How Risky is That Franchise? 5 simple tests to determine whether a franchise opportunity is too risky for you

There are some wonderful entrepreneurial opportunities available in today's market, but there are also increased risks because this is a tough economic climate in which to start a new business. In these times, your most important success skill may be knowing which franchises to avoid. As the old saying goes, "Success leaves clues." So does failure. You need to know how to spot the signs that point to problem opportunities so you can steer clear of them--and find better opportunities without wasting too much time.

In this article I will identify five simple tests you can use to quickly eliminate opportunities that carry excessive risk. Most of the information you'll need can be found in the company's Franchise Disclosure Document or through simple phone conversations you can complete fairly early in your due diligence process.

1. Unit Counts: This is the simplest test of all. Find out if the franchise company's number of operating units is growing, staying constant or declining.

Year-to-year units information is published in Item 20 of the FDD, and you can also get this data for hundreds of franchises from annual studies like Entrepreneur's Franchise 500. If the number of existing units is declining (regardless of any explanation you might receive), this is a huge red flag suggesting increased risk to joining the franchise.

2. Litigation Experience: You need to determine if there has been an increase in litigation between the franchisor and franchisees during the last couple of years. This information is contained in Item 3 of the FDD.

When franchisees are struggling or failing, you almost always see an increase in litigation because many people blame others whenever something doesn't work out. If you see a pattern of significant or increasing litigation (again, regardless of any explanation offered), this is a franchise you probably want to avoid.

3. Franchisor Financials: The franchise company is required to provide copies of their last three years' audited financial statements as part of their FDD. There are two things you want to learn from these financial statements, and you can get the answers very quickly.

First, you want to know if the franchisor is financially stable and has the resources to survive for the long run. Look for a financial statement indicating that the operation is profitable, that cash flow is positive and that capital reserves are strong.

Second, you want to make sure the franchise company does not have a rapidly increasing balance in the accounts receivable entry of the balance sheet. For most franchise companies, their largest accounts receivable are payments from their franchisees, so a rapidly increasing balance would indicate that their franchisees are struggling to pay their bills, and that's never a good sign.

4. Same-Store Sales Trends: This is also a simple factor to test, though it is not a required disclosure item in the FDD so you'll have to ask the franchisor for the information. What you want to ask is, "Have the same-store sales figures for your system gone up, down or stayed the same over the past couple of years?"

As you can imagine, most systems make every effort to increase the average performance of their units year over year because this provides a direct benefit to both the franchisee and the franchisor. If the sales trend for a company's units is flat or down in spite of these efforts, it is a clear indicator that the business volume is susceptible to economic downturns. That might not be an automatic disqualifier, but it is a clear warning sign that you should carefully investigate prior to moving forward.

5. Existing Franchisee Calls: You can get a very fast read on the attitude of the existing franchisees by randomly selecting a few for some quick preliminary calls.

Later in the process of investigation you'll want to spend quite a bit of time actually visiting with franchisees, but at this early stage in your research you just want to make a few short calls to take the general temperature of the franchisee base. You'll only need to ask two to three basic questions (How do you feel about the business? How have the past couple of years been? Knowing what you know now, would you do it again?) to get an impression of how things are going. Usually you'll see a clear pattern in the input after only a few of these calls. If your gut feeling is queasy or troubled, this is not the right franchise opportunity to pursue.

You'll usually have to complete a short form questionnaire with the franchise company in order to receive their Franchise Disclosure Document, but you can do this online in a few minutes. Once you have this document, you can complete all five of these tests in about an hour of your time. Doing so will greatly improve your chances of avoiding risky ventures and instead finding the right franchise opportunity for you.