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Navigate the Paper Trail

You've found the franchise of your dreams. Now the real work begins. Find out what the FDD, financial statements and franchise agreement really mean.
January 24, 2001
URL: http://www.entrepreneur.com/article/36392

Through your preliminary research, you've found a great franchise opportunity. But before you sign on the dotted line, you need to find out if this opportunity is as good as it sounds. Your next step is to analyze it thoroughly to determine whether it's really worth buying.

Much of the information you'll need to gather in order to analyze a franchise will be acquired through the following:

Through this research, you want to find out the following:

Don't be shy about asking for the required materials from the franchisor. After all, they'll be checking you out just as completely. If they aren't, that should sound a warning bell. Another warning sign is if the franchisor asks you to sign a disclaimer stating you haven't relied on any representations not contained in the written agreement. Such a requirement could indicate that the franchisor doesn't want to be held responsible for claims made by its sales representatives.

The FDD

The FDD is a mother lode of investor information, designed to give prospective franchisees all the information relevant to the franchise offering. The FDD contains the facts that state and federal regulators consider important to your decision regarding whether to buy the franchise. The FDD is designed to protect you, the investor, and you'll find it enormously helpful.

The document is made up of three basic sections sandwiched together: first, 23 sections describing various aspects of the franchise program; second, a set of the franchiser's audited financial statements; and third, a copy of each form or contract you'll sign if you buy the franchise.

State and federal franchise laws require that a franchisor deliver a copy of this document to you at the first personal face-to-face meeting with you or 10 business days before the contract is signed or money is paid, whichever happens first. This means you may not receive an FDD simply by requesting it (although some franchisors will send one on request), but you should certainly receive a copy well before you're asked to pay money or sign a binding contract. Ask the franchisor for an FDD early in your investigation; it may save you a great deal of time.

The first fundamental mistake most franchise investors make is to put the FDD aside and not bother reading it. Sure, it can be a bit intimidating--some FDD documents are thick, bound minibooks--but they're not impenetrable. If you understand what you're looking for--the red flags that should alert you to investigate the business further--and focus on the key investment information, the FDD is an extremely useful introduction to the franchise program you're considering.

Key Items In the FDD

Not all the information in the FDD is enlightening or particularly useful, but you can dig out much that is. Look for this key information as you read:

The Financial Statements

One of the FDD's strengths is that it delivers three years of audited financial information about the franchisor. Item 21 of the disclosure document should include the balance sheet for the most recent fiscal year and an income statement, as well as changes in financial position for the most recent three years. These financial statements are audited reports prepared by a certified public accountant. Subsidiaries are allowed to use a parent's financial information, but only if the parent corporation will guarantee the obligations of the subsidiary franchisor.

The sample pro forma operating statement provides a forecast of projected sales and expenses that might be incurred by a franchisee in the geographical zone where the unit might be located. Very few franchisors provide this information or make any earnings claim. In part this is because such claims must be substantiated by backup data, according to the FTC.

Earnings claims must represent what the average franchisee can achieve, not what one unit made in the program. They can never guarantee that any franchise will achieve a stated level of performance. Data from nearby franchisees can be used, or data from franchisees in an area similar to yours from a demographic, socioeconomic or location standpoint.

The sample pro forma will be accompanied by a caution label required by the FTC. It contains the following caution: "These figures are only estimates of what we think you may earn. There is no assurance you'll do as well. If you rely on our figures, you must accept the risk of not doing as well."

Although many franchisors are reluctant to provide earnings projections, insist on seeing one. You'll need a realistic forecast that states what your income and expenses might be. Take caution to heart also. Don't simply rely on these figures as an accurate basis for projected income and expenses. Cross-check the data as much as possible. When interviewing other franchisees, ask them what their income and expenses are. In addition, talk to industry associations and independents involved in the type of business you will be purchasing.

Uniformity and the Franchise Agreement

The franchise agreement is the foundation on which your franchise is built. It gives both parties a clear understanding of the basis on which they're going to operate. It should ensure uniformity to protect the franchisee as well as the franchisor. Remember, your business is only as good as that same business down the street or in the next town. If people have a bad experience with another franchisee, the odds are they're not going to want to do business with you either.

There's an obligation on your part to sustain this uniformity. This agreement establishes standards of operation including what quality products you're going to use and what quality services you must provide. It eliminates future problems and has a deterrent value. A lot of problems can be avoided if you know that a certain activity would violate the franchise agreement. The company won't try to do something to you that it knows is a violation of the agreement. By the same token, you may not try to do something that you know is a violation.

The franchise agreement provides for remedies in the event of defaults. It outlines what will happen if you do something wrong, including the steps and notices the company must give you. After the company gives you this notice, how much time do you have and why? If you don't agree with the demands, what recourse do you have? The franchise agreement provides for all of this.

What Should the Franchise Agreement Include?

The following information is inherent to an agreement:

It states that you're a part of the franchise and have a certain fixed fee to pay as part of the consideration. It has location provisions. The company will have the right to approve sites. If the company desires, it will have the right to go on a direct lease. In some instances, your franchise agreement might even be tied to a lease directly. The company will determine what the plans and specifications of the general location should be, and will provide that your equipment conform to company specifications.

By the same token, the company has the responsibility to assist you in site and equipment selection and in the general layout of your business, so you can have every opportunity to succeed. That's part of the franchisor's obligation and is stated in most franchise agreements. The agreement will have a section covering the use of the proprietary market and the use of the franchise name. Franchisors will provide that you may not contest their right to the use of that name and will also provide that you must notify the franchisor if somebody else is using the franchisor's name in your area. The agreement will require that you conform to the operating manual and use the products, systems and supplies specified by the company.

Here we get into an area of trust. For example, a franchisor can't require you to buy a product that's available at a better price somewhere else. That's in violation of antitrust laws. These laws have become a great concern to franchisors, since some have gone out of business because they violated those laws and were sued by franchisees.

Franchise Agreement Provisions

Other provisions in the franchise agreement include:

For a franchisee, the short term can also be an advantage. With the short term, you can get out of the agreement and not pay a royalty. On the other hand, you may want to hold the franchisor to the agreement for a longer period of time. This is something you'll have to assess according to your interest in working with that particular franchisor.

Both parties have certain rights and duties on expiration or termination, and they'll be spelled out in a special section of your franchise agreement. Usually it will provide that on expiration or termination you must pay all the sums you owe the franchisor, cease using their name and, in some cases, give the franchisor the right to purchase the physical assets. There's often a provision that deals with the operation of the franchise upon the event of disability or death. The franchisor then has the right to operate the business.

This covers the basic considerations that you'll find in most franchise agreements. Again, we can't stress enough that you should have an attorney examine all documents closely. Most franchises are very capital-intensive, and you want to protect yourself as much as you can.

Obtain Professional Advice

After you receive the FDD, you must take another vital step to make the most of it: Find professional advisors to help analyze it. Unless you're experienced in reading financial statements and analyzing complex commercial contracts, the money it costs for the assistance will be well worth it.

Using the information in the FDD, a good accountant can put together a projection for your planned business and give you an educated guess about whether it will be profitable and how much money it may generate. Without a basic cash-flow needs analysis, you'll have no idea how much capital you'll need to run the business and no clue as to whether it will meet your income needs.

An attorney is invaluable in reviewing the FDD and the franchise agreement. The franchise agreement is usually quite long and complex--after all, it will govern a complicated commercial relationship over a long period of time. An experienced eye looking it over with your interests in mind can identify any essential points of negotiation. Your lawyer can also explain exactly what all that legalese means for you as a franchisee.

Source: The Small Business Encyclopedia, Start Your Own Business, Entrepreneur magazine and Entrepreneur's StartUps magazine.


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