disclosed to you that might hinder future performance of the business? Make sure to ask this question point blank--your attorney can include their answer in the purchase contract to protect you.

You should also go to the franchisor and conduct a complete investigation of the franchise just as if you were going to open a new unit from scratch. This exercise will give you valuable information to understand the business and to make sure you've asked the seller all the right questions.

Finally, you should ask the franchisor to confirm the information you're receiving from the seller, including specifics. They won't want to do this, because they don't want the legal liability, but they also don't want you to join their system under false pretenses. If the seller is not being honest with you, you'll often pick up clues from comments made by the franchisor.

This article focuses on the negative potential of the resale process. Don't misunderstand, though: Resales can be great, as long as you avoid a few basic mistakes. Invest the time to gather the relevant information, and you should be fine.

Next month, we'll answer your questions about how to place a reasonable value on the business and how to use advisors to protect your interests.

Read Buying an Existing Franchise, Part 2 of this article.