Doing your due diligence before buying a franchise involves some detective work. Here's how to uncover what you need to know.
When Chad and Rhone McCall relocated to Austin, Texas, in January 2007, they were looking for a business to buy. The couple, both 36, checked out existing enterprises before finding a franchise opportunity that provided services to senior citizens. Intrigued, they set out to unearth everything they could about two competing franchises with senior-care offerings. BrightStar Healthcare, a relatively new franchisor, had fewer than 30 franchisees--so the McCalls decided they were going to contact them all.
"We talked to all but one or two," says Chad. "The BrightStar franchisees were very interested in sharing the positive experiences they'd had with corporate. That was not the case with the other franchise, where franchisees were less happy and less willing to make themselves available to talk."
The deal was clinched after the McCalls attended both franchisors' "Discovery Days," where they met with managers at the companies' headquarters. At the BrightStar meeting, they visited the corporate office and spent half a day with a full-time salesperson calling actual customers and prospects. The process gave the McCalls a chance to immediately experience a typical day as franchise managers before making their decision. And they learned that their skills from past careers--investment and finance for Chad and health-care sales for Rhone--would be put to good use as BrightStar franchisees. The other franchisor offered no such hands-on opportunity.
The McCalls signed up for multiple territories and opened their first BrightStar franchise this month. And thanks to their extensive research process, they went into business armed with firsthand knowledge from BrightStar franchisees about every detail of their new business: what they could expect to gross, what their break-even point should be, likely real estate and labor costs, what support they could expect from the franchisor and, most important, how much revenue they needed to make a profit that would support them both.
Franchise experts say few franchisees do the type of sleuthing the McCalls did before signing up to own a franchise. Many give only a cursory look at the franchisor's disclosure document, the Uniform Franchise Offering Circular. (A new policy slated to go into effect this July calls for several updates to the document, including a new name: Franchise Disclosure Document. To read more about the proposed changes, check out "A UFOC Makeover.") That's a major oversight, as the UFOC offers key information, such as franchisor financials, lists of current and former franchisees, lawsuits, turnover rates, and in about a quarter of cases, earnings information.
"Often, [prospects] meet a lot of nice people at Discovery Day and say, 'Wow, they're great, they'll take care of me,' and boom, they're in," says Gordon Dupries, a franchise consultant and FranNet franchisee. Prospective franchisees who really want to find out about a franchise need to read its UFOC, ideally with the help of a franchise attorney. Remember, the UFOC represents the franchisor's point of view. The document should be used as a starting point to dig deeper and find out more from franchisees, vendors and customers of the franchise, says Lawrence "Doc" Cohen, past chairman of the International Franchise Association and a Great American Cookies franchisee.
Cohen advocates calling as many franchisees as possible--as well as former franchisees--and visiting several stores if the concept has a storefront. Says Cohen, "The key question [to ask] is, 'Knowing what you know today, would you buy it again?'"
Earnings, Part One: Comparing Apples With Apples
If earnings claims are made in the UFOC, Cohen says, they should be treated with skepticism. Remember, the claims are generally an average figure covering many different franchise types--ones with large and small formats, urban and suburban locations, longtime and new franchisees. What you really want to know is how a new franchisee of your type, and with your past experience, will fare.
That's what San Francisco-area couple Mark and Tina Hoenig set out to learn when they decided to relocate to Maui, Hawaii, in search of a better quality of life. Mark, 50, had a background in software sales, while Tina, 37, was an interior designer. When the pair zeroed in on a Puroclean water-damage repair franchise, Mark says he asked franchisees about their backgrounds to find people with sales and marketing expertise similar to his own. He learned that sales and marketing experience was often more advantageous than other factors such as age, contractor experience or an MBA. Says Mark, "I would talk to those [franchisees] who were like me and ask, 'What did you actually make the first year? [And] the second year?'"
Earnings, Part Two: Comparing Apples With Oranges
Mark compared several franchises in the field, learning that some were large and established with more than 1,000 franchisees, while Puroclean was newer and had fewer than 175 franchisees. The Hoenigs decided they preferred a more ground-floor opportunity. That way, it would be easier for them to introduce new technology.
Cross-comparing franchisors is an often-overlooked but important tool for finding the best franchise opportunity for your needs. Dayna Hess, 35, a franchisee of The Little Gym in Hasbrouck Heights, New Jersey, spent more than 18 months researching kids' gym franchisors and delving into several competitors' models before finally deciding on one she had loved when her daughter was enrolled in it.
A former sales and marketing executive, Hess says she found many differences--from required gym size to mandated color schemes--when comparing franchisors. She went beyond talking to franchisees and created her own cost estimates, researching the business as if she were opening it on her own. She looked into available retail spaces and rental rates, calculated labor costs, then estimated how many birthday parties she'd book and how many children she'd need to sign up to make a profit. When she opened her Little Gym franchise in 2006, Hess says, "I was dead-on with where I expected the numbers to be."
Dupries offers this tip for prospective franchisees looking to suss out costs: Ask the franchisor for a "vanilla shell" financial statement--a blank statement showing all the costs relevant to their business model. "Some people forget workers' comp costs or the water bill or transportation," he says. "So know what items are relevant."
Another way to get a quick rough estimate of franchisee sales is to extrapolate from the royalty income line of the franchisor's revenue statement included in the UFOC, says Mark Siebert, CEO of consulting firm iFranchise Group. If you know the royalty rate and the number of franchisees, and you can factor in the effect of departures and new sign-ups, then team with an experienced franchise accountant to get a back-of-the-envelope idea of average revenue.
Many prospects don't ask franchisors enough questions before deciding on a particular franchise, Dupries says. For instance, they may go through Discovery Day without asking to see the training or operations manuals that they're allowed to view at that point. Real estate is another important component that prospects frequently overlook. Dupries says many expect help from the franchisor in finding a location, but they don't always get it. Prospects should find out the average time it takes franchisees to find a location and how many franchisees are still looking six months or more after signing up. If necessary, scan announcements of sign-ups, then compare those figures with the current and previous years' store counts to get an estimate of how many are still searching for a storefront.
"Finding retail real estate is really tough in many [areas of] the country," Dupries says. "I had one fellow buy a franchise from me to operate while he waited to find a location for his sub sandwich concept. It had already been a year. Meanwhile, [his] living expenses were burning up cash."
Risk vs. Return
Worries about real estate and other overhead costs were factors in Armando DeMolina's decision to buy homebased franchise i9 Sports, which operates sports leagues for kids. He was excited about i9 but afraid of making an emotion-based decision, so he asked his wife, Margie, 37, and in-laws to research the company and play devil's advocates. But they gave i9 a thumbs up.
DeMolina focused his research on established i9 franchisees in his region of Broward County, Florida, asking them about costs, marketing plans, ramp-up time and more. After conversations with three local franchisees and a Saturday trip to watch a franchisee's league play, DeMolina, 40, had a solid picture of his expected role, as well as first-year revenue and profits. He also identified his biggest concern with the i9 model: that he would not be able to find available sports fields to hold his games. Franchisees helped him with strategies for overcoming that hurdle, and he was able to locate an underused local park to host his events. DeMolina opened in April last year and started his first season in September with a flag-football league. He signed up a capacity crowd of 186 kids--at $145 a head.
In-depth research pays off in situations like DeMolina's, says Siebert, because it helps identify possible risks and potential rewards. "Franchisees need to understand the concept of risk vs. return," Siebert says. "What you'll make is half of the equation. Measure your potential risk, not just potential reward, to understand if that risk is worth it." For more information on researching a franchise, visit entrepreneur.com/franchises.
A UFOC Makeover
Since 1979, the Uniform Franchise Offering Circular, or UFOC, has offered details about franchise operations to prospective franchisees. Before the UFOC was required, the franchising world was a playground for criminals who perpetrated numerous scams, ripping off prospective franchisees for millions, says franchise attorney David Kaufmann.
Since the UFOC's appearance, the industry has been virtually scandal-free, he notes, a sign that the UFOC is doing its job. "Now franchising is among the cleanest marketplaces in the U.S.," he says, "with franchisees who are among the most informed investors in the world."
If the UFOC has done a good job of keeping franchisors honest up to now, the situation should only improve this year when the document takes on a new set of regulations and a new name: Franchise Disclosure Document. Starting this July, the FTC will require franchisors to comply with the new disclosure law, which should make it easier for prospective franchisees to learn about franchisors. Among the highlights:
- The new law encourages more disclosure about earnings. Information about business costs can be freely disclosed, and financial results can be given in the FDD for a subset of franchisees without having to compare them to the entire chain.
- The FDD and other informational documents may be sent electronically--a change franchise attorney Andrew Caffey says will save franchisors money and encourage them to send information to prospects sooner.
- Franchisors must disclose contact information for all franchisee associations in their system, including ones approved by the franchisor as well as independent associations. Before, prospects had to find these on their own.
- If a franchisor's corporate parent guarantees the business or provides supplies to franchisees, its contact and financial information must be disclosed. Previously, corporate parents could go unmentioned.
- More lawsuit disclosure is now required. Franchisors must list suits they've filed against franchisees over the previous year, not just vice versa.
One caveat to the new rule: Franchisors don't have to make any disclosures to high net worth investors or those making a large-value investment in a franchise. The thinking is that these investors should have the resources to uncover the facts they want to know on their own.
Even with the improvements, prospective franchisees should be aware that the FTC doesn't check the information listed in franchisors' UFOCs. Within the bounds of the law, franchisors can and will paint the rosiest financial picture they can in their disclosures, says Mark Siebert, CEO of consulting firm iFranchise Group. Ultimately, it's still up to prospects to check out franchisor's claims. Says Siebert, "Any research materials the franchisor gives you should be taken with a grain of salt."
State of Affairs
Fourteen states (California, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Rhode Island, South Dakota, Virginia, Washington and Wisconsin) require franchisors to file or register with state officials before any offering activity can take place.
If you're in one of these states, it means franchisors have gone through the process of document review by state examiners and achieved registration, clearing an important hurdle in the life of the franchisor. Registration is no guarantee, of course. It simply means the company has taken an important step to comply with the law. It has filed its offering on the public record in that state and will remain under the annual scrutiny of state officials.
If you live in a registration state, you should call the appropriate agency to confirm that the company is currently registered to offer and sell franchises. --Andrew A. Caffey
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